The Challenges of Generating Income in Our Zero Interest Rate Environment

Jay D. Franklin CFA, CFP, FSA | Clarity Capital Advisors |

In response to the economic devastation due to Covid-19, the Federal Reserve resurrected its “Zero Interest Rate Policy” that was last used in the Global Financial Crisis of 2007-9 and lingered for an additional six years. Furthermore, considering the drop we have seen in longer-term interest rates, investors requiring income face a difficult challenge. We will review the different options starting from the least risky. All quoted rates are as of 7/10 or 7/13/2020.

US Treasuries

The US Treasury yield curve is the best forecast of expected future returns from Treasury bonds. The numbers below show yield-to-maturity for Treasury bonds of differing terms.







Even these very low interest rates do not come without risk—the risk of rising interest rates. A 1% across-the-board increase in interest rates would induce a portfolio loss of about 18% for an investor in long-term treasuries (based on the duration of VUSUX). By moving to government agency or mortgage-backed bonds, one can increase the yield by about 1% (based on VMBS), but this would introduce the risk of prepayment (early refund of principal, forcing reinvestment at lower interest rates).

Investment-Grade Corporate and Municipal Bonds

Early in the pandemic, the risk of these securities became apparent, and their value was preserved only due to aggressive intervention by the Federal Reserve. Nevertheless, the risk of default remains, and investors need to be compensated for that risk as follows (30-day SEC yields of Vanguard funds):

Short-Term Corporate (VSCSX)


Intermediate-Term Corporate (VICSX)


Long-Term Corporate (VLTCX)


Short-Term Municipal (VMLUX)


Intermediate-Term Municipal (VWIUX)


Long-Term Municipal (VWLUX)


Please note that the interest on muni bonds is exempt from federal taxes. Muni bond funds that focus on specific are also exempt from state taxes, but they carry lower yields in addition to state-specific risks (some state and municipal pensions are in much worse shape than others).

Non-Investment-Grade (Junk) Corporate Bonds

During the market dip of March, junk bonds lost about 19% of their value but have mostly recovered, thanks to the Fed’s intervention. Based on VWEAX, their current yield is about 5%. Although investors may be tempted by their yields, junk bonds are not a good companion to stocks. During severe market downturns, when the stability of bonds is needed the most, junk bonds will disappoint. It’s also important to remember that the quoted yield on high-yield bond funds assumes that all holdings will pay their coupons, even though it’s likely that at least a few (maybe more) will default.

US Equities

The current dividend yield on the total US stock market is about 1.7% (based on VTSAX). If we limit ourselves to dividend-paying-stocks with a history of dividend increases, we get about 1.9% (based on VDADX). If, however, we filter for only-higher-than-average yielding stocks, we get about 3.6% (based on VHYAX). It is worth remembering that when a stock has a very high dividend yield, it is often an indication that the market has assigned a high level of risk to that company and perhaps does not expect the current dividend to be sustained (i.e., a value trap). Over the last 10 years, the Vanguard High Dividend Yield Index Fund (VHYAX) has substantially underperformed the Vanguard Total Stock Index Fund (VTSAX). Year-to-date in 2020, VHYAX has suffered a larger drop and has had much less of a recovery than the overall market. In our new Covid-19 world, we should fully expect some companies to reduce (or even eliminate) their dividends as well share buybacks.

International Equities

Although international equities, in general, are higher yielding than US equities, investors should be wary of them as a source of stable dividend income due to their vulnerability to currency fluctuations. As with high-dividend-paying US stocks, they have seriously lagged the overall US stock market both for ten years and the pandemic period.

Real Estate Investment Trusts

With the significant uncertainty facing shopping centers, hotels, and office spaces, this asset class has faced severe challenges, performing even worse than high-dividend-paying stocks during the pandemic period. The current yield of the Vanguard US REIT Index fund (VGSLX) is about 3.8%, but this includes 0.9% return of capital, so the true yield is about 2.9%.

Hybrid Asset Classes (e.g., Preferred Stocks)

To summarize, there is no magic bullet in preferred stocks or in any other type of hybridized security that mixes the risks of stocks with the risks of bonds. The market does not owe you a higher return because you bought a single security with a risk profile similar to a blended portfolio of dividend-paying stocks and high yield bonds. Also, during a severe downturn, when there is a flight to safety, these types of securities can be especially hard hit. For example, the iShares Preferred and Income Securities ETF (PFF) dropped by about 31% during March and remains down about 8% year-to-date 2020.

How Income Can Be Taken and Expectations Going Forward

For our clients in retirement who are making regular withdrawals from their portfolio, we raise the cash by selling the asset classes that are above their targeted weights, effectively rebalancing the portfolio. An important thing to keep in mind is that while dividends and bond interest (except muni bonds) are 100% taxable, when cash is raised by selling a position, most of the proceeds are not taxable because they are just a return of the original basis. For example, suppose we have just bought a $1,000 position that paid a $50 dividend that was taken as income, the entire $50 is taxable. Now suppose that instead of a dividend, the position appreciates to $1,050, and we sold $50 worth. Only $2.38 of that $50 is taxable. Although there has recently been a lot of negative publicity about it, company share buybacks are an efficient way of distributing corporate income to shareholders without generating taxes (assuming they do not sell their shares).

Going forward, for financial planning purposes and based on information from Vanguard, we expect a 60/40 portfolio of global stocks and investment-grade bonds to return about 5.2% with a standard deviation of 10.9%. If another advisor tells you to expect more, it only means that he/she plans to take more risk or is relying on historical returns to repeat themselves, which is completely unrealistic.

If you would like to learn more about our approach to generating income in retirement, please call us 800-345-4635 or email us at