Investors seeking yield may take on unexpected risk
Current levels of low interest rates
Investors seeking to produce income from their portfolios may have a difficult task. Equities are paying dividends in the range of 2.5%.1 A core fixed income portfolio, the foundation of most income portfolios, is yielding about 2.3%.2 Include a cash component to a mix of stocks and bonds, and you will have a portfolio yielding somewhere close to 2.0%. Not much for yield investors to get excited about.Reaching out for additional yield (and risk)
These low rates have led many investors to reach out on the risk spectrum to seek additional yield. However, investors may be getting more than they have bargained for in the way of additional risk. Historically, there has been a sense that investment income provided a sense of safety or “downside cushion” for investors. That may be true to a limited extent, but when investors concentrate their portfolios in higher risk areas of the markets to seek yield (e.g. high yield bonds), the additional risks may outweigh the additional income received. 2015 has provided a strong example of this. The displays below demonstrate the examples of hypothetical additional yield that investors have picked up in 2015 for reaching out beyond core stocks and bonds for income. In exchange for more yield, investors often expose themselves to the more volatile return pattern of these assets. In each case, the total return for the higher yielding assets, which has the greatest impact on portfolio value, has been less than that of the core asset. In some instances, that return difference has been substantial, as in the case of Master Limited Partnership (MLPs). MLPS are currently providing a 4%+ greater yield than global equities, but they have lost 25% more in return YTD through September. That has been a very difficult trade-off.
Sources: Core Bond – Bloomberg U.S. Aggregate Bond Index; Long Treasuries – Bloomberg Long Treasury Index; High Yield – Bloomberg High Yield Index; EMD – Bloomberg Emerging Markets Debt Index; Global Equity – MSCI World Index; Infrastructure – S&P Global Infrastructure Index; Utilities – S&P 500 Utilities Index; MLPs – Alerian MLP Index.
This is not a condemnation of any of these asset classes. Each one can play a beneficial role in a diversified portfolio. However, as with any investment, there is a trade-off between risk and return, or in some instances, risk and yield. A greater understanding of the additional assumed risks can help enable yield seekers to do a better job of assessing and assembling these assets in a responsible way to produce long-term results.
The bottom line
Difficult market environments can lead investors to decisions they normally would not make. In the case of a low interest rate environment, some will reach for, or concentrate the portfolio in, riskier assets providing higher income numbers. Unfortunately, this higher income can come with wide swings in total return. For those unaware of the potential risks, 2015 may have been a rude awakening. There are sound ways of incorporating income into investment portfolios. An appropriate balance of return, risk, and yield can be accomplished for almost any investor who is willing to step back from blindly pursuing income. Yield strategies should be diversified and sustainable, to help position the portfolio for long-term success.1 Equities represented by MSCI World Index, as of September 30, 2015.
2 Core fixed income represented by Bloomberg U.S. Aggregate Bond Index, as of September 30, 2015.