How safe is your yield?

It’s now been eight years of continuous market volatility combined with sustained low interest rates, so it can be tempting to reject long-term investment plans in favour of short-term yields.

But you face two serious consequences when chasing such yields:

• Financial service providers are meeting the demand for yield with products that promise income levels you want, but may not be easy to deliver.
• Those higher yields may be attached to risks that are out of proportion with the potential gains.

Here’s a closer look at the issues.

1. Yield that includes return of capital payouts

Not all yield is created equal. You need to look beyond the yield figure itself, to the underlying components. It’s human nature to go for what looks to be the best value. Consider an investment product boasting 8% yield. While the 8% looks attractive, it may not be. It comes down to how the yield is derived.

Consider a high-yield investment product that advertises a payout of 8% but is only earning 3% per year in its investment portfolio.

What’s making up the difference? A significant part of the yield consists of return of capital. The investment product is giving you your own money, eroding the principal.

After five years, you’d find your investment had fallen from $10,000 to $8,145 (or $6,302 after 10 years).

2. The risks of reaching for yield

We live in a low-yield environment. Canada’s 10-year government yields hover around all-time lows. This decreases the yields of many other fixed-income asset classes and yield-oriented equity securities, with corporate and high-yield bonds also near all-time lows.

In this environment, the most likely way to find high-yield investments is to increase the duration of your investments or to decrease the credit quality you’re after. But, with both equities and fixed-income investments, this approach carries multiple risks.

In the case of fixed-income products, if you opt for bond-based products with longer durations, the attractive coupon supposedly offsets the increased interest rate risk you’re assuming. However, the effect of a rate rise is downward pressure on bond prices, meaning potential interest payments may not cover the capital loss if the investment isn’t held to term.

Or, you might compromise on credit quality. Many companies are cashing in on the current low cost of borrowing, even if they don’t need the money.

But raising money this cheaply can come at the expense of the investor.

It might be more straightforward with equities where there’s a selection of high-yielding dividend stocks. Many are healthy companies able to afford to pay the higher dividends, but be sure to check the fundamentals. A large dividend payment may be unsustainable or may lag behind a stock price correction, which will ultimately see the dividend drop off.

In today’s yield environment, it’s even more important to know the nature of the yield and the risk associated with it.

While challenging, many would argue where there is economic uncertainty, there are great investment opportunities.

Updated June 2016.

David Barr, CFA, is the President and CEO of PenderFund Capital Management. He is also co-Chief Investment Officer.