Past is Prologue for Income Investors?

Investment income has long been relied upon to cover future and current spending for individuals, endowments, public and private pensions, as well as other institutional investors. Income-producing assets, largely in the form of fixed income securities, have anchored portfolios for many decades. Historically, bonds offered yields several hundred basis points above inflation. However, interest rates have fallen dramatically over the last 40 years.

Today’s paltry yields and elevated bond price risk complicate investing for income, but compelling options for flexible, nimble investors always exist.

A New Era in Yields

Inflation rose sharply from 1973 through the mid-1980s , twice reaching 10%, and driving bond yields higher along with it: the 10-year U.S. Treasury yield peaked at nearly 16% as did the Moody’s Aaa Corporate Bond index in the fall of 1981. Long-run interest rates in the U.S. are shown in Chart 1.

Chart 1 | Historic, Decades-long Trip in Descending Rates and Yields

Source: Bloomberg

With the unprecedented central bank bond purchases injecting liquidity since the 2008 global financial crisis and even more since the COVID-19 pandemic broke out a year ago, central banks have emerged as giant competitors to private investors for the available supply of bonds. Combined with demographic shifts lifting demand for bonds globally, yields are negative in real terms in the U.S. and in nominal terms in many developed countries. In fact, the total U.S. dollar amount of negative-yielding debt globally is a stunning $17.8 trillion.

Chart 2 shows the evolution of aggregate negative-yielding debt globally in USD. This creates a multitude of problems for individual and institutional bond investors alike. Rather perversely, a bond with a negative nominal yield means an investor pays a premium to buy the bond today and will receive less than that cash outlay in the future. Yet given the financial repression of monetary authorities, demographic- based demand for fixed income and statutory requirements for many financial institutions to hold “risk-free” or high-quality bonds, we are likely to see continued pressure on bond yields for the foreseeable future.

Chart 2 | The Ascent of Negative-Yielding Debt, Globally; Cumulative, USD

Source: Bloomberg

In Negative Real Yield Territory

The next 40 years will most certainly not be like the last for bond returns; from December 31, 1980, to December 31, 2020, the annualized total return of the Bloomberg Barclays U.S. Aggregate Bond Index was 7.62%. With a current yield-to-worst (the measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting) of 1.14% for the same bond index as the starting point, there simply is not much room for yield compression. At 1.14% yield, we are already in negative real yield territory today.

The Dividend Income Solution

Bonds aren’t the only source of income for investors. Income can also be sourced from equities in the form of dividends. Dividends have advantages over fixed income in that dividends can grow, are taxed at a lower rate to U.S. owners, and the stocks that produce them have the potential for capital appreciation. To be sure, they come with the elevated principal risk inherent with equities. Tax policies also change over time and could possibly change with a new administration. However, even at symmetric tax rates, the after-tax yield on stocks is still superior to that of bonds currently.

In this paper, we present our thoughts on the significant shifts in the income landscape that all investors should consider when building an income component to a diversified portfolio. We believe this is a long-term problem (many decades long) and are assessing income portfolios in that context. Dividends can, and should, be a long- term part of the solution to the income problem. Ironically, despite the obvious challenges investors face in  generating income, dividend stocks today are priced attractively when compared to historical valuations and other income-producing securities as indicated in Chart 3.

Chart 3 | FTSE All-World Index

Source: FTSE Russell, FactSet, HSBC FY1 DY = Forecast 1-year dividend yield. *All components of FTSE All-World Index

Conventional “Income” Sources No Longer Work

Investors’ capital does not generate the same level of income as in decades past. This is apparent looking over the last 35 years of data on personal income receipts on assets per the Bureau of Economic Analysis. Segregating interest income from dividend income, we see the dramatic shift in the share of investment income from fixed income interest to dividends. Interest income as a share of receipts on assets peaked in the mid-to- late 1980s at approximately 18%. That figure today stands at slightly above 8%. In contrast, dividend share of personal income receipts on assets has steadily, though with some expected cyclicality, increased from roughly 4% share in the mid-to-late 1980s to about 6.5% today. Note in Chart 4 that over this time series the asset base, investors’ capital, grew from approximately $47 billion in 1960 to $2.6 trillion today. The conclusion is significant and highlights diminishing returns on fixed income interest and the power of dividend income over time.

