Unlock the Potential of Income

Unlock the Potential of Income

Adam Sparkman

Good morning. And thank you for joining us for today’s webcast on Unlocking the Potential of Income. I’m Adam Sparkman, a client portfolio manager with Thornburg Investment Management. Coming to you from our headquarters here in Santa Fe, New Mexico. I want to welcome all of those attending the webcast today, both in the U.S. and abroad. Today, we’re focusing on income.

We’ll discuss topics ranging from our outlook for income producing securities in the current environment, how we’re positioning the portfolio amid inflation and rate uncertainty and where we see opportunities across the income landscape. I’m pleased to be joined by my colleagues, Jeff Klingelhofer and Matt Burdett. Gentlemen, thanks for joining us today. We’ll have a Q&A session at the end, but if you’d like to submit questions, you can type it directly into the webcast at any time.

Jeff and Matt let’s jump right into it. So, as I mentioned, we’re obviously here today to talk about income, but I think it may be helpful to set the stage a bit on why we’re so constructive on income as a theme given the current environment. Matt, from a macro perspective, how have you seen the income landscape shift in recent years and why do you think that shift has set us up so productively for income as an emphasis of total return?

Matt Burdett

Sure. Thanks for the question. Look, I think we’re going through a period of cost of capital normalization, right. So, we went through this period post global financial crisis where interest rates were suppressed, yields were suppressed. With the pandemic and the inflation surge that happened, obviously central banks had to move and return to a more normal monetary policy stance.

And so, when you take a look at a at a long enough time series and you look at where the Fed funds rate is, it’s actually not high, right. It’s really more about kind of where its long- term average was prior to the global financial crisis. And I think the viewers can see a chart that shows that today’s effective Fed funds rate is basically where it averaged from the end of 1982 up until the end of 2008.

Right. And so, we cut off earlier than 1982 because there was a lot of energy related inflation dynamics that you don’t necessarily have in the U.S. today. So, what this means is simply from an equity perspective and income opportunities is that, you know, look, cash, when you have a normal interest rate environment, cash flows you get today should be worth more than those cash flows you get years down the road.

Right. Whereas in a 0% interest rate environment, the growth multiples could be very, very elevated. Right. And so, this is more of a normalization of that dynamic. Now, obviously, when interest rates started to normalize, you saw some things break. You saw the UK LDI crisis, U.S. regional banks. Who knows? Maybe there’ll be other things, right? But generally speaking, we think this is a multi-year kind of transition that sets up really nice opportunities for us for income solutions.

Adam Sparkman

All right, Jeff, maybe we’ll stick to the topic of the Fed here for a minute. I want you to maybe not prognosticate as much on rates. Central banks have obviously played an outsized role within financial markets over the past 15 years, But I think it might be helpful just to think more about the Fed’s reaction function moving forward from here and as far as what it means for fixed income investors.

Jeff Klingelhofer

Yep. No, I think that’s really important, and I will I just want to comment first on the question itself. I think this is the first time as a fixed income manager that I’ve been asked specifically not to prognosticate where rates are going to go in the next three or four months.

Adam Sparkman

So, we’ve still got Q&A.

Jeff Klingelhofer

But I think from a very, very high level, a lot of what Matt talks about, right, is the normalization that we’ve seen over the last number of years. And we all knew this normalization was coming. We were as a broad market, we expected it coming out of the global financial crisis, that normalization to happen 2010, 11 or 12, and it didn’t. And then 15, 16, 17 and it didn’t, and then 18, 19, 20 and it didn’t. But finally, we got it. And of course, the question is to me, where are we heading unless from pure interest rates. But I think you hit the nail on the head. What is the Fed actually trying to even accomplish?

And something we’ve talked about for quite some time. But I think not only has it served as a very good roadmap looking backwards, I think it continues to serve and will continue to serve as a very good roadmap looking forward. And that is to go back to the actual congressional mandate of the Federal Reserve, something we’ve talked about many times. We oftentimes talk about the Fed as a dual mandate, central bank, right, achieving maximum employment and price stability. But if you read their congressional charter, they are actually a tri-mandate central bank, right in their congressional charter. It reads that the goal of the Federal Reserve is so as to effectively promote the goals of maximum employment, price stability and moderate long-term interest rates. And that last one, I really think is key. It has nothing to do with moderate long-term interest rates in and of themselves, but it has everything to do. When I’ve talked to former Fed officials with the flexibility around how they think about the two mandates that they do directly focus on.

