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Can You Get 7% Per Year in Income with Only Moderate Risk?

|Includes:ACG, BAF, BTZ, HYG, IEF, KMP, NBH, Annaly Capital Management, Inc. (NLY), SHY, SPY, VNQ

With ten-year Treasury bonds yielding around 2%, many investors are looking for investments that can provide higher levels of yield. Barron’s just ran a cover story on this topic, titled:

"How to Get Safe Annual Payouts of 7%: Despite rock-bottom interest rates, you can still earn investment income of 7%-plus per year. How to keep money flowing during retirement."

But is it really possible to create a low-risk portfolio with a yield of 7% or more?

The prevailing low yields on Treasury bonds are encouraging many income-oriented investors to look beyond the relative safety of government bonds.  The big challenge for income investors is not simply to find high-yield assets but to find high-yield assets with tolerable levels of risk.

As of this writing, Portugal’s 10-year government bond yield is 10.93%, but this high yield reflects the bond market’s perception that there is substantial default risk for bondholders.  Similarly, the Barron’s article identifies a series of well-known yield-generating asset classes, but does not do much to help investors solve the real problem which is how to determine the risk levels of these high-yield assets.  The title of the Barron’s article is "How to Get Safe Annual Payouts of 7%," but the reader is left with the problem of determining the safety of building a portfolio out of these asset classes. We all know that junk bonds are yielding between 7% and 8%, but are these indeed "safe annual payouts" as the Barron’s article suggests?  The same question goes for REIT’s, another of the high-yield asset classes Barron’s proposes can be used to build safe high-yield portfolios.  The article also suggests leveraged bond funds as a candidate for safe income portfolios.  The same issues apply. The crux of the problem is that while yield is simple to obtain, estimating risk takes more effort.  Fortunately, there are objective, rational ways to quantify the risk in an asset class and (to a lesser extent) of an actively managed mutual fund.

In October of 2010,  I authored an article on this topic titled, "Yield vs. Risk" that appeared in Financial Planning magazine.  I have further developed this approach in a series of articles published in Advisor Perspectives.  When I look at the list of high-yield asset classes proposed for safe income in Barron’s, I am struck by the fact that some of them are anything but safe.  Vanguard’s REIT ETF (NYSEARCA:VNQ), lost 37% in 2008.  MarkWest Energy Partners (NYSE:MWE) lost more than 69% in 2008.  That does not mean that these are not good investments—many of them are, in my opinion.  The challenge is figuring out who they are great investments for.  Given that income investors tend to be older, and the Barron’s article’s subtitle makes it clear that the approach is aimed at people in retirement, are these really plausible investments?

Measuring Risk

The starting point for measuring risk in an asset class is a measure called implied volatility.  For a review of the concept, see the article linked above.  Suffice it to say for the moment that implied volatility is a standard measure of future risk potential in an investment and it is available from many data providers including Morningstar.  So, for example, if we wanted to look at the expected risk in Vanguard’s REIT ETF (VNQ), we could easily obtain this.  The implied volatility for VNQ from now until the middle of next year, is about 37% and the yield is 3.4%. For reference, the implied volatility for the S&P500 (NYSEARCA:SPY) over the same period is about 31% and the yield fromSPY is 1.96%.  So, while the yield from VNQ is considerably higher than that of the S&P500, the expected risk in VNQ is markedly higher than an investment in the S&P 500 Index.  Implied volatility really can be thought of as relative risk, and the implied volatility numbers are telling us that VNQ is riskier than the S&P 500.

When we move from discussing risk in a single security to estimating risk in a portfolio with multiple holdings, the problem is more difficult.  We need not only to project risk levels for each security but also to calculate how the different securities move relative to one another.  This can be accomplished using computer models called Monte Carlo simulation.

Building a Portfolio

To explore this issue further, I decided to build a portfolio using the list of investment alternatives proposed in the Barron’s article.

Obviously, I can only use the listed securities such as mutual funds, ETFs, and MLPs.  My goal was to create a portfolio with the lowest possible risk level that would yield at least 7%.  The process of building this portfolio was exactly the same as the approach presented in my 2010 article in Financial Planning (and linked above).  Along with the list of securities proposed in the Barron’s article, I included two government bond ETFs: SHY (short-term) and IEF (intermediate-term).  While both of these ETFs have low yields, they can help to control the overall portfolio risk level.

The process of building a portfolio is more complex than simply selecting a set of high-yield securities.  The portfolio needs to combine investments with relatively low correlation to one another in order to control risk.  I ran an optimizer using projected risk levels for each of the possible investments, constraining the maximum investment in any single security to 10% of the portfolio, and the resulting portfolio is shown below:

Name Fund Ticker



Expense Ratio

Annaly Capital Management NLY


15.1[HM1] %

AllianceBernstein Income Fund ACG




T. Rowe Price Emerging Markets Bond PREMX




Neuberger Intermediate Muni NBH




iShares High Yield Bond HYG




BlackRock Muni BAF




PIMCO Emerging Local Bond PELAX




Eaton Vance Income Fund EVIBX




Vanguard High Yield Tax Exempt Bond VWAHX




Kinder Morgan KMP



BlackRock Credit Allocation BTZ




Fidelity New Markets Income FNMIX




iShares 7-10 Year Treasury Bond IEF







iShares 1-3 Year Treasury Bond SHY







Model 7% Yield Portfolio

The portfolio has a yield of 7.1% and an expense ratio of 0.64%.  The projected and historical risk level of this portfolio is slightly less than the risk of a portfolio that is 50% allocated to Vanguard’s total stock market index (VTI) and 50% allocated to Vanguard’s aggregate bond ETF (BND).

Long-dated options on the S&P 500 suggest that the expected annualized volatility of the S&P 500 will be about 29% as of this writing.  When I calibrate my Monte Carlo simulations to reflect this level of volatility for the market, the projected volatility for the Model 7% Yield Portfolio is 15.5%.

I was somewhat surprised that it was possible to construct a portfolio with such a high level of yield at this relatively low risk level.  The high level of allocation to a risky asset such as NLY was something of a surprise.  The projected volatility of NLY is 26.7%.  There are also options traded on NLY and the implied volatility is right about 30%, so our projected volatility is very close to what the options market suggests.

Several of investment alternatives that were proposed in the Barron’s article are not included at any level of allocation.  Notable exclusions are Vanguard’s REIT ETF (VNQ), MarkWest Energy Partners (MWE), and Fidelity Real Estate Income (FRIFX).  The relative portfolio contribution to yield provided by allocations to these funds was not sufficient to justify the risk that they add to the portfolio.

A Low-Risk Portfolio With 7% Yield?

The Barron’s article that inspired this article is well worth reading.

Readers who may be unfamiliar with some of the asset classes discussed in this piece will find a good overview here.  My analysis usingMonte Carlo simulation suggests that it is, indeed, possible to build a fairly low-risk portfolio with a yield of 7%.  Accomplishing this feat requires a careful combination of these types of asset classes that can provide substantial yield.  You can still do quite well, however, even with a simple equal-weight combination of the assets in the portfolio I constructed shown above.  Allocating equally to each of the securities in that portfolio (6.25% allocated to each ticker) results in a portfolio with 6.2% yield and a very similar level of risk.

Given all of the uncertainties with the growth prospects of U.S. and global economies, it is hardly surprising that more attention is being given to asset classes beyond traditional stock and bond indexes that can be used to build a portfolio which generates substantial income at moderate risk levels.

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