Beware Of Chasing Yield

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Many themes for these blog posts come from friends’ and clients’ questions.  This week two friends asked about prospects for generating more income.  We’ve written on this topic before, but in an extremely low interest rate environment, further analysis seems appropriate.

A starting point in any discussion should be recognition that you can almost always find greater yield.  Most recently, you could have bought a one-year government bond with the promise of more than 100% return on your money. Unfortunately, the government was Greece just prior to its recent default. That example is extreme, obviously, but the underlying principle is important to recognize.  At least with respect to publicly traded securities, there’s no such thing as a free lunch.  No issuer of securities will gratuitously offer more yield than necessary to find buyers.  If any security provides a better than market average yield, you can count on the fact that a buyer will be assuming greater than market average risk.  Don’t for a minute believe that your research has uncovered an underappreciated opportunity.  Recognize that you are competing for yield against the wealthiest, most powerful financial entities in the world.  Not that such entities don’t make occasional giant mistakes, but it’s rarely because they didn’t know about an opportunity that you found.

If that principle is true, what accounts for worldwide financial giants pouring unprecedented amounts of money into securities yielding effectively zero and losing money after inflation?  A prime example this week came from Germany, where the two-year government note was sold at a majestic yield of 0.089%.  In other words, investors were willing to loan money to Germany for two years for a mere $890 per million per year, the lowest return in the euro-era.  These investors didn’t overlook the alternatives.  Their behavior is simply a quintessential example of investors concentrating on the return of their money rather than the return on their money.

While some do, most investors don’t look first to equities when looking to boost yield. In fact, high dividend-paying stocks have become a popular theme in recent quarters.  But such stocks are far from risk-free.  While a meaningful dividend can provide a helpful buffer when markets are not advancing, we urge investors not to ignore price fluctuations.  Utilities, typically payers of substantial dividends, provide a clear example of how a quest for yield can be penalized in weak market environments.  From its peak in 2000, the Dow Jones Utility Index fell over 60% in less than two years.  No amount of income can compensate for such a precipitous decline.  While that index’s nearly 50% decline in 2008 was a bit less severe, it certainly defeated the purpose for those who bought supposedly conservative income producers when the broader stock market looked toppy.  More than four years later, the index is still far below its 2008 peak.

Far more typical for investors looking to boost yield is a turn to bonds.  Bonds have, in fact, been a sound–if only moderately profitable–investment over most of the past decade.  Unfortunately, most bond yields are at or near hundred year lows, which makes future profit potential problematic at best.  Any rise in interest rates will take away the yield and very possibly turn total return negative.

The Federal Reserve’s reduction of short-term yields to virtually zero was designed to force yield seekers out into riskier investments.  Many have ventured into municipal bonds, high yield (junk) bonds and emerging market debt.  So far, those approaches have justified the risks assumed.  Future profits become increasingly improbable, however, with rates as compressed as they have become.  The erudite James Grant, publisher of Grant’s Interest Rate Observer, has spoken and written eloquently and often against the Fed’s financial repression.  He argues that Fed actions have created mispricing across a broad array of assets.  When investors are desperate for yield, they have a strong tendency to accept the most attractive alternative, even if it falls far short of its historic value.

It is important to recognize that total return is as critical for bonds as it is with utilities.  Simply holding bonds to maturity can be destructive to wealth if inflation rises appreciably in the interim.  Emerging market bonds have always been volatile, and each carries its own country-specific risks.  High yield (junk) bonds currently appear particularly attractive relative to government and agency bonds with minimal yields.  Newcomers to the high yield arena should recognize that investor fear can be destructive to junk bond prices.  From late-2007 to early-2009 the IShares High Yield Corporate Bond Index fell by more than 40% and today sits about 15% below its earlier peak.  It’s also worth recognizing that when economic times get tough, junk bonds default at uncomfortably high rates.  Even municipal bonds, looked upon by many as extremely safe, have experienced substantial volatility in recent years.  In 2008, when there was fear that many municipalities would be unable to meet all their obligations, the average municipal bond dropped in price by 17%.  Just over a year ago, muni bonds suffered another double-digit price decline.  At such price troughs, the news is invariably bleak, and many sell with losses.  Furthermore, if prospects for other assets look more attractive, sales at losses might be necessary to raise capital.

