Insights for Non-Profits

Introduction

For many investors, the need for current income to support spending needs is a primary investment objective. For example, investors that may place a priority on maintaining stability of current income needs include:

• High net worth investors in or near retirement
• Endowment/foundations with significant non-discretionary spending needs
• Well funded, mature pension plans

Traditionally, a balanced portfolio consisting of a diversified basket of stocks and U.S. government bonds provided sufficient income to meet the needs of income-oriented investors. However, the historically low yields currently available on government bonds has virtually eliminated what has been a fairly consistent source of income over the past 30 years. Likewise, with limited room for further interest rate declines, bonds likely have little ability to mitigate stock market volatility and/or capital losses during stock bear markets when incorporated into a balanced portfolio.

In light of the current market environment, bond investors seeking additional income have several options:

• Accept additional interest rate risk by increasing exposure to longer maturity bonds
• Accept additional credit risk through greater exposure to corporate and lower quality bonds
• Find alternative source of income, such as real estate investment trusts (REITs)

However, investors should always consider the risk exposure of their total portfolio, and potential adjustments to bond holdings should not necessarily increase overall risk levels if stock exposure is likewise modified to maintain a consistent risk profile. One potential consideration is focusing on high free cash flow and dividend yielding stocks, which have historically provided additional yield and attractive downside risk management relative to the broad stock markets.

Lastly, investors should recognize that market and economic conditions change over time and the specific combination of asset classes required to meet current income needs can vary. Thus, even as some asset classes may be offering attractive or satisfactory levels of income in a given market environment, investors should also look beyond income to fully understand whether they are adequately being compensated for the risk taken in the portfolio.

Why Traditional Solutions for Income Oriented Investors May Not Work Today

Historically, both stocks and bonds have generated a meaningful part of their total return from dividends and coupon payments, which are generally considered relatively safe and stable sources of income. For example, the chart below illustrates that a portfolio consisting of 50% U.S. large cap stocks and 50% U.S. intermediate-term government bonds generated approximately 53% of its long-term average return from income since 1926.

Additionally, bonds have historically acted as a ballast to limit volatility of an all stock portfolio and have limited sustained capital losses during stock drawdowns. As the chart below shows, in both the 1973 to 1974 and 2000 to 2002 stock drawdowns, the 50% stock/50% bond portfolio was able to significantly mitigate the declines associated with stock market losses in excess of -40%.

However, with current interest rates near historic lows, returns achieved from U.S. government bonds over the last 30 years (both from an income and total return perspective) may be challenging to replicate going forward. As such, a traditional balanced portfolio’s capacity to generate income is also near all-time lows. Specifically, the chart below shows that the income return of the same balanced portfolio described on the previous page is currently approximately 1.7%, compared to an average of 4.3% since 1926 and a high of over 10% in the early 1980s. Thus, current levels of bond income may have a much more limited ability to absorb stock market losses. Additionally, today’s low yield levels appear to leave little room for further meaningful interest rate declines. Given the inverse relationship between bond prices and interest rate movements, this makes the prospect of rising bond prices seen during several previous stock market declines (e.g., from 2000 to 2002) less likely. For reference purposes, the yield on 5 year U.S. government bonds at the beginning of 2000 was approximately 6.3% versus 1.7% at end of 2014.

Likewise, assuming government bond returns of 2.0% over the near term (not unreasonable with current 5 year U.S. Treasury yields at 1.7%), a 14% return would be required from the stock portion of the 50/50 balanced portfolio just to achieve a total return of approximately 8% (i.e., the long-term return average of the 50/50 stock bond portfolio). Since 1926, U.S. large cap stocks have failed to achieve these return levels in 83% to 94% of rolling 3, 5, and 10 year periods.

As such, while the income generation and total returns of U.S. government bonds may have previously been sufficient to meet the long-term goals of income oriented investors, the current bond market environment presents significant challenges to implementing this more “traditional” balanced portfolio approach and forces investors to consider modifying the risk profile of their bond portfolio.

