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Shooting Yield’s Whitewater Rapids

Monday, December 7, 2015

Sheila Jamison and Rich Jamison

With an almost certain interest rate increase, the word “yield” is prominent in investors’ minds again. But yield has several quasi-definitions in common use. The differences among these often cause confusion. Yield conversations can become complicated and puzzling. That often leads to bad investment decisions.

When you think about yield, it’s best to start with defining what that means in your consideration. Are you thinking of yield as an investment characteristic? Are you thinking of it as the cash your portfolio throws off each year; as a source of income to go spend? Be wary of blurring the distinction between these ideas. Otherwise, that blur can overshadow sound investment thinking.

An Example

The Jones family (isn’t it amazing how many times the Jones get themselves into trouble?!) looks at yield this way. Yield is the percent dividend they get from their stock. John and Jenny Jones worked for the same company and accumulated lots of its stock, generally from bonuses and 401(k) matches. Believing wholeheartedly in the company, they hold only that one stock (already stepping deep into the danger zone regardless of what that one stock is).

Their stock pays a 3% dividend. Having accumulated the stock for many years, they have almost a million dollars in that stock. At 3% they figure they gain about $30,000 every year. To the Jones, that is yield.

But what if that stock drops 10%, 20% or 30% in value? (Think the stock of a established, long-term “blue chip” company can’t drop 30%? Take a quick look at IBM over the recent past!) But let’s limit this example to only a 10% fall in price. The Jones made $30 thousand by their scoring method. However, their portfolio is now worth only $930,000 if they left that 30 grand in the portfolio. If they spent the dividends, the portfolio’s worth only $900,000.

Clearing the Confusion

The Jones used yield as an investment characteristic. This can be a useful parameter to include in making investment decisions about an individual security – that is, when “to buy or not to buy … that is the question.” But in terms of overall portfolio investment we suggest you consider yield from this perspective:

Portfolio Yield = Dividends + Interest + Appreciation – Losses

Note that the Jones only looked at the first part of the portfolio’s yield, the dividends. That isn’t sufficient.

Chasing Yield

That’s another term you’ve heard often. With current yields at historical lows, investors are confronted with unsatisfying incomes from these traditional investments. Chasing yield refers to seeking out – and indiscriminately investing in – securities offering higher yields.

No “Free Lunch”

Chasing yield can lead investors to concentrate their portfolios into asset classes, sectors and securities that supposedly offer – or traditionally have offered – higher yields. But those yields can come with additional risks.

Almost everyone understands the basic relationship between investment risk and reward. However, all too often the misapplication of yield’s definitions disrupts this understanding. Investors often seek yield while ignoring the total return of their investment.

A Few More Examples

We could see that fallacy of looking only at yield for dividend-paying stocks in the Jones example. Stocks are subject to market volatility, economic cycles and/or corporate events.

But what about bonds? One notable source of higher yield is high-yield bonds. You might think that’s why they’re called “high-yield” bonds — but that’s more because of marketing. Their issuers felt that the prior name, junk bonds, didn’t enhance investors’ opinion of them. They got this name because they don't always pay investors back. The reason they pay higher yields is to compensate investors for taking a higher risk of issuer default.

A Special Caveat NOW

Stay away from leveraged Bond Funds and ETF’s (Exchange Traded Funds) when rates rise. Many investors flock to these securities because they offer a higher yield. They’re not for the faint of heart because they’re EXTREMELY volatile.

Here’s how one such fund, ProShares Ultra 20+ Year Treasury ETF, fared in the autumn of 2011. The ETF closed at $105.25 on August 31. It then surged to $140.52 by October 3. Then it plunged to $111.38 on October 27 – a loss of 20.7% in just 18 trading days!

Remember – leverage is simply a multiplier. These funds offer higher returns in stable or falling rate environments from the multiplier. The other edge of that sword is that they also offer higher losses on the way down when rates are rising. Know the additional risk you’re taking in a rising interest rate environment when you have leverage in your portfolio.

"The minute there is leverage involved it is going to kill you on the downside''

says Ashvin Chhabra, chief investment officer at the Institute for Advanced Study, a research center in Princeton, N.J.

Though not usually as dramatically volatile, even the top rated investment grade bonds have large swings in their total return (that is, interest plus price gain or loss). Putting numbers on these, here are some for a few asset classes that yield-seeking investors will probably consider for use in their portfolios. The returns are for the 20-year period from October 1, 1995 to September 30, 2015 (called the “Current Yield” in the table. Compare the current yields to the worst one-year returns during the period.

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1 Barclays U.S. Aggregate Bond Index. 2 Barclays Global High Yield Index. 3 FTSE EPRA/NAREIT Global Developed Index. 4 Alerian MLP Index. 5 Barclays U.S. Treasury Index.

This is not to say you should necessarily avoid these asset classes, even those with such painful downsides. Sometimes a position in one or more of them may be right. Other times, it’s not. However, be careful when deciding how much to allocate to any one of them … and keep your specific risk tolerance in mind while doing so. Despite the lure of yield, you can't escape the reality of the markets.

Managing Yield: 3 Rules

The first rule is to keep investment decisions distinct from decisions about how to generate income. This is often more difficult for a retired individual to implement but applies to everyone.

Next, note how much yield the current market environment can reasonably deliver. Don’t expect to get more because you want more … or because you need more. The market doesn’t care on iota about what you want or need. Look for a responsible level of yield from your investments.

Third, pay attention to the portfolio risks you will inherit with any investment. That means evaluate the source of each stream of payments. The income from a security – be it a bond’s interest payment or a stock’s dividend – comes from the underlying business of the security's issuer. The company behind the security has to earn enough revenue to pay its bills first and then pay you. (Depending on the type of security you own, there may be others ahead of you in the payment line.) Remember, higher yields generally are tied to higher-risk investments. Leveraged funds are a good example of how this higher risk can sometimes be masked or hidden.

Based on 3 Principles

  1. Balance your portfolio to seek both current income and long-term growth. That growth underlies future income.
  2. Understand the rewards and risks of different yield strategies as noted earlier.
  3. Adapt to the changing market risks and opportunities.

Admittedly, all three rules and all three principles are built on the “simple but not necessarily easy” standard. Compare it to running a marathon. Simple – just keep putting one foot in front of the other until you cross the finish line. Easy – well, not so much. Even if you have trained diligently for it, it’s still hard work.

And that’s where we come in. We’re available and willing to provide help to you if/when you want it to navigate the sometimes treacherous waters of yield.

Sources

How investors get yield wrong and how dangerous that can be: Three principles that can help advisers manage yield responsibly for clients. Phill Rogerson. Investmentnews.com. November 19, 2015.
Money Magic: Bonds Act Like Stocks. Michael Corkery. wsj.com. January 21, 2013.
Data from Finance.yahoo.com. Retrieved December 4, 2015.