Hey there, time traveller!
This article was published 15/2/2013 (1175 days ago), so information in it may no longer be current.
A good stretch can be just what the doctor ordered. Yoga -- which involves more stretching than most activities -- is great for health. But stretching can go too far. You can strain things, or even -- in the case of reaching on a stool for an item high up on a shelf -- potentially fall, break some bones or worse.
The same can be said about seeking a steady return on investments. With interest rates in the basement, safe fixed-income investments such as GICs are paying a paltry couple of percentage points, barely keeping pace with inflation.
So a little stretching for yield -- from dividend stocks, corporate bonds and income funds -- isn't a terrible thing. It can be a very healthy 'exercise.'
Yet all this stretching for yield is getting a little out of hand, many market observers agree. The extreme thirst for income in a desert of low returns is pushing investors to extremes -- all the more now that some of the riskiest assets in the income market, high-yield bonds and dividend stocks, have had some good years.
"People are overly enamoured right now with yield-producing securities, which can be a dangerous situation, because interest rates are so low the lure of dividends and income distributions can be quite powerful," says Hardev Bains, a portfolio manager and president of Lionridge Capital Management in Winnipeg.
"A lot of people buying into these products probably shouldn't own them, because they're riskier than they realize."
Corporate bonds, dividend stock, preferred shares, REITs (real estate investment trusts) and the income mutual funds that often own these securities are not inherently high-risk. These assets often provide investors with steady incomes and/or good, long-term growth prospects.
But demand for these assets has driven up their price, lowering their yields and making them less attractive. Investment-grade corporate bond yields do not pay much more than GICs or government bonds, and many dividend yields on blue-chip stocks are paying less than four per cent.
Yet, a fair number of equities are paying dividend yields over four per cent. At first glance, a yield higher than four per cent sounds like a bargain, but investors must consider whether this higher payout is as good as it looks.
"When looking at a dividend stock, income trust or a REIT, the risks are the yield is not sustainable, and that there is a higher risk in the fall of the price of the security than you would get with a high-grade bond," Bains says.
When a company, for example, cuts its dividend to investors because its revenues drop, its share price often gets hammered.
What can often confuse investors is the higher yield on a dividend paid by companies that are on shaky economic ground, making them look like overlooked gems, but in reality they're "value traps."
"The reason the yield is so high is because the price of the stock has come down quite a bit," he says.
"And the reason the price had come down is because the outlook for the company isn't very good, and that ended up bearing out in reality."
So while investors may get a couple of years of good returns, the stock price keeps falling and, in some cases, their money gets wiped out. Two examples that need little explanation about their fall from grace as income producers are Yellow Media, publisher of Yellow Pages, and Eastman Kodak, at one time the largest manufacturer of film.
Yet, even more than dividend stocks, high-yield corporate bonds have been drawing a lot of attention of late because they've had good returns in the recent past -- something that isn't likely to continue in the future, says Bob Stammers, director of investor education with the CFA Institute in New York.
"When you're the last guy at the party, the opportunity's usually passed, and that's really where we are with high-yield bond opportunities," he says, adding the CFA website blog recently focused on this increasingly effervescent problem.
"The high-yield fixed income market is too over-bought, so values are at the point now where there's no price appreciation left."
Whatever you want to call it -- high-yield, non-investment grade, speculative or junk -- this asset class is fixed income in name, but it's really an alternative asset unto itself, he says.
"It's really not fixed income because it's credit risk, not interest rate risk, that's the play."
Like all bonds, high-yield ones are sensitive to interest rates. When rates fall, the values of these bonds increase. When rates increase, their value decreases because investors can find newly issued bonds that pay better rates.
We're at a point today where rates can't fall much more and are likely to increase, he says. But high-yield corporate bonds involve more than just interest-rate risk. There's a concern about getting your money back. If the economics for a company deteriorate badly enough, it might default on its bond payments and investors may only get a portion of their money returned, or even none at all.
