Chasing yield: Is sustainable income a better way?

While some retirees and their advisors clamor for yield-oriented investment strategies, we believe this fascination with yield can result in some unexpected, often unpleasant, consequences. In fact, the current market environment, with all eyes on the timing and pace of an U.S. Federal Reserve interest rate hike, should give yield-seekers additional pause because of the potential for immediate increased volatility.

To help investors evaluate their own investment situation, we’ve extensively researched the overall impact that a focus on yield can have on multi-asset portfolios and concluded that yield objectives over 3.5% begin to erode a portfolio’s capital base. As you can see from the hypothetical scenario below, such erosion can occur at an increasing rate as forecasted yield increases to 5.0%. Unfortunately, too many investors are not only seeking yields higher than 3.5%, but they have ventured into investment scenarios that are significantly tilted toward yield with little regard for long-term risk.

return versus yield chart

Hypothetical analysis provided for illustrative purposes only.

Many yield-seeking investors have stretched beyond the more traditional sources of yield, such as money market accounts, U.S. Treasuries and investment-grade fixed income assets. Such alternatives can help to provide potential for more short-term income, but at a much higher risk than many investors can withstand given their lower-risk preferences. For example, the yield on U.S. high-yield bonds was 6.6% as of March 2015. But, during the financial crisis, the worst 12-month return for the asset class in the last 20 years was minus 31.2%.1 By comparison, the worst 12-month return for a typical bond portfolio, as represented by the Bloomberg U.S. Aggregate Bond Index, over the last 20 years, was only minus 3.7% from November 1, 1993 to October 31, 1994.

Could your own portfolio withstand a loss of 31.2%? Most retirees would face significant, prolonged lifestyle changes from that type of loss—particularly if that loss occurred at the beginning of their retirement years.

Ironically, many of these investors believe they are taking a “safe” investment approach because they are living on yield-generated income and leaving their principal “untouched”. Unfortunately, this is a potentially costly fallacy if the methods used to boost income result in too much risk and do not allow for capital appreciation. We believe investors who seek responsible yield through diversification by using a multi-asset investment strategy will likely enjoy a potentially more sustainable future income stream and fewer sleepless nights.

In our opinion, the key factors underlying a responsible-yield portfolio are:

  • Balance: Current income from a portfolio should be balanced against long-term growth requirements.
  • Diversity: A portfolio should include a mixture of strategies and globally diverse asset classes.
  • Risk: The assumed risk in the overall portfolio must be weighed against the investor’s risk tolerance.
  • Adaptability: More frequent monitoring and asset-allocation adjustments are needed because of changing market conditions.

So, it is important to consider how you might build a portfolio aimed at producing sustainable yield. At Russell Investments we choose to take a design-construct-manage approach.

  1. Design: Build a portfolio that produces income, but avoids eroding the portfolio’s capital base and avoids creating too much cost to total return.
  2. Construct: Diversify yield sources and risk profiles within asset classes to help better withstand market stresses.
  3. Manage: Employ mindful, timely management that adapts to ever changing market conditions.

How responsible, or irresponsible, is your yield-oriented investment plan? For more information on Russell’s findings regarding yield-oriented investing, please review our full report.

1 U.S High Yield: Bloomberg U.S. High Yield Index as of March 2015.