Seeking investment income has become a challenge lately. This is particularly true in the current environment of near-zero nominal interest rates in the US and investment-grade corporate bond spreads that are well below recession-period averages. I have heard many ideas recently on how bond investors can supplement their dwindling inflow of cash – from real estate investing to more sophisticated strategies, like option selling.
In a recent Animal Spirits podcast episode, legendary author Burton Malkiel offered his proposed solution to the problem – which, not surprisingly, involves more assumption of risk than most income investors have been traditionally accustomed to:
For the safer, more stable part of the portfolio, maybe the thing that one ought to do is use some bond substitutes. One type of bond substitutes might be blue chip companies that have very good dividend yields. They will give you more stability and they will at least give you some rate of return. What kinds of companies am I talking about? Something like IBM (IBM), Kraft Heinz (KHC), AT&T (T).
Of the three names offered by Mr. Malkiel above, AT&T, which yields a compelling 7.6%, is the one that I would feel most comfortable holding for income-generation purposes. Below are the three main reasons why I believe this to be the case.
At its core, AT&T operates a subscription model. Granted, mobility services are far from being considered fast growing, and plenty of skepticism still exists around the company’s Warner media business. In addition, the carrier has been undergoing a drawn-out process of bleeding broadband and premium TV revenues as a result of secular, probably irreversible trends in communication and media consumption.
But at the end of the day, AT&T has a large user base from which it can derive a fairly predictable stream of cash. The mobility segment, for example, represented a sizable 42% of AT&T’s total revenues in the most recent quarter. Within it, the total number of subscribers and connections has increased sequentially each quarter for the past eight straight periods at least. At the same time, ARPU (average revenue per user) has also trended in the right direction, although not without a few bumps along the way.
As a result, AT&T’s revenues, gross profit and free cash flow have been increasing over the years – see chart above. To be clear, the trajectory has not always been straight up and to the right. But the results have been good enough to allow the carrier to make rich dividend payments that have been rising (albeit very slowly lately) for the past 36 years.
Low correlations with stock market
The other benefit of holding bonds in a portfolio, apart from the income payments, is diversification. Long-term treasuries (TLT) have historically been the ideal complement to an equities portfolio due to the negative correlation with the S&P 500, at a ratio of -0.3 over the past 20 years or so.
To be clear, AT&T’s stock is not negatively correlated with stocks in general, which makes it a less ideal form of diversification. However, compared to the great majority of other stocks in the market, its correlation factor of about 0.4 is among the lowest that one can find. See the rolling three-month correlation between T and SPY since November 1983.
Source: D.M. Martins Research, data from Yahoo Finance
Here is something interesting to keep in mind about the benefit of diversification. Since the start of the Great Recession bear market, in October 2007, T has produced more volatility than the S&P 500. However, if blended together with the broad stock index at a ratio of 50/50, the overall portfolio would have seen a one-percentage point reduction in volatility compared to the equities benchmark. This is the “magic” of low correlations at play.
Less risky, when blended with cash
AT&T stock is quite a bit more risky than long-term treasuries, which many would have considered a good income-producing investment in years past. But below is a different way to think about risk (which I will equate with volatility, for simplicity) and rewards (i.e. yields).
Long-term treasuries currently yield 1.6%. Meanwhile, AT&T stock yields nearly five times as much. Below is a graph that compares the three-month rolling volatility (i.e. one annualized standard deviation of the daily returns) of T and a long-term treasury ETF. Notice that T has been somewhere between 1.5 and 2 times as volatile as government bonds over the past one, three and five years (see last column on the table below).
Source: D.M. Martins Research, data from Yahoo Finance
Assume that the volatility dynamic between AT&T stock and treasuries remains the same going forward. In this case, to turn a long T position into an investment that has bond-like risk, one might need to blend some cash into the portfolio. For example, a 60/40 allocation to T and cash, respectively, could reasonably be expected to produce similar volatility to long-term treasuries. The good news is that such position would yield an estimated 4.5%, which is substantially better than the 1.6% yield of government bonds.
Last few words
I understand that holding T stock is nowhere near the same as owning treasury bonds. At the very least, the risk profiles are very different, which could justifiably push the more conservative investor away from shares of the Dallas-based company.
But 2020 has marked an inflection point for income-seeking investors. As a result of record-low rates, treasuries have all but lost their appeal as cash flow-producing instruments. To make up for loss of regular payments, some creativity may be needed, along with a bit higher tolerance for risk.
Within this framework, I believe that T is a stock worth considering, more so if blended together with other assets to reduce volatility and the risk of sizable losses.
Think differently, reap the rewards
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Disclosure: I am/we are long CALL OPTIONS ON TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.