The Pitfalls of Chasing High Yield Bonds

By : Ginger Weber | April 14, 2012

With interest rates hovering near zero, many investors are concerned with what they are earning on savings, money market accounts, certificates of deposit, and other fixed income investments. The tendency among both individual and institutional investors is to seek high yield bonds. Recent history reminds us of the dangers inherent in this approach.

Ginger Weber is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt County

This newsletter will expose the risks of chasing high yield bonds or equity investments and show you how to generate cash flow through a “total return” approach to investing.

The Dilemma

During periods of strong market performance, the true risks particular to a given investment are often masked. Over the past 25 years, our advisory team has found that these risks are seldom fully disclosed to clients.

Famed investor Warren Buffet sums it up by saying that, “it’s only when the tide goes out that you learn who’s been swimming naked.” During the recent market decline, many bond managers and income-oriented investors were reminded of the true risks involved with the capital markets.

Beginning in 2002, with low-interest rates and an economic and market recovery on the horizon, investors’ appetites for higher yields grew. Given that rates on traditional interest-bearing investment vehicles were very low (like they are today), investors looked elsewhere.

Many turned their attention to complex mortgage-related securities, high yield bonds, global shipping companies, Canadian Royalty Energy Trusts, and high interest-bearing preferred stocks sold by many brokerage firms.

During the economic boom spanning from 2002 to mid-2007, these investments performed quite well, however, their risks were masked. Retirees and the managers of pension, hedge, and mutual funds poured billions of dollars into these vehicles, blind to the true risks involved with them. Brokerage firms and their advisors amassed huge profits creating and selling these instruments, but led their clients to huge losses when the economic, credit, and corporate profit cycle rolled over. Investments that were once championed as safe vehicles appropriate for yield-oriented investors, fell apart in the ensuing years. Take for instance the following:

Given that yield-oriented investors tend to be retirees or others with fixed monthly obligations who place a high priority on safety of principal, these types of losses are enormously disruptive and can lead to real hardship.

The Solution

We have long cautioned investors against chasing higher yields in their fixed income portfolios and from targeting their retirement income needs solely from interest-bearing investments. Instead, we favor a total return approach to investing that targets the generation of portfolio cash flow through both the income and capital gain it generates.

Our total return approach consists of three components which help retirees meet current living expenses and unexpected cash needs, enhance their financial peace of mind, and provide for some portfolio growth to offset the negative impacts of inflation over time.

The first component of our strategy is about liquidity and safety. We advise retirees to maintain at least a year’s worth of living expenses in a safe money market account that is readily accessible.

Second, we encourage clients to maintain another several years worth of living expenses in high-quality, short duration bonds which provide income, reduce portfolio volatility, and provide a safe source of funds to draw from.

The final component of our strategy involves maintaining a highly diversified global equity portfolio that is tilted toward the most rewarding segments of the capital markets. Dividend and capital gain distributions can be used to replenish cash reserves and the short term fixed portfolio as needed. During challenging market periods, cash flow needs can be met by drawing on one’s money market account or fixed income portfolio to avoid selling equities at depressed prices.

We have found over the years that this approach has given our clients a sense of security, confidence and peace of mind. Most importantly, it has allowed them to maintain some exposure to the stock market, thus enabling them to keep up with the rising cost of living over time.

Vanguard’s Findings

Vanguard, one of the few mutual fund companies we recommend, recently conducted a study on portfolio spending. The study highlighted the two main approaches for generating portfolio cash flow – the income approach, which targets yield oriented investments (like bonds) and the total return approach, where a balanced portfolio of stocks, fixed income and cash investments is utilized.

Using real market data, a $1,000,000 starting portfolio value and a 5% distribution rate, Vanguard compared the two approaches and how they fared over various 30-year historical periods. The report concludes that “a decision to move entirely into bonds significantly decreases the portfolio’s ability to sustain the desired level of spending over the long run” and that “the total return approach is the more prudent, and most likely only viable, long-term spending method.” The study, which covered more than 80 years of historical market returns, produced the following results:

Inflation-Adjusted Ending Balances

For an investor contemplating how to go about generating portfolio income, this study has powerful implications. The traditional approach of purchasing a portfolio of corporate or municipal bonds, guaranteed annuities, or other yield oriented investments to generate retirement or other income is fraught with risk. For example, as retirements grow longer due to the increasing life expectancy of Americans, the traditional approach leads to a high likelihood of you outliving your money.

The total return approach, in which a reasonable targeted amount of cash flow is withdrawn from a balanced portfolio’s income and capital gain, has a much higher likelihood of lasting 30 years or more. That time horizon would apply to many of today’s retirees.

Closing Remarks

If you are an investor frustrated with low yields on your investments and are looking for alternatives, we strongly suggest that you steer clear of common yield-oriented investments such as high yield bonds or long term corporate and municipal bonds, preferred stocks, and royalty trusts. These are highly risky instruments that can lead to significant capital losses.

A total return approach that focuses on maintaining sufficient liquid reserves, a fixed income allocation of short duration, high quality bonds, and a globally diversified equity portfolio tilted toward the most rewarding areas of the global capital markets will offer the highest probability of long term success and can increase the longevity of your portfolio.

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