Let’s say you buy 20 bonds. Each of them yields 5%. Nineteen out of 20 mature at par and you get your money back, with interest.
One of them defaults. You are back where you started!
It is said that income investing is a negative art. Your goal isn’t to pick the winners—it’s to avoid the losers. You want to pick winners, invest in stocks. Have you seen a chart of Beyond Meat? Bonds generally don’t do that.
It is also said that income investing is like picking up nickels in front of a steamroller. You’re earning a 4–5% coupon, and you could get whacked pretty much any day, just like what happened at Toys “R” Us. It is a bit like selling puts.
As a negative art, bond investing has become more and more difficult. Yields are slim, and they are not what I would call “safe.”
The default rate is virtually zero, which means we are at the peak of the cycle. And getting 3% on XYZ high-grade corporate bond fund does not sound like a great idea.
This is one reason why there has been such a historic rally in municipal bonds, pension nonsense notwithstanding.
Bond investors now allegedly think about what could go wrong.
What Could Go Wrong
I am far from the first person to worry about the corporate credit cycle.
Nine months ago, people were flipping their lids about the rise in BBB credits and the potential ginormous migration to junk.
I know a few smart hedge funds who bet against all the paranoia. They did quite well.
The credit cycle will turn eventually.
Corporate debt issuance has been historic. Up until this point, there has been near-limitless demand for it.
It will take a skilled portfolio manager to avoid the turds.
I think last Friday was the first day I seriously considered the possibility that we were headed towards a recession—with two-, three-, and five-year note yields plunging below two percent.
The Key to Investing
I suspect most income investors reading this are dividend investors. Dividend investing is similar to bond investing.
High dividends are good, but they can also be bad if they are signalling a future dividend cut. Anything much over a 5–6% dividend in a stock should be viewed with some suspicion.
With regard to dividend investing, the key is not necessarily to buy big, fat dividends, but to buy growing dividends. Most people have it all wrong—they go yield hogging and end up paying the price.
Believe it or not, Apple is one of my favorite stocks. Not because it is a growth stock, but because it is a dividend stock.
It has a decent yield, but one that is likely to grow. One day it will have to figure out how to more aggressively return cash to shareholders.
I am going to tell you the secret to investing. Are you ready?
Invest in companies with dividend growth, and reinvest the dividends on a regular basis.
Say you had a million dollars. Buy 20 stocks with dividend growth. Set up the dividends to reinvest. Look at the P&L once a year. Make some adjustments. Repeat.
The 35/55/3/3/4 Portfolio
My guess is that this growth phase we’ve had in the stock market for so long is getting down to tag ends.
Recent history has demonstrated that it has paid to buy stocks without dividends. I have never understood why you would buy a stock without a dividend. Making enough extra cash to give some to you is how a company demonstrates that it’s profitable.
I have written before about the 35/55/3/3/4 portfolio. But I have never spent much time talking about the composition of the component parts.
The 35% in equities should all be invested in stocks with growing dividends, across all sectors.
The 55% in fixed income should be split between Treasuries (including TIPS), corporates, mortgages, municipal bonds, and a handful of international bonds.
Then you have the 3% commodities, the 3% gold, and the 4% REITs.
The blended yield of this portfolio is probably around 3 to 3.5%. You could retire on that!
Yield hogging is a pejorative term, and it should be. The whole financial crisis started because people decided to reach for another 30 basis points. Rule number 42: don’t be dumb.