And I think what Matt talked about, which is really important, is looking backward in a period of very low interest rates and very low inflation.

Central banks around the world are trying to push inflation up, and that itself isn’t normal, right? Traditionally, central banks are supposed to pull inflation down. And so I think what we’ve exited is a world where that third mandate was defined as one of financial stability, which makes sense because it was complementary to pushing inflation up. But today, one where they’re focused on social stability, they’re focused on compressing the wage gap.

And really, as I look forward, I think that puts us in a higher inflationary environment for longer a higher interest rate period for longer, but overall a stronger consumer backdrop and one probably where income matters a lot more looking forward.

Adam Sparkman

Okay. Maybe sticking on the topic of inflation and inflation expectations, we’ve seen inflation come down dramatically from the near double-digit highs of 2022, but we’re still well above that Fed target of 2%. What is some of the things that are making inflation a little bit more stubborn or sticky than what many expected?

Jeff Klingelhofer

Yeah, and I think it dovetails really well off the prior conversation. Right. The prior question is that what the Fed is focusing on today is partly compressing the wage gap. And they talk about this in almost every single speech, ensuring that the economy works for, quote, all Americans. Right? What they told us coming out of having run in a period of very depressed interest rates was one, it was good for the economy, but it actually wasn’t good for the lower wage income earners. And they learned a valuable lesson in that time period. And that valuable lesson was that they could actually run the employment side of their mandate a little bit hot without that runaway inflation.

But I think what the Fed is really focused on calibrating here today is they might have run it just a little bit too hot. Right? And what we’ve seen is the Fed has been very good at bringing overall inflation down. It’s no longer 10-11 problematic type levels from a capital allocation perspective. Today, it’s running roughly in the low threes.

And I would argue that two versus three is roughly a rounding error. Yes, the Fed still says they want to get back to that 2% inflation objective, but I think they’re going to be very patient and waiting for it, because where we see inflation coming today is from the good parts of inflation, low wage income earners in particular exerting upward force on services inflation.

But the challenge is, is they’ve traded a very easy to control form of inflation goods inflation into a very sticky form of inflation. And that sticky form of inflation is because it’s predominantly coming from labor today and labor and wages tend to be much more sticky. And as we look forward, we think it’s likely to be very challenging for the Fed to continue to move down to that 2% inflation objective because a number of wage gains are already locked in right now. Right? What we saw looking backward is a significant part of the workforce, got raises not just right here now, but actually guaranteed raises into the future. Right. Ten 12% raises in 24, 25, 26, some even out as much as five years. So, I think inflation is going to be a little bit more sticky. But again, it creates a very good backdrop for the consumer broadly. And we just have to make sure that we keep things broadly balanced between labor and capital.

Adam Sparkman

Okay. So, Matt, if some of the structural drivers that are keeping inflation high or maybe going to be a little bit more challenging to solve. Maybe inflation stays structurally at a little bit higher level than what we’ve been used to. On the equity side, where do you think investors should be looking and why did dividend stocks make a lot of sense in that a little bit of higher inflationary environment?

Matt Burdett

Sure. Yeah. Look, I think it’s really it’s a good complement to take equity income so dividends right to compliment a fixed income portfolio. Right. Which we just kind of always thought of as the ballast of your income generation and the simple reason is that dividends can grow, right? Fixed income is just that it’s fixed, right. You know, the best yields are getting is what the price you pay. Right? And with dividends, you can find companies that have what we say, a willingness and ability to pay dividends. Right. And so, dividend growth over time has exceeded that of inflation. And I think the viewers can see a chart that’s basically just comparing the S&P 500 dividend growth relative to inflation. And you get a little more than 200 basis points spread between dividend growth and inflation, at least in the post-World War Two era. You know, we’ll have to see what happens with the labor market that Jeff was commenting on and how sticky things get and other geopolitical factors we have to consider. But I think it’s kind of a home base for an income portfolio actually can include some dividend paying stocks that help kind of serve as a ballast to that fixed income.

Adam Sparkman

Okay. Yeah, the dividend growth seems like a nice hedge. If we do get stuck in a structurally higher inflationary environment. Jeff, maybe turning back to the fixed income broadly in this current environment that you’ve laid out, where are you in the team finding the best opportunities within the fixed income asset class?

