For Income-Focused Investors, Now Is the Time for Bonds

In 2021, I published research in the Journal of Wealth Management exploring how an investor with an income focus should vary the allocation between stocks and bonds based on the current yield environment. I found that equities could be especially attractive for income investors when dividend yields exceeded bond yields, and vice versa.

At the time, that would have suggested a relatively aggressive portfolio allocation, with 60% or more in equities. My, how times have changed.

Today, with bond yields exceeding dividend yields by approximately 300 basis points, the emphasis in portfolios for income-focused investors should likely be on bonds, especially given expectations around decreasing yields.

While portfolio risk levels may remain typically static for regular investors, for income-focused investors it's important to consistently revisit allocations to ensure they are efficient given the current market environment.

Revisiting the Research

Certain investor cohorts, such as retirees, often have a clear preference for income from a portfolio. For example, the Society of Actuaries found in a 2015 survey that only 17% of pre-retirees planned to spend down their wealth in retirement, while 32% planned to withdraw only earnings and leave principal intact (while 27% of pre-retirees planned on growing financial assets and 23% had no plan).

When it comes to generating income, an investor should theoretically be indifferent between liquidating capital and yield, since they have similar effects on portfolio value. In reality, income-focused investors typically have a strong preference against selling down principal despite the potential inefficiency of the approach and implications on the available opportunity set of investments. These investors often have a strong dislike of annuities, despite annuitization widely considered to be the most efficient approach for generating retirement income (and hedging longevity risk).

I've explored how to build efficient income portfolios, in research published in the Journal of Portfolio Management in 2015 and, more recently, for a piece published in the Journal of Wealth Management in 2021. The key contribution of that piece was exploring how the potential benefits of investing in stocks and bonds can vary for income-based investors based on the yield environment.

The yield environment has varied dramatically over time, which has important implications for income-focused investors.

In the Journal of Wealth Management research, I explored how income-focused investors should have changed their allocation to equities using historical data from 16 countries from 1870 to 2019, primarily leveraging the Jordà-Schularick-Taylor Macrohistory database.

The allocations were determined using an approach based on the Constant Relative Risk Aversion utility function focused primarily on the income generated by the portfolio. This is different from other approaches, such as mean variance optimization, that include both income return and price return components (i.e., focus on total return).

I found that optimal equity allocations for income-focused investors should vary both depending on the yield environment and the preference around income stability by the investor.

Contrasting yield differentials with optimal equity allocations suggests that the optimal allocation to equities can vary significantly for income-focused investors over time.

For example, when dividend yields exceeded bond yields in 2021, the optimal allocation to equities historically would have generally exceeded 60%. Today, in an environment where bond yields exceed equities by approximately 300 basis points, the optimal equity allocation is likely below 10%.

Note that these changes aren't related to future market expectations but rather are focused on the income available to be generated from the markets. This is not to say that equities shouldn't have a role, especially for investors with taxable monies given the favorable tax treatment of dividends compared to coupons from bonds. Instead, investors need to be aware of what's available in the market, especially since a number of asset classes that generate income weren't available to be included in the original study.

Now What?

While portfolio optimization routines often assume that investors are utility-maximizing robots, in reality, they have preferences that need to be considered by advisors when determining appropriate asset allocations. One common investor preference, especially among retirees, is income.

My research suggests that the optimal approach for income-focused investors is going to potentially vary materially as market dynamics shift, significantly more than it may be expected to do so for someone focused on total return. Investors and advisors focused on income need to be constantly aware of the market environment and adapt accordingly.

One possibility for investors and advisors who want to create a portfolio focused on income would be to purchase a multi-asset fund focused on income, such as an exchange-traded fund or mutual fund. While these strategies are increasingly available, I think it's incredibly important to understand how the portfolio is determined and is adjusted over time, given the substantial differences in the different strategies that exist today.