How to build the ultimate income portfolio

It’s an entirely natural progression. Since income is exactly what you want to extract from your portfolio in your golden years, why not design your portfolio from the ground up to provide that regular cash flow? After all, the idea of throwing off piles of cash every month in the form of interest and dividends is pretty cool.

There’s another reason that income investing appeals: higher returns. In fact, as MoneySense’s Norm Rothery revealed in “The stocks that pay you back,” dividend stocks may be more profitable than you dreamed. Data from Dartmouth College professor of finance Kenneth French shows that if you tracked the returns on the top 30% of Canadian dividend stocks by yield, you would have found that over the 30 years between 1977 and 2007, they provided an eye-popping return of 15.9% a year. In other words, as a group, high-dividend stocks have historically thrashed the market.

More recent research by RBC Capital Markets supports this finding. In a report published just last August, RBC found that since 1986, Canadian dividend-paying stocks have outdone the market by an average of 3.5 percentage points a year. Stocks that not only provide dividends, but have a habit of increasing those dividends, did even better, outperforming by an average of 5.2 percentage points a year. “Analyzing dividend investing over an extended period helps make our case that it is an all-weather strategy and not just for times of market turmoil,” concluded the RBC paper, authored by RBC Capital Markets chief institutional strategist Myles Zyblock and his colleagues.

Given such findings, it’s no wonder that dividend stocks—and income portfolios in general—are all the rage. But there are detractors, who point out that pursuing dividends at any cost will eventually lead to heartbreak. Those detractors are right. While a good income portfolio can be as solid and reliable as a mule, a poorly constructed portfolio can be as unpredictable as a high-strung lap dog. The trick is to get the right balance between the various income-oriented investments out there—including bonds, dividend stocks, preferred shares and annuities. Then, once you’re plotted out your portfolio in broad strokes, you need to buy the right bonds, dividend stocks, preferred shares and annuities. Read on, and we’ll show you how.

The 50% solution

The first step to building your ultimate income portfolio is to get the right blend of your two basic building blocks: bonds and dividend stocks.

Traditionally, investors have looked to bonds for yield and stocks for growth. But recently many blue chip stocks have pulled ahead of 10-year government bonds when it comes to yield. Such stocks are now providing not only growth, but a higher annual cash payout too. That hasn’t happened since the 1950s. “This is the reverse of the historical mark,” says Bob Gorman, portfolio strategist at TD Waterhouse. As a result, the plans of many income investors have been thrown out of whack.

What’s the solution? With so much economic uncertainty you still need a healthy dollop of fixed income, but you may want to consider tilting your portfolio a little more towards dividend stocks. One common conservative approach is to go with a percentage of fixed-income investments (such as bonds and GICs) that’s equal to your age. So if you’re about 60, you would go with 60% fixed income. But you may want to consider nudging up your dividend stock component. TD Waterhouse, for instance, is now recommending that income investors consider a mix that’s roughly 50% equity and 50% fixed income and cash, says Gorman.

A better bond. Now you have a problem. You need to fill about half of your portfolio with fixed-income investments, but right now, bonds, GICs and other fixed-income investments are providing depressingly low yields. What to do?

Not too long ago even very conservative investors could meet their entire income needs with bonds alone. Larry Moser, regional sales manager for Bank of Montreal Retail Investments, remembers selling a 10-year Government of Canada bond yielding 7.25% to one of his clients back in 1995. The rate of inflation back then was roughly the same as today, so one simple bond neatly met all of her income needs.

Those days are over. As we went to press on this issue of MoneySense, benchmark Government of Canada bond yields were a paltry 2.5% for 10 years and a downright miserable 1.7% for five years. Meanwhile, three-month Canadian treasury bills were yielding just under 1%. Those kinds of returns don’t even keep up with the current inflation rate of around 3%, so your money is losing purchasing power every year. In other words, taken in isolation, government bonds and GICs are now a guaranteed way to lose money.

Luckily, you can find better yields among investment grade corporate issues. For example, the bonds issued by several large Canadian telecom providers were recently yielding more than 3% for maturities of about five or six years. An investment grade rating ensures that credit risks are still pretty low, although corporate bonds won’t perform as steadily as government bonds if the market ever swoons again like it did in late 2008.

Because of the higher yields, many savvy money managers are currently overweighting their portfolios with corporate bonds, compared to the index. Gorman from TD Waterhouse says his firm’s mixed-bond portfolios are typically weighted at around 65% to 70% in corporates and only 25% to 30% in government bonds. But don’t go overboard with longer-term bonds. Historically, you would have been able to earn significantly better yields by picking longer-maturing issues. These days you won’t get a lot of extra yield and prices will take a big hit if interest rates start rising.

When purchasing your bonds, we recommend going with exchange-traded funds (ETFs), bond index funds, or low-fee bond mutual funds, rather than individual bonds. The diversification you get in ETFs and index mutual funds helps to limit the risk of a big hit if a particular bond defaults. And there’s no point in paying a high fee when there are cheaper options.

