Investing for Tax-Efficient Portfolio Income by Tara Thompson Popernik, AllianceBernstein

With tax-exempt income from US municipal bond portfolios still near historic lows, investors spending from their portfolios can no longer get the income they need by simply increasing their allocation to high-quality, intermediate-duration bonds. As a result, many investors today are chasing yield into dangerous territory.

Typically, today’s yield-hungry investors are shifting to longer-duration or lower-credit-quality (high-yield) bonds, or both. Such investments may merit an allocation, but many investors do not adequately weigh the likely consequences.

We think that investors seeking tax-efficient income should weigh three considerations: after-tax income, tax-efficient growth and risk. Below, we evaluate the trade-offs for several potential solutions.

Popular Solutions

The income that can be gained from shifting the fixed-income portion of a portfolio to high-yield or long-duration bonds is indeed substantial. The left side of the Display below shows that investors can increase the after-tax annual income on a $1 million portfolio with a 60/40 stock/bond mix by about $9,000 if they shift the bond allocation to long-term, high-quality bonds. They can gain more than $21,000 of additional income if they shift it all to high-yield bonds, and about $15,000 more if they shift it to an equal mix of the two.

Tax-Efficient Portfolio Income

But the magnitude of the risk that these three popular income strategies add is not well understood. We estimate that an investor in a 60/40 portfolio now faces a 29% chance of incurring a large loss (defined as a 20% loss from peak to trough) in some period within the next 20 years. Shifting the bond allocation to long bonds would increase the risk of a large loss to 39%, because long bonds lose more value than intermediate-term bonds when interest rates rise. The risk of a large loss rises to 55% for the 60/40 portfolio with high-yield bonds and to 47% for the 60/40 portfolio with an equal mix of high-yield and long-term bonds.

These three popular income strategies are also likely to lead to less wealth over time than a core bond strategy would. For example, we project that the 60/40 portfolio with high-yield bonds, which generates the most income, would lead to a give-up in future wealth similar to a 20/80 portfolio, in the median case, as the display also shows.

In our experience, the risks that each of these three popular strategies pose are too high for most income-oriented investors.

Lower-Risk Solutions

Fortunately, it’s possible to garner more income without adding as much risk. The key is to source the higher-income (but higher-risk) investments from the stock allocation of the portfolio, rather than from the bond allocation. You can see this in the three potential lower-risk variations on a 60/40 portfolio in the display.

The first lower-risk variation replaces the broad US large-cap stock portion of the 60/40 portfolio with similar stocks with higher dividend yields. This increases the after-tax income of the portfolio by less than $1,300. That’s even less than shifting to a 20/80 stock/bond mix, but the decrease in the projected future value of the portfolio isn’t as bad as it  is for a 20/80 portfolio.

The tilt to higher dividends reduces the risk of a large loss from 29% to 25%, because higher-dividend-yielding stocks are typically less volatile. However, they offer moderately lower growth potential than the broad market.

The second lower-risk variation adds a 10% allocation to high-yield municipal bonds; importantly, it reallocates the capital for this high-yield investment from stocks, rather than bonds. This variation increases the portfolio’s after-tax income to $24,100, nearly $6,000 more than the original 60/40 allocation, and also reduces the probability of a large loss substantially—from 29% to 19%. While high-yield bonds are more volatile than investment-grade bonds, they are less volatile than stocks.

The downside is that this lower-risk portfolio is likely to be worth less after 20 years, in the median case, because high-yield bonds tend to generate much less growth than stocks do.

The third lower-risk variation combines the first two. This variation increases the portfolio’s after-tax income the most, to $25,200, nearly $7,000 above the original 60/40 allocation. The investor gets the additional income with a lot less risk: the probability of a 20% peak-to-trough loss falls to just 16%, close to the 15% probability of a large loss that a 60/40 portfolio offers under normal market conditions. The downside is that it also reduces the projected value of the portfolio after 20 years the most, to $849,000.

In our experience, the three lower-risk solutions are likely to fit the risk tolerance of most income-oriented investors better than the three popular solutions.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

This article was adapted from a longer piece by the same authors published in the September 2014 issue of The CPA Journal.

Tara Thompson Popernik, CFA, CFP®, is Director of Research of the Wealth Planning and Analysis Group at Bernstein Global Wealth Management, a unit of AllianceBernstein (NYSE: AB). Robert Dietz, CFA, is a Senior Investment Planning Analyst in the group.