Investors are restlessly seeking return on their investments in a world where global central bankers are suppressing yield and lowering borrowing costs. They have moved up and down the risk curve in both stock and bond markets in search of this yield.
I believe investors know that the higher the yield, the higher the risk. But we all sometimes fall victim to magical thinking. Therefore it is important to review the warning signs of yield mania. Let’s take a look.
One way to get yield is to put money into a certificate of deposit. Such a move locks up access to the principal, so it is only advisable for people who don’t need fast access to their money. In other words, investors trade liquidity for yield and, of course, security of principal.
Let’s look at a more extreme example. Many investors are now looking to high-yield corporate bonds, which have been yielding close to 6%. That yield sounds nice, but let’s not forget what the buyer gives up to get that yield. Companies whose bonds are considered high-yield are usually on less stable financial footing than their counterparts in the high-grade market. With that comes a greater chance of defaults. In fact, high-yield bonds have a historic default rate of close to 4% annually. When defaults occur, the losses for investors can be high, often 40% to 60%. Right now defaults are very low; but that could change. Investors need enough extra yield to offset the risk of these default-adjusted losses.
Then there is the liquidity issue. High-yield bonds are traded in greater increments than stocks by dealers who demand a cut, or what we call a "wide bid/ask spread." Another issue is the price versus call-ability. The average high-yield bond costs about $105 at face value. But more than half of the bonds are callable at $100. So if an investor pays $106 for a bond and the issuer calls the bond at $100, the investor loses $6. Just like that! Does that make up for the 6% yield? And then there are the risks of bond covenants and interest rates. Does 6% yield really seem worth all of these risks?
Investors have also been flooding into preferred stock, which, with a 5% quarterly dividend yields, sounds good. But unlike with a bond, the investor has no guarantee that the dividend will be paid. Nor does the preferred stock investor have any protection against losses if the company gets in financial trouble. At the same time, preferred stocks don’t enjoy the upside potential that common stock does. So if it doesn't have a promised return or the security of a bond, then what good is it? Preferred shareholders get paid before common shareholders, and preferred shares are typically less volatile than common shares. However, they are typically nice tools for a corporate or bank issuer and a disappointment for the investor.
What about master limited partnerships? These setups distribute much of their income to holders, but they don’t trade like stocks and offer lots of upside when things go right. Partnership and management fees can be very high. Earnings often fluctuate with commodity prices. And MLP prices can collapse when interest rates rise and investors sell MLPs for safer-yield alternatives.
Let’s face it; getting yield these days may be a case of too good to be true. Investors need to look closely at what can happen to their principal when buying these higher-yielding investments. And then they need to assess this against the historical yield the market has offered to offset the myriad risks.
As we have all learned with health care, it pays to get a second opinion, especially if you sense there is too much risk for too little yield.
No forecasts can be guaranteed.
The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.