How safe is your yield?

It’s been five years of continuous market volatility combined with sustained low interest rates, so investors can be forgiven for rejecting long-term investment plans in favour of short-term yields.

But there are two serious consequences of chasing such yields:

• Financial service providers are meeting the demand for yield with products that promise income levels that investors want to hear, but aren’t real.
• Investors are drawn to higher yields and may be taking on risks that are out of proportion with the potential gains they’re chasing.

Here’s a closer look at the issues.

1. Yield that includes return of capital payouts

Not all yield is created equal. An investor needs to look not just at the yield figure itself, but beyond the number to the underlying components. It’s human nature to go for what looks to be the best value. Consider investment products that boast 4%, 6% or even 8% yields. While the 8% looks the most attractive, the investor may actually be getting more in their pocket with the 4% product. 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.

Read: Reaching for yield, taking on risk

What’s making up the difference? Read the fine print and investors may find that a significant part of the yield consists of return of capital. The investment product is paying investors their own money in the form of distributions, which, over time, erode their principal.

So while clients are happily spending their 8% returns, they’re actually earning only 3% and decreasing their savings by 5%.

The chart shows this example and assumes an investor spends, rather than reinvests, the supposed 8% yield.

After five years, she may ask why the investment has fallen from $10,000 to $8,145 (or $6,302 after 10 years). So, educate investors on the nature of their returns—return of capital vs. dividend/interest income—to avoid this becoming a sore point.

2. The risks of reaching for yield

We live in a low-yield environment. Canada’s 10-year government yields hit an all-time low of 1.61% on July 16, 2012 (1.46% on U.S. 10-year government bonds that same day). 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.

Given this backdrop, how are investors finding higher yields? They’re changing key variables of their investment strategy and, with both equities and fixed-income investments, this approach carries multiple risks.

In the case of fixed-income products, investors may reconsider their duration or credit-quality tolerances. If an investor opts for bond-based products with longer durations, the attractive coupon supposedly offsets the increased interest rate risk they’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, an investor 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.

The first quarter of 2012 was the all-time low point for investment-grade corporate bond yields—and therefore the perfect opportunity for “corporations of every credit rating…to issue bonds and lock in interest rates the world has never seen,” says Matt Shandro, portfolio manager, Fulcra Asset Management. But raising money this cheaply can come at the expense of the investor.

Read: Don’t reach for yield

Bombardier issued a BB+ rated bond with a 5.75% coupon and a 10-year maturity in March 2012. Within a month, the price had declined 4%, meaning “it would take an investor close to nine months to earn the interest needed to offset the price drop that happened in the first month,” adds Shandro.

It might be more straightforward with equities where there is 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. If people think the dividend will be cut, the share price may drop, causing the investor to lose principal.

One example of this is Yellow Media Inc. While the Yellow Pages brand remains a household name, the actual product is found in very few homes today. Some may have considered it a safe and steady dividend-yielding stock, even after the dawn of the Internet.

However, the company failed to capitalize on the opportunity and didn’t do a good job of transitioning the business into the digital age. It has gone from a stock price of $14.50 (November 8, 2007) to $0.07 (August 14, 2012) and paid its last quarterly dividend of 2.5 cents per share (equivalent to a yield of 52.6%) in October 2011.

In today’s yield environment, it’s even more important to educate clients on the nature of the yield and the risk associated with it to avoid more difficult conversations five years out. By the same token, investors are leaning more heavily than ever on the knowledge and experience of advisors.

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

Read: Find yield in down markets

David Barr, CFA is Chief Investment Officer, PenderFund Capital Management and manages the Pender Small Cap Fund.