5 Reasons Why Reaching for Yield is Risky

Summary:

Many times in my career, I’ve heard prospective clients relate that because they are retiring soon, they need their portfolio to generate a lot of income to fund their retirement years. It’s an understandable sentiment, but it is not necessarily the soundest starting point for building a portfolio that delivers the value investors want. Investing only for income is wrought with peril, and there are five clear reasons why the prudent investor should keep asset yield in perspective.

“Don’t worry about the income, worry about the outcome.” – Warren Buffett

Why do we invest? To see returns, of course. Particularly as we age, our assets and the income they yield are an essential part of our lives. Yet, many times in my career, I’ve heard prospective clients relate that because they are retiring soon, they need their portfolio to generate a lot of income to fund their retirement years. It’s an understandable sentiment, but it is not necessarily the soundest starting point for building a portfolio that delivers the value investors want.

Today, given the low-yield environment the central banks of the world have created, investors feel starved for income. For some, it has become an obsession. But investing only for income is wrought with peril, and there are five clear reasons why the prudent investor should keep asset yield in perspective.

1. Because income is such an obviously attractive feature of an investment, it is seldom ignored and often overpriced. Think of it this way: if you’re only willing to buy income-producing assets, you are limiting your portfolio to assets that have the most obvious and sought-after trait. If successful investing is about being a contrarian and not following the crowd, this isn’t a good start.

There have been times in history when investing for income was looked down upon, and “real” investors bought assets for capital appreciation. Those times in history offered a good opportunity to go against the grain and buy some yield, but the last few years have categorically not been one of those times. In the chart below, you can see that for quite a while now, incomeproducing assets have attracted a huge amount of money.

2. If it’s too good to be true, it probably is. Once every decade or so, an “innovation” comes along that promises high yields with low risk. The junk bond craze in the ‘80s was an example of this, as were the “new” types of collateralized mortgage bonds that led to the most recent financial crisis. Investors thought that getting an extra 1%-2% on AAA mortgage-backed securities was a good idea—only to find a lot of them completely worthless just a few years later.

3. You are less likely to pay as close attention to principal risk and growth when focused on yield. As the late financial writer Raymond DeVoe, Jr. famously said, “More money has been lost reaching for yield than at the point of a gun.” All the nuances of income, growth and risk combine to determine an investment’s merit. Overweighing any one of these traits is likely to lead to suboptimal decision making.

The chart below demonstrates that many high-yielding investments, while relatively stable during good times, are not immune to severe capital losses during bad times.

4. Investing for income is less tax efficient. U.S. laws today tax interest at your highest marginal tax bracket. If you are in the highest bracket, you’re paying about 43.4% on interest and 23.8% on capital gains. That equates to an 82% higher tax rate on interest versus capital gains. Furthermore, if you need 4% yield from your portfolio to live, and you enjoy a portfolio yielding 5.5%, you’re creating 37% (the difference between 4% and 5.5%) more taxes than you need to. In other words, with high income investments, your investments are choosing how much income you generate, potentially creating unneeded taxes.

5. Yields are not consistent. If you want to live off yield alone, you’ll have an inconsistent retirement income. This has been starkly obvious as rates have continually dropped over the last 30 years. Many retirees started their retirement investing in CDs, moved on to high-grade bonds, and eventually to junk bonds as rates dropped. Imagine their surprise during the financial crisis when their principal dropped more than 25%.

Berkshire Hathaway as an Example

(Note: This is not a recommendation to buy Berkshire but instead an example that presents a stark contrast to the income-only mindset.)

As of this writing, the only bonds yielding more than 5% are junk bonds. It’s hard to imagine that to get a yield that is only slightly higher than the historical cash yield one has to buy the debt of the junk bonds. It is an asset class that not long ago certain pensions and endowments would not invest in as they were viewed as “too risky.”

Conversely, you could invest in Berkshire Hathaway and see a “yield” of exactly zero. While the firm has been incredibly profitable, CEO Warren Buffett keeps all the cash in the firm to invest when he sees an opportunity. In times of low opportunity, this has created some large cash balances. Currently, Berkshire has more than $65 billion in cash or near-cash instruments yielding almost nothing. Why does one of the world’s greatest investors decide to keep such a large amount in “low yielding” assets? Because he knows that cash, with its power to buy assets at lower valuations later, can be much better than “reaching for yield” with shaky, expensive income-generating assets.

Would you rather invest alongside arguably the greatest investor ever in a diversified company increasing its value at around 5%-10% per year and sell off chunks (only when you need it) with capital gains treatment? Or would you prefer to buy the junkiest of the junk to get ordinary income tax treatment, whether you need that amount of income or not. Viewed through this frame, the choice is obvious.

What’s the Rub?

Investing for value is the smarter approach, but the hard part is having the patience and discipline to wait for better values. Just like sitting on the sidelines during a capital appreciation bubble (like the ‘90s tech bubble) is painful, not buying something that yields 5% and must go bankrupt to deliver your 5% plus your money back takes an awful lot of discipline. Investors often assume they can sell before anything bad happens—or that it just won’t happen to them. And yet, over and over, we have seen instances in technology, mortgages, real estate investment trusts (REITs), oil and other areas where the capital losses are so bad as to wipe out nearly a decade’s worth of “yield.”

To add to the dilemma, “value” is not black or white; it is shades of grey. By definition, value is the ratio between something’s current price and its ultimate worth (i.e., all its future cash flows). A central tenet of investing is buying a 50-cent dollar; an asset whose cost is less than its total return. A yield-only mindset, however, can lead an investor in the opposite direction, buying an asset worth 50 cents for a dollar because a temporarily high rate of interest makes it appear lucrative.

We absolutely advocate holding a diversified portfolio with some income investments. In fact, we strongly advocate the use of high-quality (i.e., low-yielding) fixed income as “dry powder” when the markets are overheated; that is, capital on the sideline you can depend on being there when you need it. We also believe that overweighing the income consideration when building a portfolio can lead to some disastrous outcomes.

After all, where does the income come from if not the capital base? Allowing yourself to focus too much on the income piece without worrying about risk to the capital base is equivalent to being worried about your paycheck but not your job. The capital is the source of the income.

At the end of the day, there’s only one thing that counts for a portfolio: your total return net of risk, taxes and fees. If you develop this total return mindset, you will be on your way to making better decisions for your retirement portfolio.

This information does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may view this information. Statements, opinions and forecasts made represent a particular observation and assessment of the market environment at a specific point in time and are not intended to be a forecast of future events or a guarantee of future results. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended. Statements regarding future prospects may not be realized and may differ materially from actual events or results. Past performance is not indicative of future performance.