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

What You Need to Know

A few years ago, dividend yields exceeded bond yields. That’s no longer the case.
The optimal approach for income-focused investors changes as market dynamics shift.
It’s important to consistently revisit allocations to ensure they are efficient.

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.