Persistently low interest rates have hampered the ability of retirees to generate sufficient income from their savings. Unfortunately, yield-starved individuals are often tempted to seek out financial instruments offering better yields but are unaware of the inherent risks in doing so. Remember, there is no free lunch—stretching for yield can come at a steep price.
For bonds, investors may achieve higher yields by assuming incremental maturity or credit risk. Extending maturity leaves you vulnerable to rising interest rates and increases the volatility of the portfolio. While persistent calls for higher interest rates by market pundits in recent years have been way off the mark, that doesn’t mean rates won’t rise again. Any significant rise in rates from current levels will adversely impact long-dated bond holdings.
Credit risk, the possibility of loss resulting from a borrower’s failure to make timely payment of principal and interest, is highly correlated with the risk of owning stocks. During periods of stock market weakness, you want your high-quality bond investments to help soften the impact of declines in your stock portfolio. Substituting such bonds with lower-quality, higher-risk “junk” bonds, emerging market bonds, or other bonds with complex features to boost yield will not provide any offset that will help you during a period of market volatility.
Investors are often drawn to dividend-paying stocks, viewing them as safe investments. Blue-chip companies that possess strong balance sheets, generate significant amounts of cash flow, are consistently profitable, and pay a growing dividend can indeed be great investments.
However, stocks offering a high yield may signal a company in distress and preparing to cut dividend payments. In a dynamic global economy, no company is immune from competitive forces that could impact its ability to pay a dividend. One recent example is General Electric, a victim of both competitive pressures and a series of poor management decisions.
Other prominent companies have faced existential threats to their survival that required the dividend to be cut or eliminated to preserve cash. Examples include integrated oil company BP (Gulf of Mexico oil well disaster) and utility PG&E (liability for California wildfires).
For stock investors, loading up on higher-yielding securities such as preferred stocks, real estate investment trusts (REITs) and master limited partnerships (MLPs) means sacrificing expected long-term capital appreciation. These investments can be quite volatile, having experienced deep drawdowns in the past. In 2008 during the Global Financial Crisis, the FTSE NAREIT Real Estate 50 Index lost 37.3%, and the Alerian MLP Index lost 36.9%. Also, like long-dated bonds, these investments are highly sensitive to rising interest rates.
What can you do? Instead of chasing yields, a better strategy is to invest for total return. Not only does this consider the portfolio's yield, but also the expected growth rate of the investment holdings. If, at some point, this level of income is insufficient, an investor can supplement the portfolio with a "homemade dividend" by selling a portion of the portfolio to generate the income needed. As long as the long-term growth of the portfolio exceeds the portion sold to supplement the income yield, you won't deplete your principle.
Is your portfolio invested in long-term growth solutions, or is it risking too much for a payout? Contact AAFMAA Wealth Management & Trust today for a complimentary portfolio review!