Can You Create a 7% Yield Portfolio Focusing on Munis and Dividend Stocks?

Jan. 11, 2012 10:40 AM ET
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Portfolioist is a forum for intriguing ideas about long term investing and portfolio building. Pieces are either written or edited by Nanette Byrnes, an award winning financial and business writer, and the forum is made possible by the sponsorship of online brokerage Folio Investing and Folio Institutional. Nanette is an employee of Folio Investing.

In “Can You Get 7% Per Year in Income with Only Moderate Risk?” a blog I wrote back in the beginning of December, I analyzed a portfolio with 7% yield and “moderate” risk.  My analysis suggested that it was possible to create a portfolio with 7% yield and about the same level of risk as a portfolio allocated 50% to a total market stock index (VTI) and 50% to a broad bond index (BND).  My analysis also suggested that this portfolio had a projected volatility of 15% on a going forward basis. A helpful reader (see his comments by clicking on the article above and scrolling to the bottom of the page) found that this portfolio lost 25% from the peak to the trough for equities in the crash of 2008. MyPlanIQ  found that this portfolio lost a total of 18% for calendar year 2008.  To put this in context, the Vanguard 2010 Target Date Fund (VTENX) lost more than 20% in 2008.  Needless to say, we have experienced very volatile markets in recent years.

While the aggregate performance of the 7% yield portfolio in recent years has been very good, this does not change the fact that this asset allocation can exhibit substantial volatility. That’s why (as a rule of thumb) I estimate that the maximum loss that you can reasonably expect from a portfolio is about twice the estimated volatility. My projected volatility for the 7% yield model portfolio was 15% so the projected “worst case” loss over a twelve-month period was 30%.

Shortly after that piece was published, Burton Malkiel published an Op Ed piece in the Wall Street Journal suggesting that muni bond funds, and leveraged muni closed-end funds (CEFs) in particular, were an attractive alternative to Treasury bonds in the current low-yield environment.  I wrote a post that discussed these themes. Given the large response that we got to the original 7% yield article and to the analysis of Malkiel’s piece, I decided to design another portfolio with that same level of current yield and with an emphasis on the key asset classes that Malkiel likes for income investors: Leveraged muni funds and dividend stocks.

My analysis (which is certainly not exhaustive) resulted in the following portfolio:

(Source: Yield data from; asset allocations based on my calculations.)

This portfolio was created using forward-looking projections of risk, accounting for all of the correlations between asset classes.  As of this writing, the projected volatility of this portfolio is 14.6%. To put this in context, I also re-analyzed the risk of the original 7% yield portfolio and my current estimate for future volatility is 14.5%, a bit lower than the previous estimate. The decrease in projected volatility for the original portfolio is largely due to a decrease in forward-looking volatility derived from long-dated options on the S&P500.

Portfolio Design

This portfolio was designed in a similar fashion to the previous 7% yield portfolio.  I started with a universe of possible funds and other securities and used an optimizer combined with my Quantext Portfolio Planner (a Monte Carlo portfolio analysis tool that I designed) to try to identify a portfolio that has a 7% total yield with the lowest projected risk possible. I also constrained the maximum allocations to any single stock or fund on the basis of trial and error. My goal was to keep the maximum allocation to any single stock or fund as low as possible, without sacrificing yield. In the model portfolio presented here, the maximum allocation is 11%. My selection of individual stocks was fairly arbitrary. Malkiel mentions that dividend-paying stocks are an attractive way to boost yield, so I selected a small number of stocks with fairly high dividend yields on the basis of my experience.

Subjective?  Absolutely.

To gauge the relative attractiveness of dividend stocks and muni funds, I also needed to include some solid alternatives. For this reason, the possible universe of investments includes Treasury bonds, corporate bonds, high-yield bonds, and master limited partnerships (MLPs). I also included two muni ETFs to see how they would compare to the leveraged muni CEFs.  Finally, I included a REIT from the previous 7% portfolio.

In selecting the muni CEFs, I started with a fairly long list of these funds and gradually cut down the list.  I was looking for a small number of these funds to include as alternatives. I selected three of these funds that appeared to have the best diversification benefits among themselves and relative to the other assets under consideration for the portfolio.

In the final optimized portfolio (above), I have sorted the funds from highest allocation to lowest allocation.  Of the seventeen components of the final portfolio, the leveraged muni CEFs rank 2nd, 3rd, and 5th in having the highest allocations. The portfolio optimizer with forward risk projections agrees with Dr. Malkiel: leveraged muni CEFs look quite attractive if you are trying to maximize yield relative to risk.

As I mentioned in my earlier post on Dr. Malkiel’s Op Ed, the fact that Treasury bonds look fairly unattractive on a stand alone basis, does not mean that they are unattractive as one component of a diversified portfolio. The optimized portfolio above reinforces this conclusion. There is a 7.8% allocation in this portfolio to long-term Treasuries.

A Surprising Result

One result that surprised me somewhat is the low allocation to international bonds, one of the asset classes that Dr. Malkiel recommends for income investors.  The T. Rowe Price Emerging Markets Bond Fund (PREMX) ends up with a 5.2% allocation but other international bond funds that I experimented with simply did not seem to add appreciable value to the portfolio. This is not an exhaustive analysis by any means—my conclusion here is based on a limited sample of funds that I tested.

So what do we learn overall?

First, we affirm that it is possible to create a portfolio with a 7% yield with about the same risk as a portfolio that holds about 50% in stocks and a 50% allocation to bonds.  Second, the ability to create a 7% yield portfolio at a given level of risk is not terribly sensitive to the specific set of stocks and funds.  Third, we agree with Dr. Malkiel that leveraged muni CEFs are an attractive alternative for inclusion in an income-oriented portfolio.  The new 7% yield portfolio has quite different specific stock and fund selections and allocations than the original 7% yield portfolio.  This is as it should be.  Markets would have to be dreadfully inefficient if our projected portfolio results (yield vs. risk) were highly sensitive to the exact tickers and weights.  To put this in more technical terms, there are multiple alternative portfolios that can reach the frontier of risk vs. yield at a given level of risk.

Getting a 7% yield from a portfolio can be achieved in the current market (albeit, with meaningful market risk). This conclusion is notable given the very low yields of Treasury securities.  Whether such a portfolio or some variation on it makes sense for you depends on the specifics of your risk tolerance and the details of your specific needs.

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