Jeff Klingelhofer

Yeah, I mean, I think what really a lot of what we’ve seen is many people talk about is a normalization of underlying interest rates. And so that is to say that overall, the yield on fixed income is notably higher today across all aspects of fixed income versus where we’ve gotten used to it having been over the last 15 years, really ever since the global financial crisis. But I think underlying that is it’s not so much the interest rate environment that’s shifted, it’s the underlying inflation environment that’s shifted, one where central banks were trying to push the level of inflation up to now, one where they’re trying to pull it back down.

And so we want to be very careful in that environment, right, because the challenge, of course, is, is that inflation can be challenging for some more cyclical parts of the underlying economy, potentially some areas of profit margins, etc. And so, the backdrop that we have in fixed income is one where yields overall are higher. So, all else equal are being much better compensated to hold risk.

But spreads that is the level that you’re compensated to move from the safety of U.S. treasuries, for instance, into the world of a corporate bond or even a high yield corporate bond that additional that you’re earning on top of the risk-free rate is very, very compressed versus historical standards. And so, where that sets us up is similar to like Matt’s talking about, we want to drive the vast majority of the portfolio’s total return potential via income generation because yields and income are notably higher in today’s portfolio. So, we’re seeing significant opportunities across some areas of credit like asset backs and corporates. But what we’re doing is we’re shortening that credit duration. We’re taking the potential future volatility if we do see a slowdown in the economy, we’re taking some of that potential volatility out of the portfolio because the yield curve is inverted. So, we’re better compensated on the front end of the yield curve from a total return potential to take our credit exposure there.

But we want to balance that with interesting opportunities and things like treasuries and agency mortgages that truly are the ballast of fixed income, right? If we do head into a recession, those securities should appreciate go up in value versus some areas of credit going down in value. So, I think about the portfolios broadly and really the opportunity in fixed income as a barbell driving short credit duration, interesting areas of securitize some focus on the higher quality consumer areas like housing, we find very, very interesting.

Acyclical parts of the economy, things like insurance company, things like utilities, right? Where their cash flows don’t ebb and flow with the underlying volatility of the economy, having those on the front end. But pairing that with interesting interest rate opportunities on the mid belly to the longer part of the portfolio.

Adam Sparkman

Okay. And then makes a lot of sense on the fixed income side, Matt, On the equity side, you managed obviously the equity income sleeve of our multi-asset portfolio. I know you in the team and you mentioned this, you pay particular attention to a company’s willingness to pay attractive yield today and then also their ability to grow that distribution, that dividend over time. Why is that so important to the securities selection process? And how do you actually implement that into the actual security securities selection, maybe both from a quantitative and qualitative side?

Matt Burdett

Sure. Yeah. Look, I think, you know, historically, if you if you look at long periods of data, right, I mean, decades of data, the best performing stocks are those stocks that have dividend growth. Right. And why is that underlying those companies? They have businesses that are growing, right? So, their underlying business is growing. They’re winning in their in whatever value chain they compete in. Right. And over long periods of time, that dividend growth brings a really high. What we refer to as a yield on original costs is a yield on cost that’s growing to a high yield level. But what actually happens is the stock price tends to move up like that. That yield gets compressed back down. So, you’re getting capital appreciation along with dividend growth, Right.

And that’s really kind of a timeless way of investing. And over a long period of time that has actually been the best performing. And even in the U.S. market now, it’s all about for us. I mean we’re picking stocks, right? And what we look for are the companies that have that ability to pay, which is really a function of strong cash generation, which means they have a good position in their market, they have customers. All the fundamental analysis that you would want to do, but the ability part is, is whether or not the board and the management team actually believes paying cash out is part of is central to their capital allocation philosophy. So, we look at both when we’re selecting companies for our equity income portfolios.

Adam Sparkman

Okay. Has that been frustrating over the past 15 years in an environment where these companies have been a little bit overlooked relative to some of the stuff that’s been the highfliers or you’re still sticking to the original process?

Matt Burdett

Yeah, you know what? It’s there’s no need for us to change process. I think at the end of the day, we’re providing a very specific income solution. I think we do it in a unique way, being dynamic in asset allocation. Look, what you see over long periods of time is that dividends as a share of total return fluctuates a lot.

