Income Generation Is a Problem – Plus, The Taxman Clips Your Coupon
Income generation in today’s low yield environment remains a challenge – especially on an after-tax basis
Investors could consider diversifying sources of risk with emerging market debt (currency risk), senior loans (credit risk), and preferreds (hybrid of equity and rate risk) to seek higher pre-tax yields – and adding municipals to pursue higher after-tax yields.
The amount of global debt trading below a 1% yield now outpaces the entire market capitalization of the S&P 500.1 That’s a problem as one of the primary functions of bonds in a portfolio is to generate income. In fact, with no major developed nation’s sovereign debt currently yielding above 1.4%,2 the promise of income from bonds has been, to a degree, broken – leaving just bonds’ potential benefit of diversification.
That is not the worst news, though. If we look at yields beyond the macro level and consider the actual income paid out to investors after taxes, the search for income becomes much more challenging.
One for you, nineteen for me When yields on the Bloomberg Barclays US Aggregate Bond Index (US Agg) were 3.6% back in 2018, the after-tax yield was 2.27%.3 That was above the average rate of inflation4 and more than equities on a pre-tax basis,5 along with 80% lesser volatility.6 However, current yields on the US Agg are 1.2% pre-tax and 0.76% post-tax.7 On a global basis it’s even worse, with the Global Agg yielding 0.91% pre-tax and 0.57%8 post-tax.
Such low levels mean the standard 60/40 portfolio of global stocks and global bonds now yields the lowest amount on record on an assumed after-tax basis, as shown below. At less than 1%, the yield is below the current rate of inflation (1.4%),9 as well as the inflation expectations over the next three, five and 10 years.10 The same calculus holds if you change the bond side to include more than just investment-grade (IG) rated debt,11 also shown below. Swapping in this 95% IG/5% high yield mix for the 40% of the bond allocation, the entire mix also yields less than 1%, a level still well below inflation expectations. Adding in non-IG bonds in this fashion to a 60/40 allocation increases the after-tax yield by just 4 basis points. That’s a problem.