Many baby boomers are investing their savings in income-generating assets, which they believe can provide safety and generous yields. Not many years ago, bonds were the preferred income investment for retirees, but that has changed due to unusually low interest rates that have made bond yields too meager to provide much income. Yields on 10-year treasuries currently range around 1.8%, 20-year municipal bonds yield 2.6% and 10-year corporate bonds yield only 2.5%. The only way that retirees can obtain higher payouts in the bond market is to hold riskier investments such as foreign debt and junk bonds.
While investor interest in bonds has plummeted, dividend-paying stocks have captured headlines as well as a significant amount of investor capital. REITs (Real Estate Investment Trusts) are a stock sector known for rich dividends. Even with the significant share price appreciation of recent years, REIT yields have remained more attractive compared to bond yields. At present, the S&P REIT index pays 3.9%. Another appeal of dividend-paying stocks is the possibility of rate hikes. This differentiates these stocks from bonds, which rely on fixed interest payments and thus offer no possibility of a rate hike.
However, there is also a downside to the flow of significant investor capital into dividend stocks. As demand for these stocks has rised, share prices and valuation measures have inflated and the likelihood of further capital gains has diminished. Present valuations of dividend stocks are approaching all-time highs, as noted in this Wall Street Journal story. Investment firm research affiliates looked at stock price data from the last 40 years and concluded that dividend stocks are more expensive now than has been the case 80 percent of the time.
Investment firm Morningstar also recently determined that many dividend stocks are overpriced, including sectors popular with income investors such as utilities, REITs and consumer stocks.
Because of inflated values, investors purchasing these stocks now face increased risk of a market correction. The share price decline may exceed the dividend yield, resulting in a loss on the overall investment. Like other types of stocks, dividend-paying stocks can be volatile and excessive volatility is highly undesirable in retiree portfolios.
Public companies recognize the investor demand for higher yields and so they have been paying out the largest percentage of their profits as dividends since 2009, according to FactSet data. Unfortunately, high payouts increase the risk of a dividend cut, which may occur if profits weaken and especially during periods of economic decline. For example, during the first year of the Great Recession (2008), 62 S&P companies trimmed dividends, resulting in nearly $41 billion in lost payouts. Not only income investors suffer when dividends are reduced; these cuts affect growth investors as well since dividends typically account for 40% of a stock’s total return.
Analysis by these research firms indicates that new dividend investors may be taking on greater risk of share price declines, which can erode their portfolios. Given these challenges, some income investors are turning instead to alternative assets. These assets may provide greater safety, reliable income and robust yields in the current low interest rate environment, which is likely to continue for several more years.
Alternative assets have shown the ability to reduce volatility and enhance overall returns in a diversified portfolio as a result of their low correlation with stocks and bonds. Among the various types of alternative assets, real estate has been producing some of the best returns. A recent study by asset manager Blackrock showed real estate outperforming all other asset classes in the last 15 years by generating 10%+ average annual returns.
Investors who desire real estate exposure but also want the predictable income associated with a bond may want to look at mortgage pool funds, which have stood out as exceptional performers in the current low interest rate environment. Many mortgage pool funds returned between 9% and 11% to their investors last year. This was only slightly less than the 13% return (before management fees) generated by the NCREIF Property Index, which tracks institutional investments in commercial real estate.
Mortgage pool funds have an advantage over other types of real estate investments as a result of their low volatility. This is due to the fact that returns are generated from the fixed monthly interest payments made on loans in the fund’s portfolio. Mortgage pool fund subscribers receive monthly returns on invested capital that are as reliable as those from a bond, but generally at a much higher yield.
A characteristic of mortgage pool funds that makes them safer than most stocks is their tangible brick and mortar assets. The properties that secure the loans in a mortgage pool fund portfolio have an intrinsic value that is not subject to stock market-style volatility. Another differentiating feature of mortgage pool funds is the local nature of their business. Mortgage pool funds invest in regional markets they know well; this familiarity provides greater transparency. The value of the properties that collateralize the loans in the portfolio is determined largely by local supply and demand and has little exposure to the effects of macro-economic factors such as exchange rates that impact the stock market.
Mortgage pool funds draw their strength from real estate markets and at present many of the regional property markets are thriving. As a result, when compared to stocks and bonds, mortgage pool funds may be poised to deliver greater safety and superior returns over the next few years.