The long-term average is 50%, but there are periods of time when it’s only 14% of your total return. And when you’re in those periods like the one you’re referencing, people tend to they tend to, you know, recency bias takes over a little bit and they think, well, my price should continue to go up at this really high rate.

And you just have to really kind of question the sustainability of that. So, so we’re not changing our process, we’re sticking to our guns and actually it’s a really good backdrop for, for those types of companies that we would invest in.

Adam Sparkman

Yeah. And I think that’s what’s exciting about this chart that we have up here. You mentioned recency bias. If you look back over 15 years, it seems like there’s a lot of long-duration growth companies that have really ran and that makes sense to a certain degree at a zero-interest rate environment. We get used to that. But if you pan out and you look back over the past 50 years, these types of companies with the fundamentals that you’re describing, the ability to pay, pay dividends, to grow their dividends over time, they’re the ones that over the long term really have returned the highest returns and the lowest volatility as well to investors.

Matt Burdett

Exactly.

Adam Sparkman

All right, Jeff, maybe moving back to the fixed income side. I think a question that you’ve heard a lot right now is what do I do with my cash? I’m sitting on the sidelines and getting paid an attractive yield on that cash. Do you think that it investors should start to put that into fixed income? And I think I might know the answer here a little bit. But for investors who are saying, no, I’m going to wait until I really get the pivot, until I see the Fed pivot, you know, what’s the case for investing that money now?

Jeff Klingelhofer

Sure. I think really, to me, there is no particular answer. It’s what are you hoping to accomplish with that cash? A lot of portfolios that I run and that we run here at the firm we think about as an outcome, we think about how they serve within a broad asset allocation and what place they serve in that broad allocation.

And I would say to me, the question around cash is no different. So, it’s a little bit funny if we rewind the clock right, if we go back to end of 2021 and we said that I can give you ten- year Treasuries yielding four and a half percent, how many ten-year treasuries does the average client want? Yeah, they would have said given them all to me. Right? That’s all I want. That’s, that’s what I’ve been waiting for is for yields to go up. And of course, now that’s exactly where the situation is. Ten-year treasuries are notably higher. And you asked the average client, how much duration do you want your fixed income portfolio, how many ten- year treasuries do you want? And the answer is, well, I don’t want any. I have cash. So, to me, the importance of the normalization of underlying interest rates because of the normalization of inflation and creates the perfect backdrop for why you might want to think about investing that cash now within a context of a fixed income portfolio. Matt’s talked about this already, many fixed income portfolios investors own to serve as ballast, right?

They want that allocation to go up in periods of uncertainty because likely their equities are going down and other credit sensitive assets are going down. And the reason why is because in that period of uncertainty, the economy is slowing, it’s getting weaker. We’re experiencing the negative part of the business cycle. You don’t know when that that’s going to happen, but it always has a potential that it could happen tomorrow or not for the next ten years.

And so in that environment, the central banks around the world today have the ability to cut interest rates, interest rates and overall yields have the ability to go down, which means, again, fixed income can actually go up. Now, it took a painful 2022 and even parts of 2023 to get there, but that’s where we are today. And so, as we’ve looked at the world, right, there’s a significant case to get off and invest ahead of that of that uncertainty. And I think that’s really the crux of my answer. I think many clients are holding cash because they view that as the balance of their portfolio. But much like fixed income yield, fixed income is fixed. Cash is also fixed. That’s the benefit of cash. It won’t go up. It won’t go down. But I think for clients that are looking forward to the ballast of their portfolio, high quality fixed income portfolios today are significantly out yielding cash and should and likely will actually go up in value in the face of uncertainty. And when we’ve looked at just performance differentials throughout history, there’s a significant case to be made that investing ahead of that Fed pivot ahead of when the Fed actually starts cutting rates provides notably better protection and upside potential versus just waiting until after.

Adam Sparkman

Okay. That’s good context, Matt, maybe going back to a little bit of the theme that we were talking about, this environment of the past 15 years and prior to this cost of capital normalization, where rates were at near zero levels, that really favored growth, as we talked about, at the expense of the income strategies, both on fixed income in on the equity side as we transition back, tell us a little bit about what your outlook is for dividend payers. You mentioned that at some point things just can’t keep growing to the sky. What is the catch- up potential for dividend paying stocks?

