Investor Education
Why Investors Should Rethink Traditional Income Strategies
Why Investors Should Rethink Traditional Income Strategies
Humans are creatures of habit. We all have daily routines, whether it’s walking the same lunchtime route, watching a familiar TV show, or cooking the same meal over and over again. Once we develop a pattern, it can take a drastic change to convince us to rethink our approach.
One such shake-up to ingrained investment habits is the changing landscape of income investing.
In today’s infographic from New York Life Investments, we explain why traditional long-term bonds may not be as effective as they were in the past, and which additional income strategies investors can consider.
The Status Quo
For years, investors have relied on traditional longer-term bonds as the centerpiece in an income portfolio. These debt instruments usually pay out interest to investors on a predetermined schedule, providing a steady income stream investment. Historically, they have also been subject to less volatility than equities.
The typical bond portfolio is diversified, much like the Bloomberg Barclay’s U.S. Aggregate Index. Here’s how the sectors are broken down in the index:
Sector | Market Value |
---|---|
Treasury | 39.5% |
Government-Related | 5.8% |
Corporate | 25.0% |
Securitized | 29.7% |
Unfortunately, this income strategy has been less effective in recent years. Over the last decade, core bond duration has increased by 1.5 years while yields have decreased by almost 2%. Essentially, interest rate volatility has increased—but investors are less compensated for the risk.
In light of low rates and higher expected market volatility, it’s critical that investors explore other income solutions. Luckily, there are many lesser-known asset classes for investors to consider.
Additional Income Strategies: An Investor’s Choice
When investors decide how to re-allocate, they can keep these objectives in mind:
- Preservation of principal (risk level)
- Pursuit of capital (growth potential)
- Perseverance in markets (long-term objectives)
Which additional income strategies can they explore?
Taxable Municipal Bonds
Issued by state and local governments, the yield of taxable munis has historically been higher than that of other sectors. Taxable munis also have a strong credit rating—over 76% of U.S. municipal bonds outstanding are A+ rated or better.
Insured Municipal Bonds
Investors can get additional downside protection with insured municipal bonds, which are guaranteed to pay interest and principal back by private insurers. They have historically performed similar to munis while capturing less of the “downside”, often providing an attractive risk-adjusted return for income investors.
Short-duration, High-yield Bonds
Bonds with a shorter duration and higher yield can be a lower volatility approach to achieving the same income investing goals.
Yield and Risk in Bonds (July 1, 2014 – June 30, 2019):
Bond Type | Yield | Standard Deviation (annualized) | Yield per Unit of Risk |
---|---|---|---|
U.S. Aggregate Bonds | 2.49 | 2.94 | 0.85 |
High Yield Bonds | 6.05 | 5.60 | 1.08 |
Low-duration, High-yield bonds | 5.00 | 3.90 | 1.28 |
Short duration funds have lower interest rate risk, and can offer attractive yield per unit of risk.
Yield-Centric Equities
Equities can also play a role in an income focused portfolio. Investors should look for established companies that are achieving:
- Growth in free cash flow
- Stable or growing dividends
- Share buybacks or debt reduction
Over the last 40+ years, the annual compound return of stocks with growing dividends have outperformed dividend cutters on the S&P 500 by more than 4%.
Preparing for Your Future
Maximizing the benefit from new income opportunities can take time. For this reason, it’s important to consider potential portfolio changes now, so that these strategies can play out in the lead up to retirement years.
It may be tempting to stick with the status quo—both in daily routines and investment strategies—but those who proactively adjust their approach will be able to maximize their potential.
Investor Education
Visualized: A Step-by-Step Guide to Tax-Loss Harvesting
In Canada, tax-loss harvesting allows investors to turn losses into tax savings. This graphic breaks down how it works in four simple steps.
A Step-by-Step Guide to Tax-Loss Harvesting
Market ups and downs can be unnerving, but the good news is that tax-loss harvesting allows investors in Canada to capture tax savings when their portfolio drops in value.
While it sounds complicated, a tax-loss harvesting strategy is actually fairly straightforward. An investor can use capital losses to offset capital gains found elsewhere in their portfolio, leading to a lower tax bill. While there are important conditions to keep in mind, investors can use this strategy to enhance portfolio returns over time by reinvesting these tax savings.
This graphic from Fidelity Investments shows how tax-loss harvesting works and why it may improve tax efficiency in an investor’s portfolio.
Breaking It Down
Consider a person who invested $50,000 in a mutual fund held in a non-registered account that has dropped by $10,000 in value. To help minimize losses, they took the following steps in a tax-loss harvesting strategy.
For the sake of this example, taxes are based on the maximum federal rate and the average maximum provincial tax rate.
- Sold investment with a $10,000 loss
- Invested $40,000 into a different mutual fund
- Used the $10,000 capital loss to offset capital gains realized elsewhere in the non-registered portfolio
- Achieved up to $2,550 in tax savings
The investor realized as much as $2,550 in tax savings by utilizing a $10,000 loss against a $10,000 capital gain. Without tax-loss harvesting, this $10,000 capital gain would be taxed at a 50% capital gains inclusion rate ($10,000 X 50% = $5,000). This $5,000 in applicable gains is then taxed at a 51% combined federal and provincial tax rate ($5,000 X 51% = $2,550 in taxes owed).
In contrast, by using tax-loss harvesting, the investor would have achieved up to $2,550 in tax savings.
What’s more, you can reinvest your tax savings over each year—which may help boost portfolio returns over time if the new investment increases in value.
Tax-Loss Harvesting Tips
With a tax-loss harvesting strategy, here are some key tips and considerations to keep in mind:
- Investment Timeline: A capital loss can be used to offset capital gains not only in the current year, but in the three years prior and/or any year indefinitely in the future.
- New Investment Type: After selling an investment that’s dropped in value, it’s important to buy a different investment to avoid triggering the ‘superficial loss rule’. Investors can aim to choose an investment with similar long-term returns.
- Plan for Year-End: In order to achieve a capital loss, plan to sell an investment at least two to three days before the year’s final trading day so the investment settles before year-end.
Together, these tips can help investors strategically execute a tax-loss harvesting strategy.
Tax Made Easier
During volatile markets, investors can seize the opportunity to turn losses into tax savings using tax-loss harvesting as a key tool to help generate higher after-tax returns.
Explore Fidelity’s tax calculator to discover tax-saving opportunities.
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