Income portfolio diversification is important in order to maintain dependability to your dividend checks when the proverbial bad apple cuts or eliminates distributions. When a whole sector turns out to include an above average concentration of bad apples, which was the case with financials between 2007 and 2009, investors that had allocations to other sectors should have been able to maintain the level of their distributions consistent. They could have easily replaced any dividend cutters or eliminators into other promising and extremely undervalued dividend paying securities.
Diversification protects investors against certain risks. At some point however, no matter how many quality dividend growth stocks one holds in their income portfolio, they would not be properly positioned against other risks. One of the biggest risks that an economy can experience is the risk of deflation. Deflation is bad for corporate profits, and therefore is bad for dividend payments. The only assets that can maintain the level of income during a deflationary environment are Treasury Bonds.
In a previous article, I outlined the idea that dividend growth investors should have at least a 25% allocation to fixed income at the time of their retirement. I mentioned how an investor can simply use the proceeds from their income portfolio for the five years prior to retirement, in order to build this fixed income cushion. However, with interest rates near all-time lows, purchasing U.S. Treasuries today seems like a recipe for disaster for those starting today.
The most that investors in treasury bonds today can expect is a 2% to 3% annual return for the next ten, twenty, thirty years. This is barely enough to keep up with historical rates of inflation however. Some high quality stocks like McDonald’s (NYSE:MCD) at 3.10%, Johnson & Johnson (NYSE:JNJ) at 3%, and Phillip Morris (NYSE:PM) at 3.70% yield much more than U.S. Treasuries today. In addition, their distributions are much more likely to increase over the next 20 – 30 years. The investor who started purchasing bonds two or three years ago however could have seen better rates in the 4% to 5% range for Treasuries and Agencies.
The risk is that we get deflation over the next decade, which can hurt corporate profitability. As governments around the world have been pumping out liquidity for almost five years now, it is difficult to forecast any other scenario than rampant inflation over the next five to ten years.
However, the fears of rampant inflation have been going on over the past five years, and yet these might be over-hyped. Japan has had record low interest rates for almost 20 years, coupled with poor stock market returns. The country has been taking on debt to prop up local demand, without really resulting in anything other than deflation. Investors in Japanese bonds did much better than investors in stocks or real estate over the past twenty years.
During the Great Depression, plenty of companies cut dividends as their revenues and net incomes were hurt by the contraction in demand for their products and services. Losses in nominal dividend income ranged anywhere between 50% for the S&P 500 to 75% for the companies in the Dow Jones Industrial index. Investors in U.S. Treasuries however managed to receive a stable stream of income.
I did my first investment in U.S. Treasuries in 2010, but the rising prices made me sell for hefty profits. Since then, my allocation to fixed income has decreased to approximately 3%, and continues dropping as I allocate new funds exclusively to dividend stocks. I preferred to purchase individual bonds, rather than bond funds, and then ladder them by maturity. I am not a fan of corporate bonds, because I believe that I am not properly compensated for the risk of default due to a soft economy.
As a result I am much better off in the company stock than the bond. I am not a big fan of bond funds, because I have no guarantee that they would be holding bonds to maturity. In a rising interest rate environment, bond funds that sell existing low yielding bonds and purchase higher yielding new bonds in order to maintain their maturities could end up losing money for investors. If I hold my bonds to maturity, at least I will get my principle back, albeit with a lower purchasing power. I also avoid municipal bonds, because they have a risk of default.
As I near the five year bond accumulation period prior to the potential financial independence point, I am not seeing much value in Treasuries today. That leaves my portfolio wildly exposed to the risk of deflation. I might end up simply laddering bonds and concentrate on U.S. Agencies like Fannie Mae and Freddie Mac with duration that is less than 10 years.
However, I highly doubt that a 25% allocation to fixed income makes sense in the current environment. The most I see putting in is probably two years’ worth of expenses in short-term laddered fixed income securities with an average maturity of five years. That could work to anywhere between 6% to 8% of my total portfolio.
Full Disclosure: Long MCD, PM, JNJ