Matt Burdett

Yeah, look, I mean, it’s really hard to make a call on, you know, what’s the exact trigger point. I think I think the way we think about it is let’s just observe where we are. Right. And right now, if you were to take the global dividend paying universe, if you were to look at, you know, the MSCI High Dividend Yield Index, you know, look at the p/e ratio divided by the p/e ratio of a growth index, which is historically going to be some expected discount. Right.

Somewhere around 30% historically has been what has been. But since the pandemic, that discount has been more about closer to 50%. Right. So global dividend paying stocks are just much cheaper than they had been in prior periods. Yeah. And you can make an argument, well, okay, growth stocks should have higher multiples because they’re growing faster. I’m not arguing with that. But it’s the degree of the discount and global dividend paying stocks. So, really for us, it’s very exciting, right, because now you have this this situation where there’s a very long-term cost of capital normalization happening. Right? It’s going to play out over years. And you have a whole bunch of these companies on sale that you can buy now that are going to produce. They’re going to pay you cash today, grow that that cash over time. So, it’s a good it’s a good starting point for this, for this kind of a solution.

Adam Sparkman

Okay. Yeah. I think that that makes a lot of sense. That is a pretty incredible valuation discount that still exists despite the fact that we’ve kind of had this cost of capital normalization within the universe that you track. And where are you seeing some of the most attractive opportunities to pick up those dividend paying stocks?

Matt Burdett

Yeah, you know, like I mentioned earlier, I mean, we’re very we’re very much, you know, company specific. We look we look for specific companies. We run a fairly concentrated high conviction portfolios. That’s just kind of our DNA here at Thornburg. But in an equity income sense, the best opportunities will be outside of the U.S. And I think the viewers can see the slide that’s looking at dividend yield by country.

Throughout most of my career, Japan was the lowest yielding, but now it’s the U.S., right. So, you can you kind of want to venture out and outside of the US to find some of this great income value. And it goes back to that, that ability and willingness to pay, right. Outside of the U.S. the willingness to pay is just much higher. Right? Share buybacks are part of capital return, but it’s not the main one. It’s dividends. Right. And so, we have that going for us when we go outside of the U.S. and there’s, you know, there’s a lot of things we really like. I think energy transition names like some of these utilities that, you know, Jeff had mentioned on the credit side.

Yeah. Are just underappreciated, very long, durable earnings stories at very good valuations with high single digit dividend yields that are that are growing. So you find things like that, we really, you know, do our fundamental work around those types of opportunities.

Adam Sparkman

All right, Jeff, on the fixed income side in Thornburg, fixed income portfolios, I think are specifically designed to provide broad flexibility in search of relative value.

And you’ll talk a lot about those silos, especially within some of our strategic products. What do you think or why do you think that aspect of the investment process and portfolio construction is so important in this environment in particular?

Jeff Klingelhofer

Yeah. I mean, I’ll start with answering the question just broadly made away from just this specific environment, but I’ll come back to this specific environment because I think it really is more important today perhaps than ever or certainly over the last long while. And so the reason why we invest that way is because many areas in the world of fixed income like to think that distinct parts of the fixed income markets are different than others. Right? The world of asset backs is just a distinctly different and opposite versus underwriting and looking at a corporate. But to us we start with every bond is just a combination of how much cash am I going to get, when am I going to get it, and how likely am I to get it, right?

We talk about it as the timing, the probability, and the quantity of cash flows. And when you talk about it that way, it’s just a bond. It doesn’t matter whether it’s an asset backed or a corporate or a global sovereign or an emerging market, or whether it’s high yield or investment grade, it’s just a bond. And so the reason why we do that is because to me, especially in the world of fixed income, I kind of joke I feel bad for my equity colleagues.

They have to figure out two sides of the coin, right? Upside and downside. Through all the fixed income, all I have to focus on is making sure that I protect on the downside. Right, because a bond is fixed. No one comes and tips on top of the bond. Right. We know what we’re going to get and that’s the best possible outcome.

And so, the way I like to talk about it is when you look across those silos, you’re looking for mispricing in the market. You have where you have the ability to take potential future volatility out of the portfolio and not have the cost in terms of yield and total return. And so, there is example after example where I can get a better, higher quality, lower volatility bond that’s yielding the same thing as it’s higher volatility counterpart.

