The first post of this blog will explore the tendency to hunt for yield to support portfolio withdrawals. Some investors have a strong preference for living off the income that portfolio produces and do not want to touch the principal under any circumstances. This might have been a sound approach in the past, when the yields on “safe” investments such as CD’s and Treasuries were significantly higher and outpaced inflation. Unfortunately, the current rates on such investments are very low. As recently as 2005, CD rates were in the 3-4% range vs. 0.3-0.5% now. As shown in the table below, the yield on a sample portfolio consisting of 20% CDs, 30% Treasury Notes and 50% Stocks declined from 5.8% in 1990 to 1.8% currently.
With such low rates on “core” investments, the investors are “reaching for yield” to obtain 4-5% income they require. In the fixed income area, the popular categories include bank loans, emerging market bonds, preferred stocks and high yield (junk) bonds. While these investments provide higher current yield than traditional investment grade bonds, they can have large declines during periods of market volatility. This, of course, defeats the purpose of allocating part of the portfolio to “stable” investments that in theory offset more volatile equity allocations. As the table below shows, 2008 was not kind to these “yieldy” bond areas. Moreover, these investments tend to act more like stocks than bonds over the longer periods of time. For example, over the past five-year High Yield bonds have been much more correlated with S&P 500 than the Total US Bond Market Index (R2 is a measure of correlation or the tendency of the investments to move similarly. You can read more about it here). I would note, however, that the relationship has changed over the past 12 months.
Some of the equity areas seeing strong fund inflows over the last couple of years are shows in the table below. While these investments do offer more attractive income streams, they represent relatively small parts of the total US stock market. When large pools of capital start “chasing” these small niches (2-3% of the overall market), valuations get distorted and can lead to unexpected behavior. In other words, prices can go up for no reason other than strong investor demand (which might eventually reverse).
Another risk for these investments is that they are much more sensitive to rising interest rates than the overall stock market. With interest rates likely to continue climbing, investors should pay close attention. As you can see in the chart below, since the Fed first started talking about “tapering” their bond purchases (QE), interest rates have gone up resulting in losses for these areas while the broader stock market has held up.
There is nothing wrong with having some portfolio exposure to any of the areas discussed above. It does become dangerous when investors significantly overweight them to obtain higher yield. It can increase overall portfolio risk and lead to some unexpected results.
I plan to look into some of those investment areas in more detail in future posts.