Beyond Bonds: Income Investing in a Low-Yield World. Pat Dorsey, CFA President pdorsey@scia-capital.com

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1 Beyond Bonds: Income Investing in a Low-Yield World Pat Dorsey, CFA President pdorsey@scia-capital.com

2 When interest rates are ultra-low, bonds are not riskless investments. Bonds can add risk to a portfolio in a rising rate environment Inflation is the income investor s worst enemy. Risk and volatility are not one and the same. To beat inflation, own a growing income stream. Creative solutions can make a big difference.

income investor s worst enemy. Risk and volatility are not one and the same.

3 Bond investors face three main risks: Credit risk Interest-rate risk Inflation risk Unless you re buying individual bonds from dodgy companies or you own a super-aggressive bond fund credit risk is the least of your worries now.

individual bonds from dodgy companies or you own a

4 When rates go down, bond prices go up. When rates go up, bond prices go down. The longer a bond has to maturity, and the lower the coupon, the more it will react to interest rates. Interest-rate sensitivity is called duration. Example: A bond mutual fund has a duration of 5, so for every 1% change in rates, the fund s price will change by about 5%. The higher the duration, the more sensitive a bond (or bond portfolio) is to interest rates.

Interest-rate sensitivity is called duration.

5 16% 14% 12% 10% 8% 6% 4% 2% 0%

6 24% 21% 18% 15% 12% 9% 6% 3% 0%

7 Hyper-low rates magnify the impact of duration, because there s less yield to offset price declines. Example: If rates increase 1.5%, a bond (or bond fund) with a duration of 5 would drop 7.5%. (1.5 x 5 = 7.5.) But Pat, the Fed is going to keep rates low for a long time why should I worry? Because small moves make a big difference: At a 2% yield (an investment-grade fund with a duration of 5), a 7.5% price drop would wipe out four years of interest.

Because small moves make a big difference: At a 2% yield (an investment-grade fund with a duration of 5), a 7.

8 4.0% 3.5% Fund Duration Return if rates rise to 3% Pimco Total Return 4-5% 1.8% ~3 Vanguard Total Bond Market Index Yield Years of lost interest 5-6.5% 1.7% ~4 3.0% 2.5% 2.0% 1.5% Ten-Year Treasury Yields 1.0% Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13

9 u Bond payments do not grow fixed income. u Over time, inflation erodes purchasing power. 16% 14% 12% 10% 3.7% postwar average 8% 6% 4% 2% 0% -2% -4%

10 $1,250,000 $1,150,000 $1,050,000 $950, Year Investment Grade Bond Yielding 2.7% w/ Inflation at Long-Term Average of 3.7% $850,000 $750,000 $650, Bond Bond After Inflation Cash After Inflation

7% $850,000 $750,000 $650,000 2013 2014 2015 2016 2017 2018

11 u Academic finance says risk = volatility (beta). So, bonds are deemed less risky than equities because they have not bounced around as much. u But perhaps risk is not just past volatility. What about valuation? Is an asset with low past volatility low risk if it is overpriced? What about your goals? Does a low-volatility asset truly have low risk if it can t beat inflation?

u But perhaps risk is not just past volatility. What about valuation?

12 u Company A is a fast-growing grocery store that is valued at 30 times earnings. u Company B sells robotic surgical equipment, is also growing fast, and also trades at 30x. u Company C owns 15k miles of gas pipelines, and pays a 4% dividend growing at 20%. u Which is riskier? Which future is more certain?

u Company B sells robotic surgical equipment, is also growing fast, and also

13 u Company A (Whole Foods) has been 50% less volatile than the market. u Company B (Intuitive Surgical) has been 25% less volatile than the market. u Company C (Williams) has been 40% more volatile than the market. u Is Williams really the riskiest company?

14 Complete disaster! Low volatility! Long-Term Capital Management

15 First, ask yourself what role bonds are playing in your portfolio. Bonds generally do three things: Provide liquidity (near-term funding needs) Reduce portfolio volatility Generate income

16 u Need liquidity? Stick with bonds. u Super nervous and prone to sell during times of market stress? Stick with bonds but keep durations short. Consider active management. u Don t need liquidity? Comfortable with a bit more principal volatility? Look elsewhere!

17 If you decide that less liquidity and a bit more volatility is acceptable for you: Focus on the stability of the income stream, not monthly movements in portfolio values. Focus on the growth rate of the income stream, rather than the current yield. Over time, dividend/ distribution increases are the surest way to maintain purchasing power.

values. Focus on the growth rate of the income stream, rather than the current yield.

18 $1,600,000 $1,500,000 $1,400,000 $1,300,000 $1,200,000 $1,100,000 $1,000,000 $900,000 $800, Bonds (3.4%) Stocks (3.4% + 7% Div Growth) Bonds After Inflation Stocks After Inflation

2017 2018 2019 2020 2021 2022 2023 Bonds (3.4%) Stocks (3.

19 The usual suspects for equity income are richly valued: Utilities, Consumer Staples, Tobacco. But by looking in health care, industrials, and elsewhere, 3.2% yield + 5%-6% growth is possible. Pros: Better than bonds, ok for qualified accounts, inflation protection, low rate risk, decent yield. Cons: Current yield still not great, volatility close to mainstream equities, valuations only passable.

Pros: Better than bonds, ok for qualified accounts, inflation protection, low rate risk, decent

20 Go off the beaten path, diversify factor risk: Master Limited Partnerships Trust Preferred Securities Baskets of Mortgage Backed Securities Pipeline General Partnerships This is our High Income Portfolio.

Securities Baskets of Mortgage Backed Securities

21 Yields 6.3% with 3% income growth. Up 13% yearto-date. Volatility is 30% less than S&P 500. Holdings are all liquid and trade publically. ~20% Trust Preferred Securities: Stable 6% yield, interest rate risk minimized b/c of call likelihood. ~20% mortgage REITs and MBS mutual funds: Inverse interest rate risk, decent yields. ~50% Master Limited Partnerships: Yields between 4% and 8%, excellent income growth and tax efficiency.

22 Pros: Much higher current income than bonds, good inflation protection, low interest rate risk, materially lower volatility than equities. Cons: Not suitable for non-taxable accounts, slight additional tax-filing complexity, minor risk that MLP tax status will be changed.

23 Bonds are not the only way to generate income. Low inflation and ultra-low interest rates change the risk profile of bonds and not for the better. Risk and volatility are not one and the same. Inflation is a real risk for income investors. The premium on safety (low volatility) is so high right now that you can trade a modest increase in portfolio volatility for a material increase in income.

24 Firm-wide, only 20% of our assets are in bonds. Quite low given our average client profile We have been selling utilities. We have been selling high-yield bonds and moving clients into the High Income Portfolio. Is this unconventional? Maybe. But we think it s the right thing for our clients. And that s what matters.

25 Pat Dorsey Thank You

With interest rates at historically low levels, and the U.S. economy showing continued strength,

Managing Interest Rate Risk in Your Bond Holdings THE RIGHT STRATEGY MAY HELP FIXED INCOME PORTFOLIOS DURING PERIODS OF RISING INTEREST RATES. With interest rates at historically low levels, and the U.S.