And so that really has been a staple of how we’ve invested. But the reason why to me that matters more today than it has in quite some time is because we go back to what I said earlier. The world of spreads is very, very compressed. Or if you look across the last 30 plus years of fixed income, we are essentially near the all-time tights. If you look at that spread that you’re earning to go from treasuries to investment grade corporates or treasuries to high yield corporates. So, you’re not being compensated for a lot of that additional volatility that may come if we get a recession. And so having that broad spectrum, having the ability to take potential volatility out of the portfolio when we’re not being paid to take it, has set up what I think has been a staple of fixed income, which is protecting on the downside. That’s really where you need and want your fixed income portfolios to perform. And so that’s a lot of what we’re focusing on today. But we’re employing that generalist relative value philosophy much as we have for the last many decades to be successful in doing it.

Adam Sparkman

Okay, I think that makes sense. Matt, we’ve talked a lot about dividend paying stocks, we’ve talked about bonds, but we haven’t really talked about multi-asset and the ability to kind of look across fixed income and equities targeting the best relative value opportunities. The portfolio that your co-manager on investment income builder, it is a multi-asset portfolio.

You work closely with the Bond team here. I’ve heard you mentioned previously that you believe that income builder is really a portfolio strategically designed for this this type of market. What do you mean by that? And can you talk a little bit about the allocation, how you think about that within the portfolio?

Matt Burdett

Yeah, sure. So, look, I think it just goes back to our very flexible framework here, right. As global generalist, we’re not we’re not looking at tiny slivers of the market where we could be an expert in a small sliver. We want to know where the best relative values are across all of equities or all of equities and credit and fixed income more broadly, right. And Investment Income Builder has just had a philosophy of yes, we have a benchmark that’s 25% fixed income, 75% global stocks. But that’s less important. Yeah, right. What’s really important is it’s an income solution, right? And we want to provide the best income solution that we can. So historically, we’ve tried we have we buy bonds when yields are high, and we don’t buy bonds when yields are low.

Right. It’s really and as the chart indicates, you can see when yield to worse goes up, we’re going to go find more bonds to put into the portfolio. And usually in periods where yields are that high, equities are also under stress. So, we make that relative value argument which securities the better income, relative value. Yeah, right. And so, I think we’ve always had this just flexible way of thinking and the (Investment) Income Builder is just a great example of, of how we utilize, you know, the philosophy here. So, one day we will have spreads blow out again. It’s just a matter of time, right? And we’ll be able to take advantage of it because again, within the portfolio, the credit is not all that different from a behavior standpoint from the equities. And our equities are typically going to be lower volatility type of equities because they’re producing income and so that that asset allocation shift is not as different as people may think. Right. And I think you have to really focus on it’s an income solution. Right. And that’s really where what we’re what we’re trying to take advantage of.

Adam Sparkman

Okay. I think that that’s a great answer. Before we get to Q&A, I want to make sure we save some time for that. But I do want to shift first and hit a little bit on the longer-term outcomes of a couple of portfolios that you all manage, because really, I think it’s a powerful proof point for our expertise and income, not just within equity, not just within fixed income, but really across the spectrum and our ability to deliver consistent results to clients over time. So, Jeff, why don’t we start with strategic income. It’s a flagship product within the global fixed income franchise here at Thornburg. What do you think the keys to you and the team’s success have been over the past 15 years?

Jeff Klingelhofer

Yeah, I mean, really. I think part of answering that question is what are we even trying to do in something like it within Strategic Income? And so, the way we talk about that portfolio is achieving notably higher total return potential versus core bonds with only minimal additional volatility. And so I like to actually go back to the product’s origins and roots, right where we launched the strategy in 2007 and the setup, the backdrop in 2007 actually didn’t look tremendously different than it looks today where core bonds are, I think a pretty good staple for your average investor’s portfolio. They’re kicking off an interesting income. Now, durations a little bit higher today. Credit is a little bit; quality is a little bit lower. But overall, you have your average investor as a core bond allocation. And for the investor that was looking for notably higher total return potential versus those core bonds but wasn’t ready to jump all the way to the world of equities, traditionally in 2007, you would jump to a silo, a fixed income, the world of high yield or bank loans or emerging markets. But along with that higher total return potential, you also took a whole lot of additional volatility. And so, we had been running fixed income very successfully, I would argue, for decades prior to that. And with that siloed relative value approach, we said, well, we can deliver that return stream of notably higher total returns versus core fixed income, but we could do it in a very volatility aware format.

