The perils of chasing yield

Government fiscal stimulus and central bank programs are trying to motivate businesses and consumers to spend more by keeping the interest costs low, but at the detriment of long-term savers.

In fact, many savers are abandoning the safe investment course they’ve been on—some, for decades—and instead are launching into a futile chase for yield. Many responsible savers are now struggling with painfully low yields on their savings certificates, just as they get ready to retire and live on the proceeds of their nest egg.

With paltry yields of 1% to 2% standard on the most conservative investment products in the market, these investors are now buying longer-dated fixed income maturities or lower credit fixed-income securities to bolster their yields. Others are buying dividend-paying stocks simply to have enough income for their retirement years.

Yet many clients are unknowingly leaving themselves vulnerable to the downside risks associated with higher-yield investments. They are wrongly confusing yield with return, as the highest yield does not necessarily represent the best investment potential.

Credit risk is very closely correlated with equity risk. In other words, higher yields are offered for a reason: the underlying risk associated with the investment could pose a real threat to their principal investment being lost, or at least a good portion of it.

Historical returns

While historical returns from bluechip stocks, including the reinvestment of associated dividends, on average outperform long-term corporate bonds, long-term government bonds, and U.S.Treasury bills, they don’t outperform the alternatives all the time.

From 1928 to 2010, the lowest annual return for a five-year U.S. Treasury bond was -5.1%. The lowest annual return for high-dividend equities during the same period was -55.1%. In years where the annual return of the S&P 500 was negative, the returns of five-year Treasuries averaged +5.7%, while the returns on high-dividend strategies averaged -10.9%.

Unfortunately, many clients don’t recognize the higher level of risk with a higher-yield investment and are not prepared for the potential capital losses that could be waiting.

First priority is return of principal

To help mitigate the risk, ask clients why they got into the low-yield arena in the first place, and whether or not they would, in fact, be better off sticking with a high-quality fixed-income strategy.

At the very least, the fixed income portion of their portfolios should be the safe part—built to maintain its value even as equity markets decline. Your clients need to understand the first priority of any investment they make must be to provide at least the return of principal. A return on principal is a secondary objective.

All investors need to understand that if they are going to introduce credit risk into their liquidity portfolio, they need to be sure to get paid with appropriate return potential, just as with duration risk.

However, that’s not a concept many seasoned equity investors fully understand. To expect it of a segment of the investment community that has, by definition, leveraged risk aversion as a foundation of its investment strategy is highly optimistic, at best. Thus the onus falls to you, the advisor, to prepare your clients for the cold reality that an even slightly more aggressive capital appreciation strategy may run counter to their capital preservation requirements.

Murray Belzberg is president and founder of Perennial Asset Management, a Toronto-based wealth management firm that takes an active-core, style-agnostic approach to money management.