Risk Tradeoffs in the Current Bond Market Environment

When searching for additional income (yield) in the bond markets, investors have historically been presented with two main options:

• Take additional interest rate risk by investing in longer maturity bonds or
• Take additional credit risk by investing in corporate and lower-rated bonds

The discussion to follow will evaluate the tradeoff between these two risks in the context of today’s bond market environment and illustrate the potential risk tradeoffs for income oriented investors.

Interest Rate Risk

As the income component has accounted for the majority of long-term bond returns, the absolute level of interest rates has been the major contributor to bond returns going forward. For example, as the chart below illustrates, at beginning yield levels of 2% to 4%, the median return over the next ten years for intermediate and long-term bonds has only ranged from approximately 2% to 3%.

In general, longer maturity bonds have historically provided investors with a higher level of income relative to their shorter maturity counterparts. Additionally, these bonds tend to experience proportionately greater increases in value when interest rates fall and greater price declines when they rise. For investors willing to invest in longer maturity bonds and take additional interest rate risk, the past 30 years have provided a favorable market environment as the Federal Funds rate decreased from high of approximately 15% in the beginning of 1982 to 0.25% currently. Thus, for most of the time period, not only were income oriented investors benefiting from the relatively attractive absolute levels of interest rates, but the generally falling interest rate environment resulted in positive price appreciation for bonds overall. Additionally, the amount of default risk investors would need to take to meet their income needs was minimal with U.S. government bonds providing sufficient yields to meet most investors’ income goals.

However, with the Federal Fund Rate currently near 0% and 10 year U.S. Treasury Bonds yielding only approximately 2%, the current bond market environment presents a very different risk/reward tradeoff for income oriented investors. In addition to limited income generation potential, the table below illustrates, that with current yields near historic lows, they may be more likely to go up or stay flat over the next several years. As such, a similar tailwind from price appreciation to overall bond returns seen during the past few decades is unlikely to reoccur. For example, the table shows that at starting yield levels of 2% to 3%, yields have increased during the next three years approximately 63% of the time since 1953.

In this type of environment, U.S. government bonds, which have traditionally been seen as a source of safety by many investors may, in fact, represent a source of risk. As the table on the right illustrates, even a relatively small increase in interest rates can result in capital losses for the 10 year U.S. Treasury Bond given the low levels of income that can effectively cushion potential price declines. Thus, it can be argued that in the current bond market environment investors are, in fact, not being adequately compensated for taking on additional interest rate risk, especially in the government bond sector.

Credit Risk

Taking additional interest rate risk by investing in longer maturity bonds is not the only viable path for income oriented investors. While longer maturity bonds generally have higher levels of income, so do bonds with a perceived increased risk of default (i.e., credit risk). While several “non-government” sectors exist within the bond market, corporate bonds tend to be the most common sector where bond managers take credit risk.

In general, just as it comes to taking interest rate risk by extending out the maturity of a bond portfolio, investors need to understand whether or not they are being compensated for taking on additional default or credit risk by investing in corporate and/or lower quality bonds. As mentioned previously, the current bond market environment does not appear conducive to taking on the additional interest rate risk necessary to earn extra income. That said, compared to the relatively minor amount of extra compensation investors may be getting for investing in longer maturity government bonds, certain portions of the corporate bond markets may remain attractive from a credit risk standpoint.

As the charts on the following page illustrate, spreads between investment grade corporate and government bonds are well above their lows reached prior to 2008, and while high yield spreads have declined recently, these bonds still offer a considerable yield advantage over U.S. Treasury securities. Likewise, default rates have historically been minimal for investment grade corporate bonds year to year, while for high yield corporate bonds default rates are more significant and in certain years have become elevated (increasing meaningfully for the lowest rating categories).

Thus, in today’s bond market environment, a meaningful allocation to investment grade corporate bonds, as well as a more moderate allocation to high yield corporate bonds, may present a favorable risk/reward tradeoff for income oriented investors compared to taking additional interest rate risk by extending the maturity of a U.S. government-focused bond portfolio.