And so what we’ve managed to deliver is really the return stream of roughly high yield, but with half the volatility. And so, I think going back to one of the questions you asked earlier, it’s been the ability to look across silos, look where the market isn’t fully appreciating and all of that potential volatility. Right. And usually when the market is in appreciating that potential volatility, it’s in the face of a great market backdrop, kind of all the things that we’re seeing today, a relatively strong consumer, GDP that’s holding up, yes, it’s coming down, but we’re at the very early part of potentially some warning signs. And these warning signs in no way, shape or form say we are imminently heading towards a recession or a slowdown, but they’re pointing to the possibility that we might. Right. But the markets are discounting that. And so right now is one of those times where we can take out that potential volatility.

We don’t have to give up yield and total return, but it keeps us in the game and gives us the ability to be very nimble and pivot. So, protecting on the downside really is the crux of how we’ve generated the performance that we have. We’ve launched the portfolio in 2007 and we saw GFC (Global Financial Crisis). Many folks would think we’ve kind of seen two big market disruptions, GFC and COVID, right? But really it’s every three years or so that you get these gyrations, you see the GFC and then you had a taper tantrum in 2012, you saw significant stress in 2015, you saw 2018 stress. Of course we had COVID, we had 2022. And so, if we can consistently protect on the downside and participate on the upside, that’s really what we’re focused on. And that’s where our key to our success has come.

Adam Sparkman

Great. So, Matt, let’s shift back to Income Builder. We’ve already touched on, obviously, the importance of that flexibility from across asset class. But as you mentioned, an overarching level, this is an income solution for wanting to provide investors with an attractive yield today. To your point about that growth of the income stream, that’s kind of objective number two. And then third, really that long term capital appreciation. Can you share a bit on the long-term results of this portfolio? We’ve got north of a 20-year track record now and how you think about grading yourself on that, that objective?

Matt Burdett

Yeah, sure. You know, my kids my kids come home, and I ask them, how did you do at school? It was good. Was good as we really find out when we get the report card. So, yeah, that’s I think, the right the right way to think about it. And look, the viewers can see on the screen, two situations. The first slide is someone who invested $100,000 hypothetical investment at the inception of the income builder in the A shares, right? So, end of December 2002, and they decided that they would take all the dividends and spend them. Right. So they buy groceries. They did whatever they wanted with the money. Right. So, they did this for 21 and a quarter years. Right. And over that time, they received over $176,000 of dividends, right on their original $100,000 investment. Right. So, if you were to just do the math, that’s about that’s over $8,300 per year, right? Yeah. From that original $100,000 investment or an 8.3% yield on an original cost. Right.

Which is which is pretty good. Yeah. And what’s not in the slightest, the tax character of that income was actually very favorable because it skewed QDI (Qualified Dividend Income), mostly. And the flip side or the other side of it is that capital also more than doubled, right? So they’re able to collect the dividends, spend them okay there they got almost 2x their original investment in dividends and their capital double, right. So it’s just a very powerful type of investing strategy. And if you were to look at, you know, the last trailing four quarters dividend, that yield on cost is about 10%. Yeah, right. So, it’s just that power of dividends when they grow over time, you know, they’re not going to grow every single year. But the trajectory is to grow them the next the next scenario is for someone who doesn’t need the income right away right there, they’re saving for retirement. You know, they’re still working. And so, this person can reinvest those dividends over time.

Yeah, right. And this is a really, really powerful part, I think, of the strategy for Investment Income Builder. So, you know, this this person same $100,000 initial investment, they were able to reinvest and almost triple the number of shares they own, so they start off with 8,375, something like that tripling to almost 25,000 in shares. So, the total cumulative dividends were over 300,000. So over 3x the original investment, Right? And the capital appreciation was north of two times. So the $100,000 investment is actually in all more than $600,000. Right. Just by letting the dividends reinvest and compounding. So now if this person decides, you know what, I want those dividends today. Now, now I’m ready. I’m done, right. I want to start collecting the dividends. Well, they can turn it on. Well, guess what? There are almost 25,000 shares they now own, times the last trailing dividend, which was somewhere around 119 for the income builder. They’re now getting a 29% yield on original cost. That’s a pretty powerful tool, and it’s just it’s underappreciated I think for some of the reasons you mentioned earlier. Right. The flashy stocks have gotten all the attention and people tend to focus on those. But a strategy like this is a very durable shift that will sail through all kinds of waters and produce the income that that people really rely on. At the end of the day, in many of the conversations we have are with people who are who are looking for just what, you know, I described.

