INSIGHTS

May 27, 2013

Manager Perspective

May 2013

Total Return Investing vs. Income Investing

With interest rates across the maturity spectrum near 50-year lows, many investors are struggling to attain sufficient returns to achieve their goals. This affects not only retirees, but pension funds, and any investor who traditionally focused on income.

C. Angus Schaal, CFP^®

Senior Managing Director

Investing solely for income is extremely challenging in the current environment. Prudent investors are seeking alternatives to generational-low bond yields and zero returns on cash. The most pronounced shift has been away from government debt and high-quality corporate debt into lower rated “junk bonds”. These securities are sold by companies with weaker balance sheets and are thought by rating agencies to have a lower chance of being able to repay the debt. This means the investor is accepting a higher initial yield but also accepting a higher chance of default by the issuer. The higher demand for income producing assets is primarily due to the very low interest rate environment. However, chasing higher yields entails proportionally higher risk.

With rates this low, the most likely move over the next several years is for rates to move higher. Even if they do not get back to their average yield since 1980, investors could lose a significant portion of their principal. If interest rates were to rise by 100 basis points (1.00%) from the current levels, investors in a 10-year Treasury would lose 8.7% of their principal. Said another way, they would lose almost five years of coupon interest. The benchmark 30-year bond U.S Treasury bond would decline by an astounding 17.4% if rates were to increase by 100 basis points (1.00%). This is where we believe investors reaching for yield could be subject to major disappointments.

To summarize our current beliefs on fixed income, we counsel investors to have reasonable return expectations. While interest rates have declined substantially during the past five years, this implies that reasonable expectations of return should be meaningfully lower than they had been historically. We would add that simply because interest rates are low does not mean that they have to rise substantially from here. We can look to Japan which has had extremely low interest rates for over 20 years as they struggle with high debt levels, an aging population, and a stagnating economy. This is not our forecast, but it remains a remote possibility.

The following chart shows the difference between equity yield and fixed income yield over time. Equities tend to increase their dividends while fixed income instruments pay a steady, fixed payout. Over several years, the yield on cost for equities can increase significantly while the yield on cost for fixed income remains constant.

With rates so low and Tandem counseling investors not to increase their maturities or to move lower down the credit spectrum, how do investors achieve their investment goals? Income investors have three choices now:
1. Spend less
2. Reallocate to higher yield investments
3. Spend from total return rather than just from income.
Tandem favors the third option. We believe that investing more heavily in income-generating investments generates little to no portfolio growth in a low rate environment. Additionally – and more importantly – the portfolio is unlikely to keep pace with inflation. At the other end of the investing spectrum is a portfolio of growth-oriented investments with little or no current income. Tandem favors an investment strategy with a combination of both disciplines – income and capital appreciation – via total return investing. This methodology will best support an investor during his

lifetime. By combining traditional income producing securities with proceeds from the sale of principal assets that have appreciated, investors can receive the best overall return while preserving the portfolio over the long-term. Focusing on the entire return generated by the portfolio (income return plus capital return), rather than just the income component, investors can achieve several benefits:

a) Maintain preferred length of maturity (duration) and credit quality in fixed income
portion of portfolio.
b) Maintain targeted asset allocation of overall portfolio.
c) Allow the overall portfolio to be more tax-efficient

Many investors become confused when the term “total return investing” is discussed in the context of post-retirement investing. Total return as an investing goal remains independent of any withdrawal strategy. Using historical equity total returns of approximately 9% per year and current short-term tax-free interest rates of about 2% annually, Tandem can construct a balanced portfolio that allows investors to withdraw funds annually for living expenses, while maintaining the structural integrity of the overall portfolio. While the investor will be selling or reducing some securities over time to help fund withdrawals, the overall portfolio is expected to keep pace with, or exceed the rate of withdrawals and thus not be reduced in value based on long-term expected returns.

Disclosures:

Tandem Wealth Advisors LLC (“Tandem”) is an SEC-registered investment adviser. Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the SEC.

The information published herein is provided for informational purposes only and does not constitute an offer of investment advisory services. All information is subject to change without notice. Nothing contained herein constitutes financial, legal, tax, or other advice. No investment process is free of risk, and investors may lose all their investments. Diversification and asset allocation do not ensure a profit or guarantee against loss. Past performance is not indicative of current or future performance and is not a guarantee. The opinions expressed in this video may not fit your risk and return preferences.

Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Nothing contained herein may be relied upon as a guarantee, promise, assurance, or a representation of future events or conditions. Tandem does not assume any duty to update any of the information.

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The Certified Financial Planner™ and CFP® (collectively, the “CFP® marks”) are professional certification marks granted in the United States by Certified Financial Planner Board of Standards, Inc. (“CFP® Board”). The CFP® certification is a voluntary certification; no federal or state law or regulation requires financial planners to hold CFP® certification. The CFP® is recognized in the United States and a number of other countries for its (1) high standard of professional education; (2) stringent code of conduct and standards of practice; and (3) ethical requirements that govern professional engagements with clients. To earn the credential, each CFP® candidate must have a bachelor’s degree (or higher) from an accredited college or university and three years of full-time personal financial planning experience. In addition, candidates must take the CFP® Certification examination and complete a CFP® -board registered program or hold an accepted designation, degree, or license. Every two years, CFP® certificate holders must complete a minimum of 30 hours of continuing education. More information regarding the CFP® is available at http://www.cfp.net.

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