Thoughts On ... The Rise of Income

December 16, 2022 | Matt Barasch


Only a year ago, income was hard to come by. Stocks were pretty much the only game in town when it came to generating an income stream of greater than 4% and even that posed a challenge when trying to build a diversified portfolio of securities.

2022 has been one of the more challenging years investors have faced in the past four decades. The stock market will, on average, decline roughly once every four years, which does not make a stock market decline all that unusual. However, to see stocks decline at the same time that bonds decline does present what we would describe as a very unusual event. Let’s look at a chart and then comment:

So, what are we looking at? Each point on the graph represents the annual performance of the S&P 500 vs. the U.S. 10-year treasury bond. The upper right quadrant represents years in which both the stock market and the bond market generated positive returns, while the upper left represents years in which stocks rose and bonds fell in value. The lower right represents the opposite – stocks down and bonds up, while the lower left would be the “double whammy” of both stocks and bonds falling in value.

Returning to the chart, we would also point to the blue numbers we have included in each quadrant. These numbers represent the number of times that quadrant has occurred. So, over the past century, stocks and bonds have both been positive in a given year 63-times, while bonds have been positive with stocks declining 21-times and stocks have risen, while bonds decline 13-times. The lower left – both stocks and bonds declining – occurred only 3-times prior to 2022 with 2022 now almost certain to be the fourth time.

Lastly on the chart, we would point to the red dot, which represents 2022. As you can see, 2022 has been a major outlier, as it not only represents one of only four years over the past century in which both stocks and bonds have declined, but also it represents the only year in which both have simultaneously declined by more than 10% - both the S&P 500 and the U.S. 10-year have generated a total return of ~-15%.

The Rise of Income

We will leave the reasons for the above declines both to prior missives we have written and future ones we are likely to write. But today, we want to focus on one of the things that the above has wrought – the rise of income.

If we go back a year ago, income was hard to come by. Stocks were pretty much the only game in town when it came to generating an income stream of greater than 4% and even that posed a challenge when trying to build a diversified portfolio of securities. Moving away from stocks, almost all forms of fixed income – government bonds, corporate bonds, GICs, even high yield bonds – carried yields of less than 4% with high quality investment grade options mostly in the 2% to 2.5% range. Let’s look at a table and then comment:

Here we are looking at most of the available income options a year ago vs. today. On average, yields have gone from ~2.2% a year ago to ~4.45% today. Per $100,000 invested, this would equate to an average income increase of nearly $2,300. Put another way, the average increase in income on the above (~$2,300) is greater than the average income (~$2,200) these instruments would have generated if purchased a year ago.

Case Study – Bank of Nova Scotia

Let’s look at the above in the context of a specific name – Bank of Nova Scotia (BNS). Now, BNS is a very good business. The Canadian banks operate as somewhat of an oligopoly with a strong regulator that tends to demand more of Canadian banks from a safety perspective than regulators outside of Canada do. Further, most Canadian mortgages are insured by the government, so some of the credit risks that banks outside of Canada face are not present in Canada, which adds a further layer of protection for investors.

That said – Bank of Nova Scotia had a bad year, declining ~27%. While all of the Canadian banks have something that makes them different from their peers, BNS has carved out the niche of the emerging market bank with significant exposures in Latin America. This has been problematic in 2022 as rising rates and inflation do not tend to jibe well with emerging markets. Further, BNS undertook a CEO change, which was clumsily handled, adding a further down-leg to the performance of the stock.

Sticking to the income theme, let’s take a look at another table and then comment:

While there are a number of things we could look at in the above, let’s focus on the change in valuation and the change in dividend yield. BNS went from trading at 11.4x expected 2022 earnings on January 1st to 7.7x actual 2022 earnings as of 12/16’s close. Further, the dividend, which rose 3% for the year ($4.00 to $4.12), now generates a dividend yield of 6.3% vs. 4.5% at the start of the year.

Now, we suspect that BNS may continue to struggle here as we enter 2023. Credit is likely to prove challenging for the Canadian banks in 2023 as the housing market continues to see price declines and the broader Canadian economy likely sees job losses. But these credit cycles come and go and as history has taught us – good businesses tend to do a good job of weathering these storms with a few nicks and bruises, but without significant lasting damage.

A buyer of BNS here is likely not catching the bottom (we would not be surprised to see further near term downside for the broader market and the Canadian banks), but a buyer is picking up a business that will pay him/her ~$6,300 per $100,000 invested with a strong likelihood that this income stream will grow over time (Canadian banks tend to raise their dividends 3-5% per year; although, this will vary depending on the economic backdrop).

The 60-40 Income Investor

For many years, the industry has focused on the idea of the 60/40 investor – an investment mix of 60% stocks and 40% fixed income. The 60/40 mix was born out of an era when bond yields were 5% or more and an investor targeting a 6-8% return, could put 40% of his/her portfolio in relative safe bonds to generate 5% with the plan (hope) that the other 60% in stocks would generate 8-10%, pulling the overall portfolio return up to that 6-8% range.

For an income-oriented investor, getting to say a target yield of 4% when utilizing a 60/40 split, had become an almost impossible challenge. Returning to our earlier table, there was no mix a year ago that would have produced an average yield of 4% with even a 100% exposure to high quality dividend paying stocks likely falling short of the 4% target.

Fast forward to today and not only can the 60/40 income investor achieve his/her 4% goal, but also significantly exceed that target. Let’s take our table from above and imagine what that might look like:

While we could play around with the weightings in the above in a number of ways, the bottom line is that building a high quality income portfolio is one positive offshoot of what has been a very challenging year for investors. There are no guarantees that this backdrop will last for more than a short period of time as bond yields have already begun to come back down, especially in the 5-10 year range. But for now, the rise of income has opened up opportunities that have not existed for the better part of the past 20-years.