While the current era of low interest rates has been a blessing to those borrowing money, it has become somewhat of a curse to those counting on cash flow from their investments. Up until about a decade ago, the average retiree might have been able to live off the dollar stream generated by a portfolio of CDs and investment grade bonds.
Today, however, that bulletproof portfolio yields substantially less, and won’t even keep up with inflationary forces. Consequently, and by necessity, risk averse income seekers have been upping their risk ante in order to compensate for this involuntary struggle.
Conservative investors may rely on blue-chip dividend paying stocks, equity REITs, and even junk bonds to an extent, when building a diversified income portfolio. It would be very realistic to generate a 3-5% yield in today’s equity market without taking what might be considered excessive risk. Still risk, as it always is, can prove to be mostly in the eye of the beholder. Moving money into stocks as opposed to sitting on investment grade bonds or CDs would be considered overly “risky” to someone who has capital preservation as an even sidelight consideration.
On the other hand, bonds and CD interest generally do not grow over the duration of the obligation, so the inflationary worrywart would see the lack of growth as an affront to their purchasing power sensitivities.
One of the options for someone who is looking for better blended portfolio yield is to consider the variety of equity securities that boast yields that push, or exceed, the double-digit plateau. In this day and age, the promise of an investment that can generate that much operational return is enticing, to say the least. Of course you should view my use of the word “promise” very lightly ,and perhaps even sarcastically, since there’s almost never a promise attached to such returns.
Which means your skeptical hackles should immediately rise when you assess the durability of a higher payout security. The answer to the question posed in the title of this article is ‘maybe,” as I don’t believe a blanket statement can be made over the entire high-yield space or the potential efficacy of such investments in a portfolio. Suffice it to say that high-yield securities should involve heightened due diligence scrutiny.
Investments with higher yields are clearly doing something different compared to your average dividend growth stock that possesses a more equity market-like dividend (2-4%). So, when looking under the hood, what might be some of the general differences?
- The company is paying out more of its available profit or cash to investors (aka its payout ratio).
- The company may be exposed to income sources with questionable credit.
- The company is selling at a tremendous discount to its fair, intrinsic, or net asset value.
- The company is returning capital to shareholders in excess of what it actually earns on a quarter to quarter basis.
- On a general level, the company is taking greater than average risk with its business model.
- The company has a highly leveraged balance sheet, with poor credit ratings from the major analytical agencies.
- The company has management that investors simply do not trust.
While some of these points may be more problematic than others from an investment consideration perspective, part of due diligence should be to ascertain why a yield sits where it does. Too many investors see yield and become magically entranced to the point where fundamentals analysis is lost in the fray. If you don’t understand what it is that you are investing in – DO NOT INVEST IN IT.
A large chunk of the high-yield universe has gotten creamed over the past several years and I would not necessarily assume that just because something is “so low,” that it will necessarily not go lower or even go out of business.
Despite a decrease in long rates since the beginning of 2014, high-yield bonds and equity securities seen as being a tandem with long rates have suffered. Historically narrow credit spreads in the face of a stable economy have now been replaced with wider spreads and falling junk prices, as our economic foundation becomes a bit shakier. Global credit concerns, near-disastrously lower crude prices, and political gridlock are all factoring into this more recent market/economic paradigm.
So the next time you take a look at a security yielding in the double digits, resist the urge to jump on that train at any cost. While you might not necessarily be making a mistake, high-yield isn’t high-yield for no reason. Understand the risk as well as the reward before you make decisions that could end up biting you quicker than you might ever imagined.