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Be Prudent in the Hunt for Yield

Christine Benz
Shannon Zimmerman

Christine Benz: Hi, I'm Christine Benz for

Investors have been gravitating to some higher-yielding fund categories, but associate director of fund analysis Shannon Zimmerman says they should make sure to go in with their eyes wide open.

Shannon, thank you so much for joining me today.

Shannon Zimmerman: Always good to be with you, Christine.

Benz: Shannon, you have been talking about investors on the hunt for yield, and let's talk about what you see as some of the risks that are embedded in some of these higher-yielding fund sectors that investors have been gravitating to.

Number one, you say is that on an inflation-adjusted basis, some of those really enticing yields might not be all of that good after all?

Zimmerman: Right. Well, even just in absolute terms, they are not all that enticing. But if you are comparing the lay of the land, you see, for instance, in the high-yield category, the average yield there is about 7%. Well that looks great--not in an absolute terms necessarily--but in relative terms, relative to what you could get in investment-grade bonds. But your point is a very good one.

When you adjust for inflation, and you talk about real yields versus nominal, the named, yield it's a big, big difference. So, right now, for instance, among Treasuries, you have to get to the 20-year flavor of T-bills before you get positive in terms of the real returns. Everything else, the one-year, three-year, five- and seven-year are yielding negative amounts, which in a nutshell means that once you adjust for inflation, investors are actually paying Uncle Sam for the privilege of parking their cash in those bonds.

As a safety play, I guess it make some sense, but as a play toward making sure that you're going to be able to preserve your purchasing power into retirement, it doesn't make a lot of sense.

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Benz: And even in, say, the high-yield category with that 7% average yield, you back out the historic inflation rate, maybe running a little higher than the current inflation rate, but the historic inflation rate of 3% on average, that's only a 4% [real] yield--maybe not great, given the risks that might be embedded in the securities?

Zimmerman: Absolutely. It's an interesting time right now, and I've been looking at Bill Gross' recent investment outlook, which is attracting a lot of attention, and he's talking about the death of the cult of equities. Whereas a year ago, when he came to the Morningstar Investment Conference, he was talking about, oh, well maybe fixed-income investors should be looking to dividend-paying stocks because of the very thing that we were just discussing, the negative yields that, in some cases, fixed-income investors are receiving.

But investors who might do that, who are thinking, well, you know, I really do need income, and I'm going to chase it--you said it's a hunt, and it is a hunt, it's a dangerous hunting ground right now--they need to really do a gut check and make sure that they have the risk tolerance that they think they do before they go into equities, because even this sturdiest stock is going to give you more volatility than an investment-grade fixed-income investment certainly would.

Benz: So, we certainly saw during the bear market--and no one is saying that we're reading to retrace our way there anytime soon--but some of those dividend-paying companies not only cut their dividends but also saw significant volatility in their share prices.

Zimmerman: Absolutely, so they had to shore up balance sheets, and among financials, of course, they really had to do some deep-dive into the balance sheets to shore those up, and in some cases those dividends haven't come back yet.

So, it's worth considering, again, the risks associated with the alternatives to fixed-income investments that some folks who would otherwise be in bonds are considering right now. Junk bonds, high-yield bonds, relative to investment grade and then again dividend-paying stocks. You see a company that's yielding 4%, 5%, 6%, 7%, well, why is that? Well, it's risk and reward in the world of investment, and if a company is yielding at that level, you really need to investigate the financial health of that company, because it could be that due to a lack of financial health, the stock price has cratered, and that's what's caused that yield to look so attractive, when really, if you get under the hood of the company, it is not attractive after all.

Benz: It sounds like another thing that people should have on their radar at least is the potentially changing tax treatment of dividends?

Zimmerman: That's right. So, ... right now if you have a qualified dividend, the tax treatment is quite favorable. In the future that may not be so. So, it's worth considering, too, are you going to be able to get the same bang for your buck, so to speak, if you go toward equities and the tax treatment of dividends changes.

Benz: One thing I've been hearing from our users, too, is some worry that, if indeed the dividend-tax treatment does become less favorable, will you see some actual selling pressure as investors try to relocate those dividend-payers in tax-sheltered accounts or maybe have to get rid of them altogether?

Zimmerman: Yes, that's one of those things that's very interesting, but very difficult to discount for us. It's not a technical in the sense a quantitative screen might be a technical, but technical in the sense of, assets are on the side lines; what happens when those come into the market? Or the tax treatment for dividends is going to change; what's going to happen for investors who will suddenly find that their return is less attractive than it was when the tax treatment was so favorable.

Those kinds of things, if you look at the academic literature, they do have effects typically on the margins, but these are different times.

Benz: So, let's get your guidance on, if I'm looking at higher-yielding security types for my portfolio, what sort of steps should I take in my due-diligence? It sounds like I should consider them within my overall portfolio, make sure that I am counterbalancing them with maybe some less-risky securities or some growth-oriented securities to counterbalance the dividend-payers. In addition to that, how should I do due-diligence on the individual holdings?

Zimmerman: So the asset allocation piece that you mentioned first, that's absolutely critical. You have to know what you own now, before you can possibly be in a position to buy the next thing, because you have to know how all the pieces fit together.

The thing I would say after that, that I think is supercritical for people to remember, and is very easy to lose sight of in this hunt or this chase for yield, is that you really should keep your eyes on total return. So, a high-yielding stock or high-yield bond may come with a very attractive nominal figure. But again, that's a nominal figure, not a real one. And then, because these are risky assets, riskier than the traditional investment-grade fixed-income bond is, if the price erosion of the security takes back what the yield gives and maybe even more, you're not earning anything.

So, make sure that you keep your eyes not just on that yield--which could be so alluring, and it's so alluring that it is often used in marketing literature to attract people to a certain asset class--but on the total return.

After that, again, just to hammer on the point of risk, if you are someone whose portfolio has been traditionally in stocks and bonds, and the bond portion of it is investment grade, just know what you're getting into. High-yield bonds are not at all the same as investment-grade bonds, and it is true that the historical levels of default even among junk bonds are quite low, but default is not the only risk; there is downgrade risk as well, and that happens more frequently than default.

Benz: In terms of owning some of these risky security types, you think that, as far as junk bonds are concerned anyway, that one should think about owning them through a professionally managed fund, as opposed to trying to pick your own?

Zimmerman: Absolutely. I feel that way about bonds generally, but people have different opinions on that. But yeah, certainly for high yield, I think you'd want to own a basket of securities, rather than individual securities, and you would want it to be a basket of securities that was put together by a professional money manager who is an expert in that world and can be opportunistic, because the same types of valuation dynamics that happen on the equity side of ledger certainly happen on the fixed-income side, and particularly among high-yield or junk bond funds as well, which have a very high level of correlation to the equity markets, too.

An ETF or a mutual fund is the best kind of vehicle to own that kind of security in, and then, ... to go to your due diligence question, once you start doing due diligence at that point, you've committed to owning that asset class in a fund, and then all the same questions that you would ask of any fund that you own apply: What's the expense ratio? Who's the manager? If the fund has an attractive long-term record, how long has he or she been on the case? Does that manager invest in the fund? All these questions that we ask in the fund research group at Morningstar apply, and investors should be quite diligent, even more so, when they are getting into riskier asset classes that maybe they don't have that much experience with.

Benz: Shannon, always great to hear from you. Great to hear your insights into what has been a very hot group of funds among a lot of investors. Thanks for sharing your thoughts.

Zimmerman: Absolutely, Christine.

Benz: Thanks for watching. I'm Christine Benz for