Maintaining Overall Portfolio Risk Level in Line with Long-Term Goals

The previous section discussed the tradeoff between taking interest rate versus credit risk in today’s bond market environment and provided evidence that increased allocations to more credit sensitive sectors of the bond markets may be an attractive proposition for income oriented investors. However, most long-term investors generally choose a combination of stock and bond securities when constructing portfolios. Thus, the stock portion of a multiple asset class portfolio may require certain adjustments if more credit sensitive bond exposure is added.

In general, while longer maturity bonds are more exposed to rising interest rates, corporate and lower quality bonds tend to be more sensitive to changing economic conditions. All else equal, an adverse economic environment may potentially result in companies with higher debt levels or a lower ability to pay back their existing debt experiencing a greater likelihood of default (e.g., due to lower revenues). Thus, as the following chart illustrates, the performance of corporate and lower quality bonds has historically been more highly correlated with that of stocks (relative to government bonds), which can result in more limited downside risk management during market downturns compared to government bonds.

For example, during the adverse credit environment of 2008, investment grade and high yield corporate bonds declined by approximately -5% and -26% respectively, compared to an approximately 12% gain for U.S. government bonds. U.S. large cap stocks, as represented by the S&P 500¹, declined approximately -37% during the year. Thus, investors concerned with potentially mitigating losses and volatility during stock market downturns may wish to consider equities that have historically exhibited attractive downside risk management characteristics relative to the broad market.

Advantages of High Free Cash Flow and High Dividend Paying Stocks

We believe that one segment of the broad stock market that has historically exhibited an ability to mitigate stock market losses while potentially enhancing overall portfolio income are high free cash flow yielding stocks with above average dividend yields. To illustrate this point, the charts on the following page demonstrate characteristics from several hypothetical portfolios.

The first portfolio was constructed from stocks demonstrating both high dividend yields and high free cash flow yields. The second and third portfolios were constructed from stocks demonstrating either high dividend yields or high free cash flow yields respectively. Finally, the last portfolio consists of all stocks in the Russell 1000^® Index¹⁰, equal weighted. The statistics below are compiled in aggregate over the period from 01/01/1990 to 12/31/2014. As the charts illustrate, a portfolio consisting of the highest free cash flow and dividend yielding stocks has historically provided attractive downside risk management compared to stocks with only one of those characteristics and the broad stock markets as a whole.

Specifically, an equal weighted portfolio of the highest free cash flow and divided yielding stocks only captured approximately 73% of the Russell 1000^® Index’s¹⁰ downside return from 01/01/1990 to 12/31/2014, compared to 110% for all stocks in the Russell 1000^® Index¹⁰, equal weighted. Likewise, this market segment exhibited an annualized return during the two previous sustained stock market downturns that was approximately 15% higher relative to the Russell 1000^® Equal Weighted Index.

In terms of income production, the highest dividend yield and free cash flow yield segment also had the highest level of average dividend yields, (as depicted in the chart below), implying that the income generation has been higher. Given the low levels of bond yields discussed above, this additional income could prove attractive for income oriented investors.

Overall, companies that offer both high free cash flow and dividend yields (i.e., combining willingness to pay and an ability to pay dividends) appear to offer attractive levels of income and attractive downside risk management relative to other stock market segments and may aid in maintaining a more stable risk profile for a balanced portfolio when combined with a more credit sensitive bond allocation.

Incorporating Other Sources of Income

Other segments of the equity market may provide added opportunities to generate an attractive level of income. Companies with the potential to provide a growing level of dividend yield may help to contribute towards the portfolio’s long term income generating abilities. In addition to dividend paying common stocks, other equity securities tend to place a higher emphasis on paying out revenue as income:

• Real Estate Investment Trusts (REITs)
• Preferred Stocks
• Convertible Securities
• Business Development Corporations (BDCs)
• Master Limited Partnerships (MLPs)

