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. 2015 has tested yield seeking investors Sources: Core Bond – Barclays U.S. Aggregate Bond Index; Long Treasuries – Barclays Long Treasury Index; High Yield – Barclays High Yield Index; EMD – Barclays 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 Barclays U.S. Aggregate Bond Index, as of September 30, 2015. Alerian MLP Index: The leading gauge of large- and mid-cap energy Master Limited Partnerships (MLPs). Barclays Emerging Markets Bond Index: Includes fixed- and floating-rate USD-denominated debt from emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia. For the index, an emerging market is defined as any country that has a long term foreign currency debt sovereign rating of Baa1/BBB+/BBB+ or below, using the middle rating of Moody’s, S&P, and Fitch. Barclays Long Treasury Index: Includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value. Barclays U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (specifically: Barclays Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index). Barclays U.S. High Yield Index: Measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. The index excludes emerging market debt. MSCI World Index: Captures large and mid cap representation across 23 Developed Markets (DM) countries. With 1,643 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. The S&P Global Infrastructure Index: Provides liquid and tradable exposure to 75 companies from around the world that represent the listed infrastructure universe. To create diversified exposure across the global listed infrastructure market, the index has balanced weights across three distinct infrastructure clusters: Utilities, Transportation, and Energy. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management. Copyright © Russell Investments 2015. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty. RFS 16121