In these times of stock market volatility, many investors are looking for yield in fixed income and dividend stocks. However, there’s risk in these investments, too, so know what you’re getting into.
Do you see yourself sitting on the porch swing someday, relaxing with a cup of iced tea and waiting for the next round of dividend and interest checks to arrive in the mail?
Even if the porch isn’t your particular retirement dream and you prefer hot coffee, you may still hope to live at least partly off the yield from your investments at some point. What you may not dream about, or even take enough time to consider, is the risk involved in this retirement scenario. Yes—there’s risk even in what seem like vanilla investments that people turn to for yield.
In your reach for yield, you could be taking on risks that aren’t commensurate with the yield you’re reaching for. If you’re an investor hoping to collect those checks someday (or even now), it helps to understand the risks of reaching for yield and to try and avoid some of the pitfalls.
For instance, consider an investor who sees a certain sector, Energy let’s say, delivering high yields at around 4.5% with the underlying stocks at depressed levels. It might seem like an opportunity to jump in. However, things might not seem so good a year later if crude oil prices fall and the sector drops 25%.
The same could be true in fixed income if you buy a company’s high-yielding bond and it then defaults, leaving a hole in your investment portfolio.
“Often with outsize yield, there’s a higher probability of default or some form of a credit event or restructuring that could materially impact the bond or bond fund,” said Viraj Desai, senior manager, portfolio construction at TD Ameritrade. “Particularly aggressive investments with high yields do have to work through higher levels of credit risk that might not necessarily be apparent unless there’s an economic downturn and spreads widen out.”
“The worst-case scenario is a permanent loss of capital,” Desai warned. “One way to help prevent that is to invest in breadth and make sure you own broad composites.”
Despite this, some people get lulled into a false sense of security when they buy fixed income or “defensive” stocks. They also might get starry-eyed by the promise of high yields that may not be sustainable.
The other problem is that investors hoping to live off the proceeds from their investments aren’t really enjoying the best of all worlds. With central banks globally keeping interest rates near or at all-time lows pretty much since the recession of 2008, it’s become tougher to make a living off of interest payments. That sometimes forces people into higher-yielding but less safe options, like high-yield (“junk”) bonds. While it’s not by design, central banks arguably have helped encourage people to step outside their risk tolerance comfort zone.
Consider thinking of yield like a scale. The more one side (yield) goes up, the more the other side (reliability) tends to go down. The idea to consider is not reaching too high and simply trying to make a living wage off your investment yields.
“If you invest in individual securities, conduct the due diligence around the going concerns of the business and the potential to fund payouts,” Desai said. “With prudent research, you can build a portfolio without the most attractive yields, but with sustainable yields that can map to what your long-term goals may be.”
When we discuss risk associated with yield, there’s more than one type. First, and more common is the chance of the yield you’re depending on going down. This can happen for a number of reasons, but it’s quite common with companies that pay dividends, as we’ll see.
The other risk, which is potentially more dangerous but also not uncommon, is the actual loss of principal you invested in the underlying stock or bond. We’ll get to that in a minute. First, let’s talk dividend yield risk.
In late 2018, General Electric (GE) announced it would slice its quarterly dividend from 12 cents to just a penny a share. GE investors who wanted those regular payments had to choose between hanging onto a stock that paid a one-cent dividend or liquidating their shares and searching elsewhere for yield. As those investors learned the hard way, dividends are often the first distribution to investors or shareholders that gets chopped when hard times come.
So how can you try to avoid the situation GE investors faced? It all starts with doing the research, just as you would for any investment. In the case of a dividend-yielding stock, investors probably want to pay extra attention to how the company makes its money as well as its cash flow. If there are question marks around those, you might want to approach it gingerly.
“If you see a high dividend yield when you review a company’s financials, check to see if the company has an adequate amount of cash or earnings that can justify and support those yields as a going concern,” Desai said. “If that piece doesn’t exist, chances are those yields tend to be cut or they disappear. Make sure if you’re investing in yield that it’s sustainable. You don’t want volatility in your dividends if you’re using them for income.”
One way to keep tabs on whether dividends will be slashed is to look at the cash flow statements on the company’s quarterly reports. If it appears more cash is being paid out in dividends than the company is generating, the company may consider cutting or even doing away with the dividend. Also, consider reading any analyst reports you can get your hands on, and try to spot signs of trouble such as a missed quarterly earnings number or a company’s CEO leaving. See figure 1 below.
With stocks, there’s also potential risk to the underlying investment. Even if a company doesn’t cut its dividend, you’re probably going to come out on the short end if its shares drop 30% over the course of a year or two. Yield, even reliable yield, can’t always make up for share losses.
In general, corporate bonds are considered a bit less risky than company shares. That said, when a company struggles, you’ll often see it begin the process of suspending interest payments up the capital structure. Eventually, if things get bad enough, a company might declare bankruptcy and bondholders might not get back their investments.
Much of the default risk in bonds can be mitigated by scooping up only those that are highly rated. Various agencies like Moody’s and Standard & Poor’s issue, track, and update bond ratings on a regular basis, but they each have their own grading criteria, so investors need to educate themselves first.
Another way to potentially avoid some of the risk of high-yielding bonds is to buy a fund that invests in many of them at once. The more bonds in a fund, the better chance there’s diversification that can sometimes help investors during tough times.
“If I had a high-yield bond fund with 1,000 bonds in it vs. a high-yield bond fund with a portfolio of 30, I’d be more comfortable owning the breadth,” Desai said. “If one of the 30 defaults, that’s a material loss of capital.”
The challenge for some investors is that more risky bond funds and dividend stocks tend to pay higher yields, and that’s sometimes hard for people to pass up.
“Whenever we see an exceptionally high yield, we’re behaviorally keen to dive right in without qualifying what’s driving it,” Desai said. “It’s important to be prudent about where you deploy your capital. Be very critical about everything that winds up in your portfolio. If something is yielding 10%, ask yourself, ‘Why is that? What’s driving it?’ Make sure that the data and analysis can support that, just like with any other investment. Understand what’s driving the yield. Is that yield sustainable? Is there a risk that it could disappear?”
One rule of thumb for checking whether a particular yield might be too good to be true is to measure it against the yield of a well-known stock or bond index. For instance, if you’re considering a mutual fund that invests in “value” stocks with a focus on providing yield, check the yield of the S&P 500 Value Index, easy to find with a simple internet search. If the yield of the fund you’re looking at is a lot higher, start going over the investment carefully to see if it’s sustainable.
People trying to get a sense of bond yields might want to check the yield of their prospective investment with the iBoxx Liquid High Yield index or the Bloomberg Barclays US Corporate High Yield Index. See if the high-yield bond fund you’re looking at is in the same yield ballpark as those widely-followed indices.
“If you see another fund with a higher yield, ask yourself, is it higher because there are riskier bonds in that fund? Will it have higher default rates?” Desai said. “Do your due diligence.”
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