What’s inside your (income) box?

In a low-yield environment like we’re in today, many investors are tempted to reach for yield, ignoring the reasons why a certain investment offers that higher yield. It reminds me of the infamous con man “Count” Victor Lustig, who swindled people with his clever Rumanian Box scam. In the early 1900s, Lustig would periodically take transatlantic cruises and demonstrate his money-making machine to passengers. He would insert a real $1,000 bill into a box and explain that the chemical duplication process would take six hours to complete. After the allotted time, he would pull a lever to remove both the original note and a duplicate for the passengers to carefully examine. After a few cycles, his victims would become convinced of the enormous potential for profit and pay handsomely for the machine. The elegance of this scam is not that the duplicate notes were counterfeit; as in fact, they were real notes. But the victims were so focused on the immediate output of the box that they never bothered to look inside the box to see how the money was actually created. It reminds me a little bit of how some investors view high-yielding securities. While most of these securities are far from being scams, investors forget that higher yields come with strings attached—as there is a greater risk of not getting all the income or principal back. Why does that one year FDIC-insured Certificate of Deposit deliver such a paltry yield? Because it’s a short-term loan to the bank with the safety of having the principal guaranteed by the Federal Deposit Insurance Corporation. The investor is nearly certain to get their interest payments and initial investment back. Fundamentally, the income required to fund a dividend or an interest payment on a security must be supported by an underlying business. If a business doesn't earn enough revenue to fund dividends or interest payments on its bonds after covering other operating costs, then it’s an unsustainable prospect. Here are 3 examples of incomes from securities that investors may find attractive in a low-yield environment, and why each might have more risk than an investor thinks:

1. Dividends from traditional stock: Despite what some believe, past dividends are no guarantee of future dividends. Whether a firm chooses to pay dividends (instead of reinvesting in new projects, buying back shares on the open market, etc.) depends on complex corporate financing decisions. While there's certainly useful information in a long history of stable or increasing dividends, what happens when a specific firm or an entire industry is disrupted? The dividend may stop, the share price may crash, or both. In these cases, the past says little about the future.
2. Dividends from preferred stock: Investors may like the often higher stated yields compared to fixed income. But while preferred stock seems like it might offer the benefits of both bonds and traditional stocks–income from dividend payments and upside potential–it typically ranks behind traditional bonds in the capital structure. In other words, if there's not enough money to go around, shareholders fall in line behind other creditors and these dividends may not be paid.
3. Dividends from high yield bonds: The yields on these bonds are generally higher than traditional corporate bond yields for one of two reasons. Either the company's prospects are uncertain or they have already issued a lot of other debt that is higher in the capital structure and will get paid first. It's telling that these bonds are called ‘high yield’ when their performance has been good, but ‘junk’ bonds when their performance has been terrible.

My point is not that these 3 examples are poor investment choices. Rather, it’s to make sure that investors don’t concentrate their portfolios into one or a few higher-yielding securities with the assumption that they offer the safety of a bank CD or government bond. We believe that any strategy emphasizing income should do so responsibly in a well-diversified manner. In other words, the strategy should be designed, constructed, and managed with an understanding of the reason for the higher yield, the associated risks (including the risk of drawing more income than the portfolio can sustain on a long-term basis), and knowledge of how different economic and market environments may affect yields.