Reinvigorating income with equities

Key takeaways

• The prospect of middling economic growth and low rates makes income-generation challenging for many investors.
• A potential rise in inflation may lead to lower real yields, highlighting the greater importance of equities as a way to access portfolio income.
• High-yield and dividend-growth strategies each offer equity income with an emphasis on “quality” companies, and the two strategies can be used together in the same portfolio.

Investing for regular income seems like it should be a straightforward proposition.

And yet, there is more to income investing than many appreciate. Income investment strategies come in all different shapes and sizes, including stocks, bonds, bond-like stocks, and stock-like bonds. And the effectiveness of each strategy at delivering income can vary with market conditions.

One of the most well-known income-producing assets is the 10-year U.S. government bond. In October of 1987, this asset boasted a yield over 10%. By 2007 the yield had reached 5%, a function of rising after reaching lows during the early 2000’s recession. This year, its yield hit a record low near 0.5%.¹ The current outlook for tepid economic growth and recent comments from Federal Reserve Chairman Jerome Powell indicate low rates may be here to stay (though an effective COVID-19 vaccine soon may affect this view). In this environment, clients I speak with are looking for ways to reinvigorate the traditional approach to seeking income.

Figure 1: 10-Year government bond yields around the world are at a historic low

Source: Refinitiv Datastream, chart by BlackRock Investment Institute, Oct 28, 2020. Past performance is not indicative of future results.

The dividend approach to seeking income

Equity dividends may offer a higher yield in this historically low-rate environment. A potential advantage of the dividend approach vis-à-vis bonds is that, besides current income, equities may also grow their dividends and realize capital appreciation over time. The combination can help deliver returns that keep pace with or exceed inflation. While inflation has been subdued in recent years, the BlackRock Investment Institute (BII) recently forecasted higher inflation in the medium term, meaning that the inflation-adjusted real yield for investors could be even lower.

Notably, investors who utilize a 60/40 portfolio may already be exposed to equities as a source of income. As the chart below shows, equity dividends may comprise a greater portion of a 60/40 portfolio as bond yields have fallen.

Figure 2: Equity dividends have become the primary source of income in a hypothetical 60/40 portfolio

Sources: MSCI and Bloomberg, October 2020. Notes: The chart depicts the share of income coming from equity dividends in a hypothetical illustrative portfolio that is made up of 60% MSCI World Index / 40% Barclays Aggregate Index. This hypothetical portfolio rebalances monthly. Share of income is calculated by dividing the dividend yield on the MSCI World Index by the total income on the illustrative portfolio, using the yield of the Bloomberg Barclays US Aggregate Index as a proxy for bond income within the illustrative portfolio.

Equity income tools are sharper than ever before

In 2020, income investors face a different landscape than in decades past. As the markets have evolved, so too have the index-based solutions which now offer direct and thoughtful exposure to equity income. For example, the Morningstar Dividend Yield Focus Index explicitly seeks exposure to U.S. companies with high dividend yield, while also screening for dividend sustainability and other elements of quality. This index posts a dividend yield of 5.0% while the Russell 1000 Value and S&P 500 offer yields of 2.7% and 1.8% respectively.²

Dividend-growth strategies are another way to think about equity income. Dividend-growth indexes such as the Morningstar US Dividend Growth Index provide access to companies that have consistently grown their dividends for five years or longer and have the financial means to continue to do so. While its methodology does not explicitly seek to maximize yield, it has captured an above-market dividend yield of 2.9% by including only dividend-growing companies.³

Quality matters when thinking dividends

Notably, both high-yield and dividend-growth indexes discussed above incorporate “quality” screens. Since yield is a function of dividend payments divided by price (D/P), higher-yielding stocks may not always represent companies with durable business models that can support the distribution of high current income to investors. Occasionally a stock’s high yield can signal a “yield trap,” meaning that the yield is high mostly because its stock price had fallen sharply. Quality screens in indexes can help minimize exposure to the risks of yield traps.

Investors may also consider managing risk with income strategies at the portfolio level. This can be done with complementary fund holdings. For example, a quality factor strategy may be a good complement to an income-focused investment because it counterbalances risk related to stocks that might have a high yield but weaker fundamentals. Consider as a representation of quality the MSCI USA Sector Neutral Quality Index, which focuses on finding companies with high profitability and strong balance sheets. The below chart shows dividend yields and return on equity (ROE) as a simple proxy for quality. Both high-yield and dividend-growth strategies show a more favorable trade-off between yield and quality than the Russell 1000 Value Index. While the dedicated quality index does not explicitly seek higher yield, its significantly higher ROE versus both the Russell 1000 Value Index, but more importantly the S&P 500, demonstrates the benefits quality screens can provide at the portfolio level to income-seeking investors.

Figure 3: Quality is an essential consideration when seeking high equity income

Source: BlackRock and Morningstar as of 10/31/2020. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance.

Equity income may be the missing portfolio link

Stocks with high dividend yields may look different from stocks with high dividend growth rates; however, both are potentially useful to income investors. High-dividend strategies tend to be concentrated in more mature sectors, fall predominantly in the large value “style box,” and can exhibit higher interest rate sensitivity. In contrast, dividend-growth strategies typically capture a mix of mature and growth-oriented sectors, hold a blend of both value and growth-oriented securities, and exhibit less interest rate sensitivity than high yield focused strategies. These very different approaches to the equity income segment of the market generate only 30% exposure overlap, allowing them to be used together inside portfolios.⁴ In a low-rate world, dividend equity strategies may be the missing link to provide investors with the income they are no longer getting from bonds, while still offering equity market exposure to provide upside in an inflationary environment.