Bonds of decent quality currently hardly offer any yield – at least not in Europe. Investors with sufficient risk tolerance can, however, achieve income with equity funds, be it from dividends or other sources.
Historical comparison: Bond yields low, dividend yields on average levels
Currently, bond yields are materially lower than the longer-term average – in the Eurozone and Switzerland base rates are now around zero or even negative. Against this backdrop investors have to assume considerable default risk in order to achieve higher yields. Therefore, even as a bond investor, a degree of risk tolerance is required for yield seekers.
If the risk tolerance is high enough to venture into the asset class of equities, investors can currently realistically achieve dividend yields of 2.5% to 4%, depending on the investment region and the degree of dividend focus. Additionally, equity investors can tap other income sources and participate, at least partially, in the upside of stock markets. This does however require the ability to cope with potential capital losses.
Three potential sources of income
Dividends are an important component of total return: Over the years following the global financial crisis, companies have deleveraged and accumulated significant cash reserves. Such healthy balance sheets allow these companies to return excess cash to their shareholders e.g. in form of dividends. When selecting high dividend stocks, the portfolio management also considers quality criteria such as profitability and low financial leverage. These factors are good indicators for the respective companies' ability to sustain their dividend policies.
Share buybacks are an additional source of income for equity investors, offering an indirect way for corporations to return capital to their shareholders. Buyback programs in essence reduce the number of shares outstanding, meaning the company's profit has to be shared by fewer shareholders. In absence of other material changes, the share price is expected to go up in order to reflect the higher earnings per share (buyback yield).
Option strategies can also help generate income for investors. A fund can, for instance, sell call options with monthly tenures on single stocks held in the portfolio. The premia earned from selling call options provide the fund with income. In exchange for this additional income, the call overlay will limit upside participation of the portfolio. However, the call overlay also helps reduce the portfolio's sensitivity to the market, thereby serving as a downside cushion.
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