The Hidden Risks in Some High-Yield Investments

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Interest rates may be rising but retirees are still looking for extra yield to help fund their retirement. I'm here with Christine Benz, she is our director of personal finance, to look at where there could be some risks in seeking high-yields investments.

Christine, thanks for joining me.

Christine Benz: Jeremy, it's great to be here.

Glaser: We are going to look at three different types of investments today that might have some risks that investors aren't fully aware of or haven't fully thought through. The first are a high-yielding, foreign dividend-paying stocks or foreign dividend-paying funds. Why is this an area that could potentially have some risks?

Benz: First of all, we'll start with the attraction, which is that, yields can be really attractive relative to U.S. equity dividend yields. Yields are like 4% right now if you buy sort of a basket of high-yielding foreign stocks. That's a big plus. I do think that investors need to be mindful of the risk factors. Not that they should definitely avoid this category, but a couple of things you would want to keep in mind. One is that anytime you are looking at a high dividend-yielding product or a high dividend-yielding stock, you are usually getting a little bit of a value orientation. If you are buying a fund that tracks some high dividend-yielding universe, you are going to end up with a value tilt. That's one thing to keep in mind. You may end up with a little bit more economic sensitivity with that portion of your portfolio as well.

The other thing to keep in mind is that you may be geographically less diversified than would be the case if you bought, say, a total foreign stock market index fund. You probably will get a little less--Japan, for example, because dividend yields oftentimes are lower in Japan than elsewhere in the developed world. That's another thing to keep in mind. Mind the geographic exposures, recognize that you may be making certain bets there by focusing on dividend yield with your foreign stock portfolio.

Another thing to keep in mind is that dividend yields overseas tend to be a little more ephemeral than is the case in the U.S., where if a U.S. company is paying a dividend, it will sort of turn over every cupboard in order to maintain that dividend. Not necessarily the case in foreign markets where dividends might come and go a little more. This will be a particular issue for investors who want to buy an individual company that happens to have a high-yield attached to it. Something to keep in mind and certainly, anytime you are talking about yields, whether from bonds or stocks, you want to bear in mind tax consequences as well. If you are someone who is interested in making a big play in foreign high-yielding stocks, check with your tax advisor to talk about where to hold that particular product or individual security.

Glaser: Currency risk shouldn't be overlooked either?

Benz: Absolutely. Thank you for reminding me. Anytime you have a foreign stock or a foreign fund that is unhedged, you are exposing yourself to foreign currency fluctuations. There's a chance that your gains, when translated back into U.S. dollars, could be diminished if currency fluctuations break against you. On the flip side, you can also gain if foreign currencies gain at the expense of the U.S. dollar over your holding period.

Glaser: Let's turn to business development corporations or BDCs. Can you just describe exactly what these are?

Benz: Technically, they are closed-end funds that trade like equities. But I think a good way to think of them is kind of a private equity product for the masses. They are pools of capital that invest in either the debt or the equity of companies that aren't public typically, oftentimes smaller companies that need some sort of financing. The big advantage to BDCs and one of the reasons why they might have come on yield-focused investors' radar is that the yields can be really tantalizing. Because like REITs, BDCs need to pay out 90% of their income to their shareholders each year. It's not unusual to look at BDCs and see yields of like 9%. Also, there are managed products that focus on BDCs. They too have very tantalizing yields. That's the big attraction. Certainly, there are big risk factors there as well though.

Glaser: And when you hear 9% yield, that could be more terrifying than tantalizing, raises a lot of red flags. When you look at that number, are these businesses sustainable, is that yield sustainable? What are some of the risks that investors need to keep in mind?

Benz: Yes. Such a great point. Anytime you see a yield that high, it's your job to get in there and take a look at some of the risks. In the case of BDCs, these are oftentimes very leveraged companies whose fortunes are leveraged to the strength of the economy. What we saw in 2008, for example, was many of these companies encountered troubles, BDCs underperformed, some of them had losses of upward of 30% during that period or even more. You need to be careful. You need to recognize that these are risky companies that BDCs own, and you need to be prepared for them to experience periodic downdrafts because they are so sensitive to the strength of the economy.

Glaser: Let's dial down the risk a little bit and look at floating rate funds, like bank-loan funds. These have been increasingly popular. What are some of the pros of looking at a product like this?

Benz: Yeah, there are a couple of key pros here. One is that yields have become pretty attractive on floating rate or bank-loan or senior-loan products where you don't have to stretch too hard to find a product that is yielding in the neighborhood of 4% today. The other big attraction to floating rate products is that you do tend to have less vulnerability, much less vulnerability to changes in interest rates. Typically, bonds are very vulnerable to interest-rate changes. Floating-rate products are a little bit different in that when rates trend up, when the LIBOR trends up, so will the rate on the loans in the portfolio. They tend to perform pretty well in periods of rising rates. When we looked at what categories performed well in inflationary environments, floating-rate products also look good from that standpoint. Those are the big advantages.

Glaser: But there's some downsides as well?

Benz: Certainly. Some of the same things that we've talked about in the realm of BDCs, although to a perhaps smaller extent, are in play with the floating rate products. Specifically, you get a lot of sensitivity to what's going on in the economy. You get a lot of sensitivity to what's going on in the equity market. In periods of equity market weakness and economic weakness what we typically see is floating-rate portfolios behave in sympathy with the equity markets. Keep that in mind.

I think this is a serious category that serious investors should consider, but I would limit it to a small portion of the portfolio and certainly not think of it as a substitute for high-quality, fixed-income securities.

Glaser: Bottom-line, what should retirees keep in mind who are looking at these higher-risk, higher-yield type of investments?

Benz: I think you hit on it, Jeremy, when you said anytime you see that sort of very high, eye-popping yield, that's your trigger to get in there and take a look at what risks might be lurking in the portfolio. Keep that in mind. I think it's also worthwhile if you are looking at high-yielding securities to the extent that you can diversify across a basket of securities, I think that is a great thing to do for your portfolio. Then also, anytime you are looking at products with yields attached to them, so any sort of managed product, really focus on keeping the costs down on that product.

Glaser: Christine, thank you.

Benz: Jeremy, thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.