Adam Sparkman

Yeah. No, I think that’s a really powerful way to show it and really give a tangible example through time of seeing what that compounding can do. Well we will move to Q&A. I know we’ve got a few minutes left here. Jeff, I surprised you by not asking you to prognosticate on the Fed and rates early in the webcast.

Now we’ve come to the end, and I will kick it off by asking you, you know, we’ve had a lot of rate uncertainty. We’ve gone from the fourth quarter. I think everybody getting really excited about the Fed pivot and sooner than maybe expected back in October. January, Fed tempering expectations, pushing back a little bit. So what is your base case for the number of rate cuts that we get in 2024?

Jeff Klingelhofer

Oh, you’re leading the witness. Yeah. And it always comes down to this always the rate question. Look, I was pretty vocal last year in saying that the Fed gave us the playbook and we the market ignored the playbook. The Fed told us they’re not going to be proactive, an interest rate policy. They’re going to be reactive. And that’s a change from a period where they were proactive in trying to push inflation up. But they gave us this playbook back in 2020 and they followed it to a T thus far. So, on the way up, as inflation overshot their objective, they said, look, we’re going to be reactive. Inflation needs to be above target and we need to think it’s going to stay there.

Well, it got above Target and the Fed said, yep, precondition number one met, but precondition number two, it’s transitory. It’s not going to stay there. We’re not moving. And then eventually that proved to be incorrect. So they said pre can both preconditions are met and they adjusted interest rates, but then they told us they’re going to get to a period of rates that are restrictive and they’re going to stay there for a prolonged period of time.

And the market said, nope, that’s not possible. You’re going to be forced, you’re going to have to cut seven times this year in 2023. While that didn’t come to fruition and I think the Fed actually made a policy mistake in moving back to a little bit of a proactive stance and saying, well, as inflation has come down, sure, we’re going to take a few cuts out.

Well, they pivoted to the pivot and now we’re back to the original playbook. Yeah, right. And I think really where I stand is we’re on hold for longer. But with incoming information, I have to adjust my own expectations. I think the bias is absolutely for a Fed cut. I think the bar is very high for a hike, but I wouldn’t take it off the table.

And the reason why I say that is because at this point, inflation has stopped going down. And if anything, it’s actually started moving back up just a little bit. But it started moving back up. And so, I said earlier, I think 3% inflation is roughly the same as 2% inflation. And there is no magic number when it’s not the same. But I think if we get to close to 4%, the Fed is going to be forced back into action. They’ll have to they’ll have to hike. Okay. Now, you asked a very specific question. Let me answer a very specific question. I think we see one cut towards the end of the year, because I do think that the bite of higher rates is working.

It is slowing the economy. And I think that’s really when it kicks the Fed back into motion. But I think we just get one and I think it comes probably in December.

Adam Sparkman

Okay. Matt, we’ll wrap up with one final question, I know that we’re getting close on time here. I think the story of 2023, the Magnificent Seven, stock market concentration, a very small number of names driving the majority of returns. We’ve seen things starting to broaden out a little bit this year. But many of those names, maybe this thing of Magnificent four, fab five, something like that. It’s shrinking. Yeah, at this point. But in this sort of market where there is increasing concentration at the tops of these indexes, where do you see opportunities to generate alpha?

Matt Burdett

Yeah, look, I think in the context of a of an income portfolio, I mean a lot, a lot of the character that’s out there, we talked about right like this this extreme discount of dividend- paying stocks relative to growth. And you know there’s still an a massive under appreciation of diversification, right. Diversification for many American investors has not been a great.

Yeah. Has it really helped for you know since the post-GFC era but a lot of it has to do I think with just what we talked about, the 0% interest rate benefiting the U.S. market, which is two thirds growth versus the international market, which, number one sector financials, industrials. So really more old economy kind of stuff. So, I think, you know, what we’re trying to do is, is go find you know, do the rifle shots, find the one off ideas. I think I think the good thing is that the backdrop for us is very good. Like, like the pond we’re fishing in.

There’s a lot of fish in there, right? And. And we have the right boat to go catch those fish. So we’re pretty excited about. About what it looks like from here.

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