Chart 4 | Components of Personal Income (monthly, 1/31/59–11/30/20)

Source:© 2021 Ned Davis Research, Inc. See full disclosure at the end of this article.

In simple terms, what worked decades ago—owning bonds yielding several hundred basis points above inflation— has been systematically undone by a secular decline in bond yields. Amidst muted inflation and weakening global growth, central banks are likely to maintain a low-to-negative interest rate environment for the foreseeable future. The COVID-19 pandemic has anchored lower-for-longer policy rates in the U.S. and abroad as indicated in the Congressional Budget Office’s (CBO) recent projections in Chart 5.

Chart 5 | CBO’s 2019 and 2020 Projections of the Interest Rate on 10-Year Treasury Notes

Source: Congressional Budget Office

Aging Populations Combined with Supply and Demand Pressures Point to Lower Yields for Longer

Like nearly all goods and services, asset prices are primarily determined by supply and demand. This can change with substitutes or migration to new technologies in some cases. In the case of income-producing assets, the substitute is not so clear. That is, investors put capital to work for either growth of capital or for income production, or ideally, both. To meet spending needs either in retirement or in funding expenses for a pension or endowment, the preferred choice of that income is cold, hard cash.

We’ve discussed some of the supply side dynamics of income production in the paragraphs and charts above. The demand side is equally, if not more, important when studying the income problem. There are two simple ways to think about demand for income- producing assets—population size and the composition of that population. Chart 6 shows the United Nations estimates for the global population to 2100. Based on U.N. estimates, we are still on a relatively steep upward curve for population growth to 2050, when the world is expected to reach nearly 10 billion people.

Chart 6 | Population size and annual growth rate for the world: 1950–2100

Source: United Nations World Population Prospects 2019

While historically low rates may be a tailwind for borrowers, it’s a progressively larger hurdle for a rapidly aging global population (this is the composition part). As increases in longevity and slowing population growth dramatically shift country-level demographics, demand for stable income put additional downward pressure on yields, which, in turn, requires more capital to generate a similar income stream as highlighted in Chart 4.

Digging further into the composition of future populations, most countries face the demographic challenge of rising elderly populations and falling young populations. This creates pressure in two ways—caring for the increasingly older population, as well as funding that care and general costs of living with a shrinking working age cohort. Based on U.N. analysis, in 2019 all 201 countries with at least 90,000 inhabitants were expected to see an increase in the proportion of persons aged 65 and over between 2019 and 2050. Table 1 shows the regional expectations of U.N. analysis regarding 65 and older population share by region, with Europe and North America expected to have the highest share by 2050 at more than a quarter of the total population. This age shift is driven by declining birthrates and longer life expectancies. Life expectancy at birth for the world reached 72.6 years in 2019, eight years longer than in 1990. By 2050, U.N. analysis indicates life expectancy of 77.1 years for the world and 83.2 years for Europe and North America and 87.1 years for Australia / New Zealand.

Table 1 | Population of the world, according to the medium- variant projection

Source: United Nations World Population Prospects 2019

As a result of the increase in median age, government transfer programs, such as Social Security in the U.S., that rely on taxes born by the working population to fund benefits for those who are out of the labor force will come under increasing strain. These population trends paint a robust demand outlook in both size and duration for income-producing assets in the U.S. and elsewhere.

We should not expect a shortage of bonds for the foreseeable future given large budget deficits in the U.S. The CBO estimates that deficits are expected to grow materially out to 2050. The pandemic has created greater pressure on the government’s balance sheet with the CBO’s debt as a percentage of GDP expected to increase a staggering 45 percentage points in 2049 compared to what the agency projected last year. As seen in Charts 7 and 8, the CBO expects federal debt held by the public to reach 195% of GDP in 2050 and the deficit is expected to reach 13% of GDP versus an average of 3% over the last 50 years.

Chart 7 | Federal Debt Held by the Public, 1900 to 2050

Source: Congressional Budget Office

Chart 8 | Total Deficits, Primary Deficits, and Net Interest

Source: Congressional Budget Office

Given U.S. Treasury yields are the anchor of yield for other fixed income securities from which spread is added, this large expected Treasury issuance will create uncertainty with respect to bond yields and therefore returns. While inflation has been tamed over recent years, this might not continue given the scale of issuance and the low yield starting point. This is a topic that deserves its own discussion, and we will not address in detail here.