A Sensible Income Investor Allocation Model

by: Adam Aloisi

If you are an income investor struggling to find your way in the current economic and interest rate environment, you are not alone. With cash earning nil and investment grade fixed-income barely keeping up with inflation, the hunt for yield has become a rather treacherous endeavor. And in my view, it will not get any easier. The global macroeconomic climate has become such that a rising rate scenario seems unlikely for the foreseeable future.

Thus, some difficult choices need to be made, especially by investors without significant alternative sources of reliable income (e.g. Social Security, pensions, etc...). Do you up the overall risk of your portfolio in search of greater yield, or do you cut back on expenses to compensate for the lower income that today's low rates afford?

The Model

While I'm normally not fond of investing blueprints, templates, rules of thumb, or age based allocation aphorisms, I'm going to make an exception and provide a diversified allocation model for income investors because I think it provides a solid basis for discussion about income need, risk, and allocation.

This model, in my opinion, is appropriate for moderately risk tolerant investors that provides a diversified, quality income stream that incorporates diversification, moderate chance, and a need for a roughly four percent blended yield requirement. I've listed a suggested percentage range for each asset category that I feel appropriate for optimum risk-adjusted yield in this market and a rough median yield expectation for each respective category given the current market.

  • Blue-chip Dividend-paying or Dividend Growth Stocks (35-55% allocation 3% yield): Given the low rate environment I feel most investors would benefit with roughly half of their portfolio in solid, blue chip equities. While this might be higher than what a typical retiree would allocate to the group, the low rate environment combined with the income growth potential of many issues makes the added risk plausible. I would recommend a wide diversity of holdings here including telecoms like Verizon (VZ), growth and income names with low dividend payout ratios like Apple (AAPL), and REITs like Tanger Factory Outlets (SKT).
  • Individual 5-10 yr. Laddered Near Investment Grade or Municipal Bonds (10-20% allocation 3% yield) Historically, because of hearty yield and relative safety, I would want to have a much higher allocation to this group, unfortunately the yields here do not justify a higher weighting. If you keep credit quality toward the high side I feel you can concentrate these holdings, whereas if you stray to slightly lower quality BBB, you should create a more diversified ladder. Keep maturities below ten years, because while I don't envision a quick, upward tick in rates, the risks for holding long-term paper in a rising rate environment are quite high.
  • High Yield/Emerging Market Bond ETFs or CEFs (10-20% allocation 7% yield) Lower grade corporate and sovereign debt raises the risk level of a portfolio, but with default rates still hovering around one percent, high yield is holding its own in this market, and frankly BB debt appears to be the sweet spot within the yield curve. Unless you have individual issue acumen, with the ability to analyze financial statements and forward business outlooks, I think a diversified portfolio in the form of a reasonably priced fund is a good choice. Consider high yield composite (HYG), Western Asset Emerging Markets Income (ESD), and Alliance Bernstein Global High Income (AWF). Again, these would be highly sensitive to a rising rate environment, so keep a close eye on them.
  • MLPs or MLP Funds (5-15% allocation 6% yield) Because limited partnerships are almost exclusively found in the energy sector, this group entails much more risk than other spaces. However, the yields are attractive and businesses appear strong. Considerations include Kinder Morgan Partners (KMP), Buckeye (BPL), and amusement park operator Cedar Fair (FUN).
  • mREITs and other ultra high yield stocks (5-10% allocation 10% yield) While mortgage REITs have become a widely held vehicle for income recently, I would advise caution here and in other investments yielding better than 10%. mREITs are typically highly levered entities and the risks of a sudden payout reduction or capital structure collapse are real, albeit unlikely. And not all are created equal; substantial due diligence should be undertaken. Examples here are Annaly (NLY) and American Capital Agency (AGNC), although a diversified approach in the form of index fund (REM) is probably most prudent. Oil tanker entities, e.g. Teekay (TNK) & Nordic American (NAT) and business development companies (BDCS), e.g. Apollo (AINV), and Prospect Capital (PSEC) are other considerations in the ultra high-yield space, but like mREITs, should also be closely monitored.
  • Cash/CDs (5-10% allocation 1% yield) Last but not least I include a nominal cash allocation. This is your emergency stash and because it's earning zip, I would keep it minimal unless you have reason to believe in a major forthcoming recession, depression, or other market shaking event.

I omitted option selling, not because I don't think it's a good choice for income, but simply because most investors don't have the time or desire to incorporate an option strategy into their portfolio.

The above model provides a solid foundation for an income investor. If you take the midpoint allocation and assumed yield for each category, you come up with a blended yield of 4.3 percent. While this may not seem like a lot on the surface, with the diversification that the model affords, it provides a healthy return without the taking of extraordinary risk. And my yield assumptions are on the conservative side, higher current yield can easily be found in each category.

Further, investors needing more income and/or are more comfortable with taking on risk can decrease allocation to the lower-yielding categories and increase allocation to the higher-yielding ones, creating a higher blended yield.

The low-rate environment coupled with an unsteady global economy calls for a diversified approach to generating cash flow. I believe utilizing a mix of securities across a variety of investment categories is a prudent strategy for income investors. I welcome your thoughts.

Disclosure: I am long VZ, ESD, SKT, AWF.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.