As was the case after equity investors had experienced the 50% decline from the turn of the century into early-2003, people are turning again to real estate.  The rationale for most is different today, however, from that of eight to ten years ago.  In the earlier instance, real estate, fueled by cheap and easily available money, was soaring.  Heavy leverage was multiplying profits.  People were leaving their jobs to become condo-flippers, reminiscent of the earlier era of day traders who similarly sought the path to easy riches during the bubble.  Once chastened, real estate investors are today a more sober group, seeking yield through more conservative investments.  Others are buying up foreclosures or otherwise available properties at prices far below their peaks of a few years ago.  These investments may prove profitable, but they are probably not as low risk as they appear on the surface.

The common assumption among those turning again to real estate is that the crisis has ended and that, even if progress remains slow, we have lived through the worst.  For the good of the United States, we have to hope that to be the case.  Stock market behavior over the past decade, however, should give pause to those with a high degree of confidence that risks to newly deployed real estate capital are minimal.

Following the nearly 50% stock market decline from 2000 to 2002-03 (nearly 80% for the Nasdaq), investors began to pour money again into stocks as prices began to rise, the Fed remained accommodative and the worst seemed to be in the rear view mirror.  Traumatic as the market collapse had been, investors reflected back on the prior two decades in which buying every major market decline proved profitable.  They resolved not to lose sight of the rewards that accrued to those who were willing to buy into the early stage of each new bull market.  For some reason, however, this time was different.  Those who got back into equities after the 2003 bottom saw all of those profits and more taken away in the second market collapse from 2007 to 2009.  What they did not recognize was that we had entered a long weak cycle in 2000 similar to three predecessors in the twentieth century, the last of which was from 1966 to 1982.  In each of those instances, it had taken three or more major stock market declines to wipe away the excesses of the prior long strong cycle.  Premature buyers had profits unceremoniously taken away.  Investors couldn’t buy profitably for the long term until those excesses were expunged.

The very real danger for today’s real estate investors is that they could experience a similar fate.  The debt excesses of the prior long strong cycle have not only not been eliminated, they have been exacerbated in many major sectors.  It is likely that real estate investors are subject today to the same macro concerns and considerations that affect stock market investors.  While it is true that all real estate is local, the past decade has demonstrated conclusively that macro factors affecting the broad U.S. or world economies can put extreme pressure on local real estate.  With several major countries throughout the world (including the U.S.) in severe debt distress, a disorderly unraveling of that debt could quickly envelop most of the world in another significant recession.  As fragile as our domestic recovery has been, such an event could again wreak havoc on both residential and commercial real estate.  As illiquid as most real estate is, it would be difficult to adjust quickly to such a changed economic environment.

Some advisors have recently recommended annuities as an approach to raising client income. That approach could make sense if interest rates stay low for many years.  Buyers should recognize, however, that annuity rates reflect current interest rates and are near historic lows.  Should severe inflation result over the next several years in response to the flood of new money flowing out of the world’s central banks, returns on current annuities may fail dismally to keep pace with the cost of living.  And if punishing economic outcomes occur because the debt crisis unravels, some of the most impacted firms will be those financial organizations that offer annuities.  It is imprudent to put more money in an annuity than you would be willing to invest in a bond issued by the same company.  Financial firms have been known to fail.

It is possible, though not likely, that governments and central banks may succeed in solving the world’s debt crisis by issuing far more debt.  If they fail, however, the penalties on those who stretch for yield could be severe.

Unpalatable as patience is, it is likely to be the most profitable prescription in the long run.  In an unstable economic situation, it is unlikely that interest rates will stay low for long.  Rather than putting money in potentially mispriced assets, you will almost certainly be better served in the years ahead by preserving capital, accepting low-risk returns in the near term and keeping assets liquid to take advantage of prices that could be extremely volatile for many years.