As an example, REITs receive special tax considerations in exchange for being required to distribute at least 90% of their taxable income to investors. As a result, REITs often offer attractive dividend yields, as the dividend yield of the MSCI U.S. REIT Index11 is currently approximately 4.0% compared to 2.1% for the S&P 500¹. Because some securities such as REITs and MLPs tend to focus on specific portions of the economy (Real Estate and Natural Resources, respectively), allocations to these securities should be selective. However when the market environment is favorable, these types of equity securities may offer an attractive opportunity for yield relative to the broad equity market. Additionally, incorporating a more diverse set of income-oriented securities may also provide diversification benefits when compared to traditional dividend paying stocks and corporate bonds. Specifically, rolling 10-year correlations between the FTSE NAREIT All REITs Index¹² have been as low as 0.15 versus the Barclays US Credit Index¹³ and as low as 0.35 vs. the S&P 500^® Dividend Aristocrats Index¹⁴.

Balancing Current and Future Spending Needs

Investing with a focus on income oriented securities should be a priority for investors with ongoing spending needs. However it is also important for the portfolio to grow in order to support future spending and to maintain spending ability through periods of higher inflation. For investors with ongoing spending needs and a long term time horizon, it is important to commit a portion of equity to securities that are primarily focused on capital growth and can experience full participation in periods of market expansion. Emerging markets stocks may be well positioned to grow in periods of global expansion and in developed markets there may be certain portions of the market that are more price responsive in periods of inflation. These stocks may not offer the same degree of stability as higher free cash flow high dividend yield stocks, however this portion of the portfolio is meant primarily to build capital over a longer term time frame. Ultimately, investors must balance the need for stability and income in the near term with the goal of growing the portfolio so that future income can sufficiently meet ongoing spending.

Conclusion

Today’s market environment presents several challenges for income oriented investors. Most notably, with government bond yields near historic lows, a significantly smaller portion of an investor’s income need may be satisfied by bond income. Additionally, at these low income levels, and with limited potential for further meaningful price appreciation, government bonds may have little ability to limit volatility and mitigate losses during future sustained stock market declines.

In contrast, with spreads on investment grade and high yield corporate bonds still at relatively attractive levels, taking on additional credit risk by increasing investments in these sectors may represent a more favorable risk/return tradeoff. However, in order to potentially mitigate the increased economic sensitivity of a higher credit risk portfolio, investors may wish to consider incorporating stocks which may limit exposure to market downturns and generate attractive levels of income.

Historical data has shown that high free cash flow and high dividend yielding stocks have generally exhibited these characteristics and may thus help to maintain a more stable risk profile in the overall portfolio when paired with increased credit exposure. Additionally, real-estate investment trusts could provide an alternative source of income and portfolio diversification if purchased at attractive valuations.

Overall, an appropriate asset allocation for income oriented investors in this market environment will depend on their long-term financial goals and specific income needs. Likewise, the balance between the need for long-term capital growth and capital preservation will also play an important role in the asset allocation decision. Lastly, while today’s market environment presents a specific set of challenges and opportunities for different types of investors, a flexible asset allocation approach can help a portfolio remain consistent with its long term goals under a variety of market conditions.

Past financial performance is no guarantee of future results.

Unless otherwise noted, index returns provided by Morningstar.

Analysis by Manning & Napier.

Source: © Morningstar 2015. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction.

*Data based on the SPDR^® Barclays Aggregate Bond ETF (LAG). The Barclays U.S. Aggregate Bond Index is an unmanaged, market-value weighted index of U.S. domestic investment-grade debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of one year or more. Index returns do not reflect any fees or expenses.

¹U.S. Large Cap Stocks are represented by the S&P 500 Total Return Index (S&P 500). The S&P 500 is an unmanaged, capitalization-weighted measure of 500 widely held common stocks listed on the New York Stock Exchange, American Stock Exchange, and the Over-the-Counter market. The Index returns assume daily reinvestment of dividends and do not reflect any fees or expenses. S&P Dow Jones Indices LLC, a subsidiary of the McGraw Hill Financial, Inc., is the publisher of various index based data products and services and has licensed certain of its products and services for use by Manning & Napier. All such content Copyright © 2015 by S&P Dow Jones Indices LLC and/or its affiliates. All rights reserved. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and none of these parties shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.