Yet Matthew Shandro, a fixed-income manager based in Vancouver, says credit risk is less of a concern at the moment than interest-rate hikes. With know-how, underpriced, good securities can still be found.
"There are a lot of companies in the high-yield space that are great companies, but you have to look at it like you're a stock investor," says the founder of Fulcra Asset Management. "Instead of being happy owning a piece of the company, you're owning a piece of its debt."
But looming interest-rate hikes make these inherently risky assets more risky than usual, especially if their duration to maturity is too long.
"We buy investment grade and high yield, but we're keeping the duration to two years or often shorter than that," he says. "You don't want to own longer-duration high yields generally right now because in an absolute sense, you're getting returns that are far too low for the risk that exists."
Compounding matters for many investors is they may be investing in these risky fixed income and other high-yield assets, only they don't know it because they're buying income mutual funds or exchange-traded funds paying high yields dependent of the performance of underlying risky assets.
"I don't like the word 'bubble,' but there will be some nasty surprises," says Tom Bradley, president of Steadyhand Investment Funds, which manages an award-winning income fund.
"There are some products out there that are paying out too much yield and just can't sustain it."
If rates rise or economic conditions go south -- or both -- investors in high-income funds may find the yield they thought they were getting when they purchased the fund is not a return on investment. It's a return on capital. They're getting paid back the money they invested, which is actually a loss.
In other words, it's become more important than ever when stretching for yield to be careful what you're reaching for -- especially when it's that trendy sausage of an investment called the income fund.
Is it mostly prime cuts you're getting, or snouts and hooves?
Income always has its place: Just because we're at the end of a long bull run in the fixed-income market, which started in the early '80s with record-high interest rates in the double digits and continued to fall until 2008/2009 remaining low ever since, doesn't mean investors should stay away from these assets. If you need income from your investments, these assets are essential. Yet it's critical to understand how you're earning that income so you're comfortable with the risks. If you're buying a bond and you plan to own it to maturity, then the yield you're earning is effectively the interest payment you'll get until the bond matures. If rates rise, this will have no effect on what you earn unless you want to sell it on the market. In that case, you'll receive less than what you paid for it and incur a capital loss. With income funds, good managers should be aware of the hazards and steer the fund clear of danger, says Bob Stammers with the CFA Institute. But you also want to differentiate the yield paid by the fund from the earnings from assets in the fund. To do this, you need to look for the yield to maturity of the assets within the fund.
Understanding dividends: When evaluating a stock that pays a dividend, analysts use a number of metrics, but one of the more important measurements is the payout ratio, which tells you the amount of cash paid out as dividends from a company's earnings, says Hardev Bains with Lionridge Capital. The higher the ratio is -- 90 per cent of earnings are paid out to shareholders -- the slimmer the company's margin for error in weathering poor economic conditions. Many investors use the payout ratio to evaluate high-yield dividend stocks, because if a payout ratio is too high, a company is at risk of cutting its dividend if things get ugly and, in turn, the market punishes its stock price by selling it off.
What about REITs (real estate investment trusts)? Everyone loves real estate. After all, it's a lot easier to understand than bonds, especially considering most people are real estate investors as homeowners. And real estate has performed wonderfully in Canada of late, so REITs, which invest in commercial and residential properties and use rents and capital gains to pay out distributions to investors, seem like a natural fit for investors seeking steady income. But popularity can lead to problems, Bains says. While REITs are not bad investments, they have some risks -- especially those paying high yields. These REITs are often highly leveraged. Leverage is normal for REITs, but too much borrowing -- just like a homeowner -- can spell big trouble, particularly if a trust is paying out most of its profits as distributions. If interest rates rise, borrowing costs increase too, putting investors at risk of seeing a distribution cut, which often affects the REIT's unit price. Another concern, Bains says, is the high price of real estate. Many REITS are trading near their net asset values -- the worth of their assets. This may sound about right; you get what you pay for. But the problem is real estate may be at its peak price -- at least in Canada -- and prices could drop, hurting REITs' asset values, affecting their price and possibly payouts to investors.