After a long bull market, it can be easy to forget that high yields always bring risk factors along for the ride.
For the last several years, record low interest rates have forced investors seeking current income to get a bit creative. For the most part, this creativity has worked our just fine thanks to a long stretch of positive momentum for stocks and relatively low volatility.
It’s easy to talk yourself into a high-yielding asset as a low-risk allocation; even if there is zero appreciation, it’ll still deliver a nice return in cold, hard cash. The problem, of course, is in the assumption that the worst case scenario is a steady price. This may sound a bit basic, but asset classes with high yields tend to carry some significant risks. These risks aren’t always obvious or relevant — which is exactly what often makes high yield investments tempting.
Real estate investment trusts (REITs) have long been a popular choice for investors looking to maximize current yield. In order to take advantage of certain tax benefits, REITs must pay out substantially all of their profit in the form of dividends. In other words, these companies typically maintain a payout ratio close to 100 percent — which results in a high-dividend yield.
REITs tend to be extremely sensitive to the health of the broad economy. While most imagine houses when they hear “real estate,” REITs are much more likely to own office buildings, manufacturing centers, or retail areas such as malls (though some do own apartment buildings). When the economy struggles, companies lay off employees (which means they need fewer square feet of office space), factories shut down (which means that industrial office space sits empty), and retailers go out of business (which means more empty stalls at your local mall). All of these translate into lower cash flows for the companies that own and rent out real estate.
This nightmare scenario played out for the Vanguard Real Estate Fund (VGSLX) in 2008, when it lost nearly 70 percent of its value as the U.S. economy sank into a recession.
Real estate has bounced back nicely though; VGSLX is well above its pre-recession highs and has gained more than 300 percent from its 2009 low.
Like REITs, master limited partnerships (MLPs) can take advantage of certain tax loopholes if they distribute a substantial portion of their earnings each year. Also like REITs, this asset class can be very sensitive to certain variables.
MLPs — which typically own and operate the pipelines that transfer oil and natural gas — depend on the health of the U.S. energy sector. Though MLPs don’t sell oil or gas directly, they are certainly impacted by price movement (despite a surprising amount of shallow analysis that concludes otherwise).
Plunging crude prices in 2014 and 2015 weighed heavily on the operations of drillers and refineries. MLPs shared in the suffering, as the increase in bankruptcies and uncertainty hurt volumes and pricing.
This type of performance, in an environment that was generally positive for stocks, is obviously disappointing. The yield on MLPs can be very tempting, but it’s important to remember that is comes with exposure a very specific and very real risk factor.
Portfolio management 101 teaches that bonds exhibit low volatility — but that’s an extremely simplified idea. “Bonds” is a very broad term, including assets with a wide range of risk and return characteristics.
Long-term bonds, which have historically been a source of attractive coupon rates, often exhibit significant volatility. The Fidelity Long Term Treasury Bond Index Fund (FLBAX) has an average duration of about 16 years, which means that a 1 percent increase in interest rates would cause the price to drop by about 16 percent.
This type of price swing is not simply hypothetical; FLBAX lost 13 percent of its value in 2009 and again in 2013 (and then gained 30 percent the following year).
The consensus seems to be that long-term bonds are going to make a poor investment over the next decade or so. Research Affiliates expects an annual return of 0.8 percent. Rick Ferri of Portfolio Solutions expects 20-year Treasurys to return just 2.5 percent (net of inflation) over the next 30 years.
High-yield (or “junk”) bonds are another obvious option for investors looking to boost income. This asset class typically offers a meaningful improvement on the yields available from Treasurys and investment grade corporate bonds, but there’s an increase in risk that comes along with that extra yield. The following table shows annual performances for Vanguard’s High Yield Corporate Fund.
Though technically falling under the “bonds” umbrella, junk bonds behave more like stocks in most environments. In 2008, when long-term Treasurys added 25 percent, VWEHX lost 21 percent. During the subsequent rally in stocks, junk bond funds generally did quite well.
Despite the solid performance over the last several years, there is growing concern about the ability of the high-yield market to handle a turbulent environment in the future. Carl Icahn has repeatedly warned about a junk bond bubble building, predicting a liquidity crisis when sentiment turns against this asset class. Others have worried about a similar “rush for the exits.”
Emerging Markets Bonds
Debt of issuers located in emerging markets such as Russia and Brazil can carry very attractive yields. This is especially true for bonds denominated in the local currency (i.e., Russian rubles or Brazilian real) and not U.S. dollars.
Many investors will overlook or write off this currency risk — it seems to be a relatively minor issue that doesn’t have much downside. Because the USD / BRL exchange rate is rarely mentioned in the financial media, it’s far from the mind most of the time.
But currency risk is a big deal. The PIMCO Emerging Local Bond Fund (PELAX) has struggled mightily in recent years as emerging market currencies have depreciated against the dollar:
The 5 percent dividend yield on this fund looks nice — but three straight years of losses certainly don’t.
Utilities are another asset class that often appeals to those seeking higher yield. And this is one that is relatively stable — effectively a lower volatility version of the U.S. stock market.
Though utilities may face headwinds in rising rate environments, the biggest risk over the long term is “missing out” on the typically higher returns generated by the broader market. It’s worth noting, however, that utilities have held their own during the past decade. Since launching in 2004, the Vanguard Utilities Fund (VUIAX) has outperformed the broad market (as measured by the S&P 500).
Utilities don’t really have an “investing Kryptonite” — a specific risk factor that can produce abysmal performance, such as falling oil prices for MLPs or rising interest rates for long-term bonds.
Yield and Risk
The charts above may seem a bit repetitive, but hopefully they drive home an important point: behind every attractive dividend yield lies a number of significant risk factors. These risk factors may be irrelevant for long stretches of times, only to emerge and wipe out years of gains in a short period of time.
About the Author: Michael Johnston
Michael Johnston is senior analyst for Fund Reference, and also serves as COO of parent company Poseidon Financial. His investment expertise has been featured in The Wall Street Journal, Barron’s, and USA Today, among other publications. He resides in Chicago.