Rethinking Fixed Income With Dividends

Against the backdrop of recent bank failures, stubbornly high inflation, and uncertainty around future interest rates, traditional fixed-income investments such as bank accounts, CDs, and government bonds, aren’t providing investors with the same level of comfort they once did.

Maybe it’s time to refresh our thinking about where to invest a “fixed-income” allocation within a Financial Independence (FI) portfolio.

Let’s start with why we invest in fixed-income investments in the first place. Generally, for three reasons:

• #1- stable and predictable cash flow (e.g., interest income)
• #2- the relative safety of our capital, and
• #3- a need in our overall FI plan.

If traditional fixed-income investments are part of your plan and your cash is coming up short, dividends might help fill the gap.

You Can’t Avoid Risk, But You Can Manage It

Before we move forward, a quick refresher on “risk” which we explored in One Definition of Risk for All of Us. We don’t look at short-term price volatility to measure risk but rather we define our risk in more practical, personal terms: Our principal risk is falling short of our cash spending goals.

As a result, in the short-term, we want to rely as little as possible on the sale of stocks to cover cash flow needs. As we all know, there is nothing ‘safe’ about being forced to sell stock to generate cash when the markets are falling.

So, what if you don’t need to sell stocks in the short-term and are comfortable with their long-term prospects? Well, price volatility becomes much less concerning and the cash dividends that stock funds generate can now move into primary focus.

"Do you know the only thing that gives me pleasure? It’s to see my dividends coming in." - - John D. Rockefeller

My overarching theme here is cash flow yield and capital preservation. I'm willing to sacrifice stretching for price appreciation in this component of my FI portfolio. That is, we can think of a quality dividend fund (held long-term) more as a "bond-like" investment vs. pure equity play. This view is somewhat analogous to a real estate investor owning an apartment building. Collecting the monthly rent checks is what matters. Daily changes in the fair market value of the building are of no consequence to the long-term investor.

Interest And Dividends Working In Tandem

As background, here is a high-level view of just a few income opportunities along the yield spectrum:

• National average yield for bank savings accounts is currently around 0.4%.
• If you are willing to venture out to smaller online banks, high-yield savings accounts might get you upwards of 4-5%.
• S&P 500 passive index ETFs are currently yielding around 1.5%, with expense ratios generally less than 0.10%.
• Actively managed ETFs that are diversified and dividend-focused have a yield range of 2%-6%+ with expense ratios generally below 1%. (At the low end of this yield range you’ll find bond funds and moving up this range will be equity-focused ETFs).
• Closed-End Funds (CEFs) and Business Development Companies (BDCs) again, broad-based, actively managed dividend-focused funds have yields ranging from 6-10%+ with average expense ratios generally higher than 1%. You can find both equity-focused or debt-focused funds (bonds or corporate debt; leveraged or unleveraged) to fit your personal preference.

As you move up the yield curve from traditional fixed income investments to equity funds you also will get more volatility in market prices - - but again, do we care?

Price volatility is not a concern provided (a) we have no intention of selling our quality fund choices, (b) we are at minimal risk of being forced to sell in the short-term in order to generate cash, and (c) we can control our emotional response to inevitable market drops.

Just like the real estate investor, we are energetically focused on collecting the dividends while apathetic to the day-to-day price changes of the fund. Occasionally, we’ll have a dividend cut (or an empty apartment), but with perseverance and patience, things usually bounce back. "Successful investing is about owning businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation’s – and, for that matter, the world’s – corporations." - - Jack Bogle

By no means are dividends guaranteed, but historically, dividends have been significantly less volatile than stock prices. Since World War II, there have been 11 bear markets defined by a 20% or greater drop in the S&P 500 Index (excluding the COVID-19 induced drop which has yet to completely play out).

In three of these bear markets, dividends increased. In seven of the remaining eight, the average peak-to-trough decline in dividends was just 3%. The one outlier is the 2008-09 financial crisis which saw the S&P 500 Index drop 57%. The dividend decline was 23%, less than half of the Index price drop, and in four years dividends recovered to their pre-crisis level.

[NOTE: Recognize that a fund’s yield is important, but it should not be the sole factor used to make your investment decision. For example, the Invesco S&P 500 High Dividend ETF is today yielding 4.4% by investing in, you guessed it, a subset of S&P 500 companies. The Global X SuperDividend ETF’s yield is a much juicier 15% with almost three-quarters of its capital invested in foreign issuers including several small Chinese companies I’ve never heard of. I’m not recommending one over the other, but simply pointing out that you still need to do your homework to make sure each potential steward of your money is a quality fund and a good fit for your plan and your temperament.]

As In The Game Of Chess, See The Whole Board

Before you go off chasing higher yields, be sure to address reason #3 that we mentioned at the outset: What is the need in your plan that you are trying to fill? Always take a step back and view investment selection and asset allocation within the context of your entire financial plan.

If, for example, bank CDs are part of your plan, and you are meeting your overall cash needs, be happy. The fact that CDs (one sliver of your plan) are delivering less than inflation or less than the stock market is irrelevant.

There is no reason (from a mathematical perspective) to stretch for more yield when your plan doesn’t need it. Why jeopardize what you have and need to chase what you don’t have and don’t need? Remember, you are not investing to beat inflation, an arbitrary market benchmark, or your neighbor, but rather to meet your cash spending goals.

A Thought Experiment

Let’s assume a benevolent billionaire offered to give you more cash than you could possibly spend in your lifetime or even your children’s lifetime. Fantasize about what that number would be…now double it. That is your offer.

This pot of money comes with only one stipulation: you must keep any unspent cash in a bank vault earning nothing, zip, zilch. Which response is most aligned with your thinking: (a) ‘No thanks, a negative real return on my cash would be foolish,’ or (b) ‘Thank you and can I buy you dinner?!’

Don’t fail to see the whole board.

I am not advocating for replacing your entire fixed-income allocation with equities, but I am suggesting that well-diversified, high-quality dividend-focused funds are worth a look.

As always, invest often and wisely. Thank you for reading.

The content is for informational purposes only. It is not intended to be nor should it be construed as legal, tax, investment, financial, or other advice. It is merely my own random thoughts.

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