Most of the third quarter was marked by tranquility in the financial markets, with the S&P 500 Index posting fifty-two consecutive trading days without a daily decline of more than 1%.  While quietly moving upward, the index hit an all-time high on August 15th at 2,190.15, a 220% increase in value since the financial crisis low on March 9, 2009.  Near the end of the quarter investors were fixated on the Federal Reserve and its vacillation between leaving interest rates unchanged and raising them.  There has been only one interest rate hike since June of 2006, and the September 2016 meeting did not break this pattern.  Once again, the Federal Reserve voted to leave interest rates unchanged.

Foreign equity markets were mixed during the third quarter.  Lingering economic and political concerns in the UK post-Brexit did not mute the FTSE 100 Index, which bested the S&P 500 Index for the quarter with a 6.07% return.  Japan, the third largest economy in the world by GDP, has struggled year-to-date, but produced a positive quarterly return of 5.61%.  Fresh geopolitical concerns, such as tensions with North Korea and its push towards nuclear capability, continuing conflict in the Middle East, and uncertainty surrounding the upcoming U.S. presidential election, added to investor concerns.     

Asset class returns for the quarter and year-to-date were as follows:

 

 

Index

 

Asset Class

Third

Quarter 2016

Year-To-Date

2016

Barclays U.S. Govt./Credit—Int.

Fixed Income

  0.16%

  4.24%

S&P 500

Large U.S. Stock

 3.85%

  7.84%

Russell 2000

Small U.S. Stock

 9.05%

11.46%

MSCI ACWI ex-USA

Foreign Stock

 6.91%

  5.82%

S&P Global REIT

Real Estate Securities

-0.23%

11.47%

 

For nearly seven years, the Federal Reserve has maintained a highly accommodative monetary policy, characterized by very low interest rates.  This policy has benefited borrowers with favorable rates and attractive refinancing opportunities, but has simultaneously left savers and investors frustrated with low prospective returns on interest-bearing securities.  This frustration has led some investors down a risky path in a quest for more income. 

This quarter’s newsletter outlines our views on "chasing yield" (i.e., investing in securities primarily based on their income yield) and the risks inherent in this strategy.  We highlight some notable instances in the past decade when reaching for yield has hurt investors, as well as some common misconceptions about high-yielding investments.

High dividend-paying stocks are not a safe or sensible substitute for bonds. Despite the constant stream of investment offerings luring investors into high-yielding securities, we advise against replacing bonds with high dividend stocks in your portfolio.

  • Dividend-paying stocks are equity investments and they carry very different and more pronounced risks than their bond counterparts.  In 2008, for example, the S&P 500 High Yield Dividend Aristocrats Index (i.e. a select basket of dividend-paying stocks) lost 26.6% while the Barclay’s Aggregate Bond Index gained 5.1%.

  • The downside risk of high dividend-paying stocks is significantly greater than bonds, regardless of the income stream each provides.  A bad year for stocks can be much worse than a bad year for high-quality short/intermediate term bonds.

  • Because financial markets are relatively efficient, an investment's expected return should be proportional to its level of risk.  If safe money (the 10-year U.S. Treasury Note, for example) is paying roughly 1.60% per year, any security yielding double or triple this amount will surely be subject to greater risk.

  • While abnormally high dividend yields may be appealing to investors at first glance, they should also raise some suspicion.  Investors who buy a stock purely on the basis of the dividend may experience losses if the dividend is reduced and the stock price drops in response.  Dividends are not necessarily cut immediately when a company is in financial distress.  As such, some stocks may appear to have misleadingly high dividend yields.  With the announcement of a dividend cut, the yield drops back to a more typical level along with an accompanying drop in share price. 

  • Corporate bonds are inherently safer than common stocks because they are senior in a company’s capital structure.  In the event of a company’s liquidation or bankruptcy, bondholders are paid before common stockholders.  If there are no funds remaining after bondholders are paid, stockholders will not get paid anything.  This risk is one of the reasons why stockholders demand a higher return than bondholders.

  • A dividend focus may lead investors to overweight particular asset classes and industry sectors, as well as avoid stocks that may not pay dividends but may have more promising long-term growth prospects.

Preferred stocks, which are stocks that tend to act more like bonds, are also a false safe-haven for investors chasing higher yield.  Preferred stocks carry their own specific risks that are often overlooked.  These include long maturities, industry concentration, and oftentimes relatively poor credit quality. 

Reaching for yield often leads to unexpected losses.  The recent rise and fall of Master Limited Partnerships (MLP) is a prime example of how focusing purely on yield can lead to poor investment results.  An MLP is a hybrid entity that trades on a public stock exchange and generally operates within the energy sector.  MLPs do not pay corporate taxes and are required to distribute nearly all of their income to investors, which typically leads to a relatively high yield.  Investors often buy MLPs for their high yields (which may be double or triple that of the S&P 500 Index) without fully understanding the investment.

Higher yield is only one side of the story, as MLPs are quite volatile and are certainly not a safe haven.  As illustrated by a chart of the Alerian MLP Index, investors who were seduced by rich-yielding MLPs in 2014 experienced a precipitous drop when oil prices fell.  Many may have seen their investment cut in half by February of this year.

 

Alerian MLP Index Performance

Source: YCharts

 

Financial stocks in 2007-2009 provide another example of yield-oriented investing ending badly.  Prior to the financial crisis in 2008, many investors were attracted to financial stocks for their high dividend yields and perceived stability.  Since many of these banks and financial companies paid high dividends and appeared to be reliable and consistent companies, investors believed that these were safe investments.  However, when the financial crisis hit, many financial institutions began to fail, resulting in numerous government bailouts (Fannie Mae, Goldman Sachs, Bank of America, Citigroup, etc.).  These companies subsequently slashed their dividends, and some were completely wiped out.  Investors, therefore, lost their future income stream and much of their capital.

Recently, we have observed a “yield chasing” mentality in several areas of the market.  For example, Vanguard just closed its Dividend Growth Fund (to new investors) due to excessive cash flows into the fund.  Additionally, we have seen heavy inflows into sectors with higher yields such as utilities, telecommunications, and energy, as well as an influx into high-yield, low-quality bonds.

So, given the current interest rate environment, what are we doing about low interest rates in our portfolios?  After all, if rates are so low, why should we continue to invest in bonds?  We have never invested in bonds with the goal of generating high income.  The high-quality, low-risk bonds in our clients' portfolios are included to dampen portfolio volatility and provide capital preservation and safety.  In other words, we are not trying to hit a “home run” with bonds, nor are we attempting to sacrifice safety in exchange for income.  The bonds we select are intended to work in concert with the stock holdings in client portfolios, providing stability and liquidity in times of equity market volatility.  We continue to believe this disciplined approach is the most prudent course of action for our clients, even in today’s environment of historically low yields.  We encourage investors to focus on total portfolio return and to consider all sources of return (interest, dividends, and capital appreciation) when structuring portfolios. 

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