James Sweeney No Comments

In today’s interest rate environment, investors (especially those in retirement) are scrambling to find ways to increase the yield of their investment portfolios. Gone are the days when you could plop your cash into a CD yielding 7% and live off the risk-free interest.

What is a conservative investor to do?

Low Yield, but Low Inflation

First, a caveat. When discussing interest rates, it is important to consider not just the nominal yield, but the real yield. The real yield is the nominal yield minus inflation.

While it is true that interest rates are at very low levels, inflation is also extremely low by historical standards.

Back in the 1980’s, you could buy a 10-year treasury bond yielding more than 7% (they actually peaked above 15%!) but inflation was also near or above 5% for most of the decade (peaking above 13% in 1980).

Bond investors care a lot about inflation because they receive fixed coupon payments with no prospect for growth. To maintain their current level of purchasing power, they need the coupon payments to exceed inflation for the duration of their investment.

So, one way to think about the yield that bond investors demand on their investment is that they demand both compensation for the current level of inflation and a premium for the risk of future inflation.

In the 1970’s and 80’s you had both high current inflation and fear of future inflation. Today, you have the opposite. Inflation is currently below 2% and has been below 3% since the mid-90’s. Consequently, investors demand little in the way of compensation for inflation risk.

Despite some reasonable explanations for the currently low interest rates, the reality is that on an absolute basis, interest rates are very low.

What Not to Do

Yield hungry investors have been preyed on by the investment industry, who is all-to-happy to sell high-yielding investments, with little regard for risk.

The first example of this that I experienced was the explosion of non-traded REITS in the mid-2000’s. These are real estate investments that are not publicly traded. As such, they are not priced on a regular basis like the stock market. They also paid large dividends, typically 7%. They were sold to financial advisors, and subsequently to investors, as “bond-substitutes”, because they paid a consistent dividend and they didn’t fluctuate in value (at least not visibly).

What many advisors glossed over was the fact that non-traded REIT’s also paid huge commissions to the advisors who sold them and handsome fees for the managing partners. They also had significant acquisition costs of the underlying real estate. Add in coupon payments of 7% per year, and by the end of year 2, an investor in these products realistically had an investment worth 70% of the original investment.

Granted, with savvy real estate purchases and a little leverage, it is possible that some of these deals could have turned out okay. Unfortunately, right at the height of their popularity, the real estate market crashed. Since non-traded REITs are illiquid, by definition, investors couldn’t have sold them if they wanted to. Most of these products were locked up for at least 5-7 years and many cut or suspended the dividend payments.

After years of waiting, many of these funds liquidated for 30 to 50 cents on the dollar.

So much for “bond alternative.”

High Yield Bonds

A less egregious route I’ve seen many advisors and investors take is to keep their money in bonds, but move from government and high-quality corporate bonds to lower quality bonds known as high-yield or junk bonds.

Instead of a yield of 2-3%, investors can achieve yields of 5-6% with high-yield bonds.

But at what cost?

High yield bonds are highly correlated with the stock market. During the great recession, as the stock market plummeted, so did high-yield bonds – dropping more than 30% from mid-2007 through December 2008.

Meanwhile, the only asset that held up during that time: government bonds.

An important role of bonds in an investment portfolio is to provide stability. Government bonds fluctuate in value far less than stocks. Not only that, but during times of economic turmoil stocks tend to plummet and investors look to the safety of bonds for protection.

Conflicts of Interest

Of course, owning some high yield bonds may be appropriate as part of a diversified portfolio. However, thinking that a higher yield can be achieved without additional risk is foolish.

Sadly, I have seen more and more advisors recommending high yield bonds, not for investment reasons but for business reasons. With yields as low as they are, it has become increasingly uncomfortable for advisors who still charge 1% of assets they manage.

Here’s a simple math problem:

If you are earning a 2% return on your bond portfolio and your advisor is charging you 1%, what percent of your return is your advisor taking?

Yep, 50%.

Who in their right mind can justify that? The answer is, no one can. And for this reason, so many advisors are feeling obligated to take more and more risk with client portfolios to achieve higher yields and justify their fees. Not only is this a breach of fiduciary duty, but it exposes conservative investors to risks that they likely are unaware they are taking.

More Conservative Approaches

Of course, there are other alternatives to solving this problem of low bond yields.

The first, though maybe not the most appealing, would be to reduce your spending. After all, inflation is low. You can live today off nearly the same amount as you could 10 years ago. Further, we are in the midst of an 8-year stock market rally. Most investment portfolios have seen huge gains over that time. Having a lower withdrawal rate from a retirement portfolio may be more feasible with the gains enjoyed over the last 8 years.

Another way to reduce your spending needs is to pay off debt. If you are paying 4% interest on your mortgage and only earning 2% on your bond portfolio (1% after fees), it might make sense to simply withdraw enough from your bond portfolio to pay off your mortgage.

Lastly, you may want to scrutinize the fees you are paying for investment management. If you are paying 1% on a portfolio of $500,000 or more, you are likely paying too much. If you are a conservative investor and paying such fees, you may be giving up 50% of your return to your advisor, or your advisor may be taking risks you are unaware of in order to reach for higher-yielding investments. Neither scenario is good for your financial well-being.

Conclusion

Markets like these, with such low bond yields, require investors to carefully examine the fees they are paying and the advice they are being given. Advisors and fund managers are seeking to justify their fees by abandoning the relative safety of government bonds in favor of higher yielding junk bonds and other risky assets.

Once again, well-meaning advisors have a difficult time seeing beyond their own self-interest – keeping as many assets as possible under their management and charging high fees. However, prudent investors may consider more conservative alternatives to dealing with the low-yield environment. Rather than increasing risk, you could reduce spending, pay of debt, and seek to minimize fees.

 

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You can also visit my website at switchpointfinancial.com, email me at james@switchpointfinancial.com or call 801-753-8538.