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Trust and Estate Planning News

Don't Chase Yield — You Might Catch It
by Robert Lopardo, ATG Trust Company President

When acting as trustee we are often caught in the balance between the current income beneficiary's desire for cash flow from a trust and the need to consider the interests, vested or not, of future or contingent beneficiaries. When interest rates were between five and seven percent on high quality bonds, it was simpler to explain a balanced investment approach. With rates at historic lows, it becomes more complicated.

The basic bond equation, in normal times, is that bond prices and bond yields are inversely proportional. When rates rise, the value falls, and vice versa. Even that is no longer necessarily the case as we have seen in the Treasury markets recently that sometimes both prices and yields fall. Municipal bonds are even more confusing as credit quality concerns continue to surface and mount.

Further concern is that rates are so low now, they really cannot go much lower. At some point interest rates will rise but no one knows when. But when they do, consider this: A move from five percent to six percent is a 20% increase and bond prices will move to reflect that in some way. But a move from one percent to two percent is a 100% increase, and again, bond prices will move accordingly.

So what is a prudent fiduciary supposed to do? The answer is the same as it always was - take what the market gives you, but define your markets carefully. This is the first environment in a long while where dividend paying stocks give the investor more income than bonds.

Each case is different but a look at an "equity income" portfolio is worth the time for the right situation. One equity income approach can briefly be described as this:

• Analysts seek companies that provide a high level of current income and long term capital appreciation that qualify for preferential tax treatment. This is accomplished by attempting to invest in quality large-cap and mid-cap dividend paying securities that are selected on the basis of qualitative, quantitative and valuation analyses. Analyst also seek to lessen downside risk and enhance long-term returns.

In English, we are looking at larger companies that have a strong dividend history, cash in the bank, low debt ratios, more mature business lines with well defined competition. The nice thing about dividends is that over time they tend to increase, which makes the company more attractive and thus increases its value to investors. So both the income and price can increase.

This approach is not designed to hit home runs, but singles and doubles. It is also not a high yield approach. Our plan targets yields of about one and one half to two times the S&P 500 dividend yield. Yet this is not a compromise. It is a strategy.

So what about bonds? We think you still need them in a portfolio to bring balance and limit risk overall. They used to be a way to generate income as well, and they will again. But for now they are the hedge against falling stock markets (at least that is the theory).

In summary, we are not looking to change anyone's basic investment plan. Rather we are repositioning funds allocated to equities from growth to this equity income type of strategy where it makes sense.

Where does it make sense? Trusts invested in a total return concept are a primary target. This is not at all necessarily the statutory total return notion, although that might work. More likely with us it will be accounts where the current beneficiary is clearly the primary focus, such as a marital or family trust for a surviving spouse who needs a certain amount to live on regardless of whether it is income or principal. It could also work in a foundation approach, for example.

To be clear, we are not talking about putting everything into equity income mode. Instead we are saying shift some portion of the equity portfolio to this concept to improve yield while maintaining some growth potential.

It is a case by case game as always, but don't chase yield. Let yield come to you by having a consistent discipline and sticking to it.

THE TRUSTED ADVISER is published by Attorneys’ Title Guaranty Fund, Inc., P.O. Box 9136, Champaign, IL 61826-9136. Inquiries may be made directly to Mary Beth McCarthy, Corporate Communications Manager. ATG®, ATG® plus logo, are marks of Attorneys’ Title Guaranty Fund, Inc. and are registered in the U.S. Patent and Trademark Office. The contents of the The Trusted Adviser © Attorneys' Title Guaranty Fund, Inc.

[Last update: 4-25-11]