Among low-fee active bond funds, we recommend the PH&N Bond Fund (Series D), the PH&N Total Return Bond Fund (Series D), the McLean Budden Fixed Income Fund (Series D) and the Beutel Goodman Income Fund (Class D). All have a larger proportion of corporate bonds than the overall bond market index. Management expense ratios (fees) range between 0.6% and 0.9% per year.

If you prefer to invest in ETFs, you can buy the iShares DEX Universe Bond Index Fund (XBB), which tracks the overall Canadian bond market. However, if you want to tilt your portfolio towards corporate bonds, you should consider separately purchasing corporate and government bond ETFs in whatever proportions you want. The iShares DEX All Corporate Bond Index Fund (XCB) tracks only Canadian investment grade corporate bonds. It’s currently yielding about 3.3% after fees. The iShares DEX All Government Bond Index Fund (XGB) tracks only government bonds. It’s yielding about 2.1%. So if you invested two-thirds in corporates and one-third in governments, you could earn a combined yield of about 2.9%.

If you prefer GICs instead of bonds, you can do almost as well—if you shop around. Some of the more aggressive financial institutions were offering five-year GIC rates of 2.5% to 2.75% as we went to press. That’s a better yield than you’ll get with top-rated government bonds with equivalent maturities.

Let the dividends roll

Now that you have your bonds, it’s time to take a closer look at which dividend stocks to buy. We’re going to provide you with some general guidelines below, then you can flip to our Retirement 100 equity listing to pick the specific stocks you want. There we assign letter grades to all 100 of Canada’s largest dividend paying stocks, plus we provide a recommended short list of our Retirement All-Star stocks.

Our first tip follows from the RBC study we mentioned above. It found that while, as a group, dividend stocks outperform the larger market, you get an even better boost if you focus in further on the companies that increase their dividend payout on a regular basis. That’s why in the Retirement 100 listing that follows, we award extra points to stocks that have a history of regularly hiking their dividends.

Our second tip is not to get too greedy. It turns out that you should avoid many of the stocks which pay the very juiciest dividends, no matter how enticing they may be. That’s because sky-high dividend yields often indicate that the market views the dividend as unreliable. The yield is the annual dividend per share divided by the price per share. So a very high yield may simply indicate a very low stock price. Too often the dividends for such stocks are eventually cut.

Finally, when searching for suitable dividend stocks, you’ll want to make sure the company doesn’t pay out so much of its profits in dividends that it might be unsustainable. You’ll also want to make sure the company retains and reinvests enough money in the business. “If we get a high level of dividend payout, we have to make sure they’re maintaining the assets in their current form,” says Stuart Kedwell, vice-president and Canadian equities co-head at RBC Global Asset Management. “If we’re getting a low payout, we need to see that the capital they’re not giving back to us is going to be put to good use.”

Canada versus the world

There’s one other consideration when you’re choosing your dividend stocks, and that’s whether to go with all Canadian stocks, or look at including U.S. and overseas dividend payers too.

In general, the experts tend to warn against the “home bias” of investing too heavily in the Canadian market, but investing in Canadian dividend stocks is a special case. That’s because these dividends are ready-made to provide the Canadian dollar income you’ll need under domestic economic conditions. That way you don’t have to worry about exchange rate changes, and, if inflation were to increase in Canada, many Canadian corporations would grow profits and dividends to offset it.

Just as importantly, you get the best tax break going on dividend income from Canadian stocks held in non-registered accounts. For example, if you earned $85,000 a year in Ontario, your marginal tax rate would be 43% on foreign dividend income. But when it comes to Canadian dividends, your effective marginal rate would be only 24%. That means you’d pay $430 in taxes on every $1,000 you got in dividend income if the stock were foreign, but only $240 in taxes if it were Canadian.

The upshot is that you’ll probably want to tilt your mix of dividend stocks towards Canada unless you’re investing in a tax shelter. Gorman of TD Waterhouse says a typical income investor might consider an equity mix across her overall portfolio of “at least” 60% Canadian, with the remainder divided between 24% invested in the U.S. and 16% in non-U.S. international stocks.

Guaranteed for life

There’s one more product that you should consider for your ultimate income portfolio, and that’s the annuity. Many income investors overlook this income staple, but where else are you going to find a guaranteed cash flow for life? The problem is that payouts are affected by current interest rates, so they are much lower these days than historical norms. A typical yield that a 70-year couple could get on a fixed annuity is about 6.4% of the purchase price a year for as long as either spouse lives.

But if you don’t have a pension from work, an annuity may still have a place in your portfolio as a hedge against “longevity risk” or the risk that you’ll live much longer than you think. Consider your needs carefully and do your research, as these products have lots of different options and features. Used appropriately, they can be a great complement to your conventional stock and fixed income investments.

Now that you know how to assemble your ultimate income portfolio, it’s time to pick your stocks. Check out Canada’s best dividend stock listing, complete with All-Star picks that have delivered 39.2% returns over the last four years.