In a low yield environment, many investors have been drawn to high-income strategies. What are the risks?
Investment strategies claiming high yields are intuitively appealing to investors, mostly due to the behavioral tendency of large payouts acting as 'a bird in the hand' being worth more than 'two in the bush,' and implying mixed feelings about using total return for portfolio drawdowns. Particularly in an environment of low yields for safe assets like savings accounts, CD's and money market mutual funds, higher yield options have been in strong demand. There's a bit of anchoring here as well, as high yields for certain investments are often compared in relative terms to rates for CD's or government bonds, which provides part of the story, but certainly not all of it.
As a refresher, investment return comes in two forms: price impact and income. When combined, these equal one's total return, whether the income part is paid out in cash or reinvested.
Some of this is rudimentary, but worth reviewing for the sake of context. Yields on fixed income investments are generally related to two factors —the amount of interest rate risk and credit risk being taken. Because future interest rate conditions (based on central bank policy to some degree, but more so on inflation) are uncertain, investors demand a larger 'premium' for investing further out on the yield curve, which explains why 30-year treasury bonds yield substantially more than 30-day treasury bills most of the time. Additionally, the risk of default from a corporate issuer is higher than that of a government issuer, so credit spreads are generally positive —'riskier' issuers are forced to issue debt paying higher rates to entice investors to choose these bonds over 'safer' options. When foreign bonds are added to the mix, this credit premium reflects other factors such as political regime stability, economic fundamentals, currency volatility and local inflation. Consequently, the less stable nations in the emerging world are forced to offer much higher yields to attract investors (Brazil and Turkey are current examples). In the bond world, outcomes are largely constrained to being paid back or not, and what your yield is, which keeps things fairly straightforward.
With equities, income comes from dividends, which are set by management at a per-share basis, and funded from corporate earnings. The sweet spot here is offering dividends high enough to satisfy demands of existing shareholders, but not paying out too much, which could hamper the use of earnings for organic growth and/or merger and acquisition activity by the company, as well as other uses, such as share buybacks. Dividends are typically paid in cash, so investors are rewarded immediately (the 'bird in the hand' thing again). This used to be a more important factor decades ago when stocks were evaluated almost exclusively based on their dividend yields, as that was the only tangible thing shareholders were receiving from their ownership —absent a corporation action of some sort . One problem for companies is that once a dividend policy is put in place and a certain per-share amount is announced, investors are fickle about wanting to see that per-share amount grow over time, which puts added pressure on management to ensure earnings are large enough to accommodate the dividend. There can be a penalty for lack of dividend growth, which is considered a sign of poor health or lackluster industry prospects; a dividend cut is an even greater faux pas that is to be avoided at all costs, as there is apt to be a severe negative reaction to a stock's price (even the hint of a dividend cut can send investors running for the exits). Because of this tendency and lack of flexibility, many companies have instead been using cash to conduct share buybacks, which are a stealthier way to 'pay' shareholders and offer less measurable results. These have their own nuances and issues, so a topic for another time.
Generally, for equities, a decent dividend yield, prospects for growth and a reasonable payout ratio has been a good recipe for investment success over the years. When yields get 'too' high, though, it can signify a problem. Often, the basic math points to a drop in price that has occurred while the dividend hasn't been adjusted —causing the yield to shoot up. Since there's no free lunch, often investors are acting in advance of a dividend cut or other uncertainty to do with a company or industry. If conditions aren't that bad, new investors buying in at that yield might be rewarded, but if dividends are cut, the yield will fall, rendering the sky-high yield a temporary phenomenon. The key is sustainability.
High-income portfolios often feature several of these factors, which, as you can see, contain risks. If nothing else, higher-yield portfolios can feature greater concentration in certain segments, such as below-investment grade bonds, emerging market debt, stocks that offer high payouts but lower growth prospects (e.g., utilities, telecom), are unique structures such as energy master limited partnerships, and/or they contain leverage in order to 'juice up' yields somewhat. Aside from bond coupons and stock dividends, some strategies also sell equity options, such as covered calls or puts —and these premiums also become a unique form of income.
Income adherents argue that income payments always represent positive absolute return to a portfolio, and can help offset negative price impacts, which is true. The level of risk taken by these strategies is very strategy-dependent, but income-oriented portfolios can be as risky as conventional asset allocation portfolios designed to achieve a certain total return, and, in some cases, can be riskier, based on how nichy, illiquid or unique the concentrations.
In many cases for high income portfolios, investors receive a higher dividend payout and possibly lower price return, which is just another configuration of a traditional asset allocation portfolio, which offers more of a balance between income and price return, with probably a bit less of the former and more of the latter over the long-term. So, an investor might 'feel' better getting more income, but the net result may not be that different. Of course, in unique cases like certain charitable remainder trusts and the like, more income than price return might be preferred (or even required) —there are always exceptions to the standard rule.
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Read the previous Question of the Week for February 29, 2016.