²U.S. Intermediate Government Bond data is reflective of the Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index, which is an unmanaged index representing the U.S. intermediate-term government bond market. The index is constructed as a one bond portfolio consisting of the shortest-term non-callable government bond with no less than 5 years to maturity. The Index returns do not reflect any fees or expenses.

³U.S. Long Government Bond data is reflective of the Ibbotson Associates SBBI U.S. Long-Term Government Bond Index, which is an unmanaged index representing the U.S. long-term government bond market. The index is constructed as a one bond portfolio consisting of the shortest-term non-callable government bond with no less than 20 years to maturity. The Index returns do not reflect any fees or expenses.

⁴U.S. Long Corporate Bond data is reflective of the Ibbotson Associates SBBI U.S. Long-Term Corporate Bond Index, which is an unmanaged index representing the U.S. long-term corporate bond market. The index includes nearly all Aaa- and Aa-rated bonds. If a bond is downgraded during a particular month, its return for the month is included in the index before removing the bond from future portfolios. Index returns do not reflect any fees or expenses.

⁵The Bank of America (BofA) Merrill Lynch U.S. Corporate Master Index is an unmanaged index of investment-grade corporate debt publicly issued in the U.S. domestic market. The securities must have at least one year remaining term to final maturity, a fixed coupon schedule, and a minimum outstanding of $250 million. The Index is denominated in U.S. dollars.

⁶The Bank of America (BofA) Merrill Lynch U.S. High Yield Cash Pay Index is an unmanaged index used as a general measure of market performance consisting of fixed-rate, coupon-bearing bonds with an outstanding par which is greater than or equal to $50 million, a maturity range greater than or equal to one year and must be less than BBB/Baa3 rated but not in default.

⁷The Barclays U.S. Corporate High-Yield Index measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below, excluding emerging market debt. The U.S. Corporate High-Yield Index was created in 1986, with history backfilled to July 1, 1983, and rolls up into the Barclays U.S. Universal and Global High-Yield Indices.

⁸The Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment grade, fixed-rate, taxable, corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers that meet specified maturity, liquidity, and quality requirements. Securities in the index roll up to the U.S. Credit and U.S. Aggregate Indices. The U.S. Corporate Index was launched on January 1, 1973.

⁹The Barclays U.S. Government Index is comprised of the U.S. Treasury and U.S. Agency Indices. The U.S. Government Index includes Treasuries (public obligations of the U.S. Treasury that have remaining maturities of more than one year) and U.S. agency debentures (publicly issued debt of U.S. Government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. Government). The U.S. Government Index is a component of the U.S. Government/Credit Index and the U.S. Aggregate Index.

¹⁰The Russell 1000^® Index (Russell 1000) is an unmanaged index that consists of 1,000 large-capitalization U.S. stocks. The Index returns are based on a market capitalization-weighted average of relative price changes of the component stocks plus dividends whose reinvestments are compounded daily. The Index returns do not reflect any fees or expenses.

¹¹The MSCI U.S. Real Estate Investment Trust (MSCI U.S. REIT) Index is a free float-adjusted, market capitalization-weighted index that is comprised of equity REITs that are included in the MSCI U.S. Investment Market 2500 Index, with the exception of specialty equity REITs that do not generate a majority of their revenue and income from real estate rental and leasing operations. The Index represents approximately 85% of the U.S. REIT universe. The Index returns do not reflect any fees or expenses.

¹²The FTSE NAREIT All REITs Index is a market capitalization-weighted index that and includes all tax-qualified real estate investment trusts (REITs) that are listed on the New York Stock Exchange, the American Stock Exchange or the NASDAQ National Market List.

¹³The Barclays US Credit Index comprises the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities. The US Credit Index was called the US Corporate Investment Grade Index until July 2000, when it was renamed to reflect its inclusion of both corporate and non-corporate issuers. Index history is available back to 1973. The US Credit Index is a subset of the US Government/Credit Index and the US Aggregate Index.

¹⁴The S&P 500^® Dividend Aristocrats Index measures the performance of lcompanies within the S&P 500 that have followed a policy of increasing dividends every year for at least 25 consecutive years.