How to Build a Safe Income Portfolio

Traditionally, investors thinking about retirement have invested in a mix of stocks and bonds designed to balance safety and growth. The closer to retirement or more risk-averse they are, the more of their portfolio they hold in bonds for safety and regular income. The system has even been institutionalized in the form of “target-date funds” that automatically put more of your holdings in bonds as you near retirement.

But today, the bond market is at an extreme that has many investors questioning this model.

Bonds just don’t fulfill the needs of retired investors any more: Interest rates are so low they don’t provide enough income to live off of, and most bonds will probably lose value over the next few years. Ten-year bonds issued recently have yields under 2%. Treasury Inflation-Protected Securities (TIPS) are actually being issued today at negative yields. (At the January 31 Treasury auction, 10-year TIPS were issued with an interest rate of -0.63%.)

Not only are those interest payments too insignificant to fund your retirement, but once interest rates rise (which they will, eventually) those low-yielding bonds will fall in value. Bonds that are being issued at just slightly below face value today will most likely be worth significantly less than face value in a few years.

Buying newly-issued bonds today would be foolish.

Still, it’s hard to throw an entire investment paradigm out the window. What do you replace it with?

Today isn’t the first time bond investors have had to adapt to a new paradigm. Thirty-two years ago, in 1981, 30-year Treasury bonds were being issued with yields of 15%. And previously-issued 30-year bonds were selling for huge discounts: a 30-year bond issued in 1970 that yielded 7.875% could be bought for 56% of face value in 1981.

Yet, investors thought bonds were a terrible investment. A bond trader quoted in the New York Times that year said, “Anyone who buys a bond today to hold for more than five years is out of his mind.”

The reason was high inflation and a 35-year bear market in bonds that had lasted from 1946 to 1981. At the time, investors thought inflation would remain in the double digits for the foreseeable future. The bond trader above and others quoted in the same New York Times article also expected inflation to continue to rise, making even the newly-issued 15%-interest-rate Treasury bonds a bad investment.

In retrospect, that seems like an insane assumption. But, as New York Times financial columnist Floyd Norris wrote a little over a month ago, “A lot of people on Wall Street in 1981 could not remember a time when bonds were good investments.”

Of course, over the next 30 years, the bond market enjoyed a wonderful rally, and we now find ourselves in the opposite situation: everybody buys bonds, and yields are at rock bottom.

And unsurprisingly, Wall Streeters are now acting as if they can’t remember a time when bonds were bad investments. Or, as a Barclays banker quoted in Norris’ column said, “They say that fish don’t know that they live in water—until they are removed from it—and we wonder if some of the many market participants whose entire professional experience has been conditioned by the financial backdrop created by the bond market rally might underestimate some consequences of its termination.”

Luckily, you aren’t a fish. And hopefully, as a reader of Investment of the Week, you’ve had the courage to take control of your investments, and thus have the power to abandon this outdated old paradigm now, before the aquarium-dwelling bankers come to the same realization.

Of course, abandoning low-yielding bonds is probably going to leave a pretty big hole in your retirement account. And you’re going to want to fill it with something safe and income generating.

One solution, which many retired or retiring investors have already embraced, is to craft a personalized combination of dividend-paying stocks. The hundreds of dividend-paying stocks traded on major exchanges makes it easy it tailor a portfolio to your risk tolerance and income needs. Just take a foundation of 2%- and 3%-yielding blue chips and dividend aristocrats, add some undervalued stocks with temporarily high yields or dividend-growers to boost your yield in the future, and then top off with a sprinkling of riskier but higher-yielding investments.

Here’s what such a portfolio might look like:

Income Portfolio Pyramid

This pyramid works just like the food pyramid we all remember. The categories at the bottom should make up the foundation of your portfolio. A good foundation of low-yielding but reliable blue chips and dividend aristocrats will hold your portfolio’s value, while offering some income and growth potential. This level should include low-volatility stocks of blue chip companies like 3M Co. (MMM), Coca-Cola (KO) and McDonald’s (MCD).

As you move up the pyramid, the yields get higher, but risk increases too.

On the second level are stocks with good yields, and not too much risk. On the left side I’ve listed some of the sectors that traditionally boast higher dividend-payers, like financials, telecoms and energy. Appropriate holdings in this category will vary over time: after the 2008 meltdown, for example, financials went from being some of the best dividend-payers in the market to some of the worst (they also lost a lot of value). Right now, utility yields are lower than average (because of higher-than-average interest), but there are still great yields to be found in other part of the energy sector, like oil and gas drillers and distributors. This part of your portfolio may also include telecoms like Verizon (V, 4.6% yield), insurance companies like Arthur J. Gallagher & Co. (AJG, 3.6% yield) and banks like Bank of Montreal (BMO, 4.7% yield).

On the other side of this level, I’ve created a category for turnarounds and undervalued stocks. That’s because stocks that are normally fairly average dividend payers can see their yields soar when their prices drop. Obviously, you never want to buy a stock just because it’s cheap—and dividend cuts are always a risk—but stocks that have been temporarily beaten down can present great opportunities to investors who are more focused on income than short-term capital gains. These might be stocks that got dumped because of a bad earnings report or bad news, or that are in an unpopular sector. Look out for opportunities in names not traditionally associated with income: Cypress Semiconductor Corp. (CY) is currently yielding 4.4% because the cyclical semiconductor sector is in a downswing. Freeport-McMoRan Copper & Gold (FCX) is another idea in this category, it’s had a rough year and is now yielding 3.9%.

The third level of my pyramid is an alphabet soup: master limited partnerships (MLPs), business development corporations (BDCs) and real estate investment trusts (REITs) are all special types of investment entities created primarily to pass income on to investors. They have their own risks, but in used in moderation (just like dairy and meat, which occupy this spot in the traditional food pyramid), they can be great income-boosting portfolio components.

Finally, at the top we have the category that represents fats, oils and sweets in the traditional food pyramid, traditionally labeled “Use Sparingly.” That’s how you should treat unusually high-yielding investments. This category might include some higher-yielding MLPs or REITs, or really undervalued stocks. Think France Telecom (FTE), which is yielding almost 18% in the wake of the European credit crisis, or Atlantic Power Corp. (AT), which is always a good dividend payer but currently yields 11% because of a recent price drop. These stocks can really juice your portfolio’s yield, but they need to be supported by a base of more reliable, predictable holdings.

Of course, not every stock is going to fit neatly into one of those categories, and the yields are just representative ranges: some dividend aristocrats yield more than 3% and some REITs yield less than 5%.

But if you keep this pyramid in mind when adding stocks to your income portfolio (or starting one from scratch) it will help you create an steady income stream that also meets your risk tolerance and lets you sleep at night.

Need some more ideas? Then I highly suggest you check out my newsletter, the Dick Davis Dividend Digest, which will provide you with 25 to 30 great ideas every month. Plus, subscribers get complimentary stock tips daily! There’s no better place to find great investments for every level of your income portfolio.

Just click here to learn more.

Wishing you success in your investing and beyond,

Chloe Lutts

Editor of Investment of the Week

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