The Ultimate Income Portfolio

Income investors seek a substantial, long-term income stream from their portfolios, and they don’t want to rely on capital appreciation or to deplete principal.  Also seeking income may be investors who do not want to rely on economic growth to fuel returns on their investments.

Conventional approaches to constructing income-oriented portfolios use either bonds or high-yield stocks. In this article, we will explore a compelling alternative to that approach: a carefully selected model high-yield portfolio consisting primarily of low-beta, high-dividend stocks, against which the investor sells call options.

Such a portfolio has many advantages over conventional approaches.  It produces more income, has less risk, and has lower correlation to interest rates. Income-oriented portfolios made up of long-term government bonds and high-yield corporate bonds will look attractive in some market conditions, but the high-yield / covered call strategy looks more attractive in others, including the current conditions. 

Choosing the desired exposure of a portfolio to interest rates is an important tactical consideration, as is recent performance relative to expectations.  In the last three years, long-term and intermediate-term government bonds have generated high total returns, and yields on these asset classes are now very low.  A major question from a tactical standpoint is whether government bonds are poised to under-perform.  In addition to having under-performed in recent years when it comes to total return (and thereby having attractive valuations), many high-yield stocks are currently providing very high dividends.

The model high-yield portfolio

Consider the following portfolio, which I constructed by choosing a number of high-yield, low-beta, moderate volatility stocks.  High Yield Low Beta

The total yield on this portfolio is 6.1%, more than 50% greater than the 3.90% that long-term government bonds offer.  This portfolio has also been slightly less risky (measured by annualized volatility) than long-term bond ETF TLT in the last three years.  Although my Monte Carlo simulations suggest that this portfolio is slightly more risky than TLT on a forward-going basis, its risk level and that of TLT are comparable in the long term.