Reaching for Yield: Income Investments Bring Risk

Do you see yourself sitting on the porch swing someday, relaxing with a tall glass of iced tea while waiting for the next round of dividend and interest checks to arrive in the mail?

Even if the porch isn't your particular retirement dream and you prefer hot coffee, you may still hope to live at least partly off the yield from your investments at some point. What you may not dream about, or even consider, is the risk involved. Yes—there's risk even in the so-called "plain-vanilla" investments people turn to for yield.

In your reach for yield, you could be taking risks that aren't commensurate with the yield you're looking to get. If you're hoping to collect those checks someday (or even now), it helps to understand the risks of reaching for yield and ways to try and avoid some of the pitfalls.

Consider an investor who sees a certain sector, such as energy, delivering high yields at around 4.5% with the underlying stocks at depressed levels. It might seem like an opportunity to jump in. However, things might not seem so good a year later if crude oil prices fall and the sector drops 25%.

The same could be true in fixed income if you buy a company's high-yielding bond and it then defaults, leaving a hole in your investment portfolio.

Consider thinking of yield as a scale. The more one side (yield) goes up, the more the other side (reliability) tends to go down. Often with outsize yield, there's a higher probability of default or some form of a credit event or restructuring that could significantly lower the value of the bond or bond fund. Aggressive investments with high yields naturally come with higher levels of credit risk that might not be obvious unless there's an economic downturn that prompts spreads to widen out.

It's important for investors to do their research so that they are building a portfolio with the most sustainable yields, while not necessarily the most attractive yields.

When we discuss risk associated with yield, there's more than one type. First and most common is the chance the yield you're depending on goes down. This can happen for several reasons, but it's quite common with companies that pay dividends. The other risk, which is potentially more devastating, is the actual loss of principal you invested in the underlying stock or bond.

Here, we'll focus on dividend yield risk.

In late 2018, General Electric (GE) announced it'd slice its quarterly dividend from 12 cents to just a penny a share. GE investors who wanted those regular payments had to choose between hanging onto a stock that paid a one-cent dividend or liquidating their shares and searching elsewhere for yield. As those investors learned the hard way, dividends are often the first distribution to investors or shareholders that gets chopped when hard times come.

So how can you try to avoid the situation GE investors faced? It all starts with doing the research, just as you would for any investment. In the case of a dividend-yielding stock, investors probably want to pay extra attention to how the company makes its money as well as its cash flow. If there are question marks around those, you might want to approach it cautiously.

If you see a high dividend yield when you review a company's financials, check to see if the company has enough cash or earnings to support those yields going forward. If not, chances are those yields could be cut or disappear altogether. You want to try to ensure you're investing in yield that is sustainable. You especially want to avoid volatility in your dividends if you're depending on those payments for income.

One way to keep tabs on whether dividends will be slashed is to look at the cash flow statements on the company's quarterly reports. If it appears more cash is being paid out in dividends than the company is generating, the company may consider cutting or even doing away with the dividend. Also, consider reading any analyst reports you can access, and watch the news for signs of trouble, such as a missed quarterly earnings number or a lot of executive turnover.

With stocks, there's also potential risk to the underlying investment. Even if a company doesn't cut its dividend, you're probably going to come out on the short end if its shares drop 30% over the course of a year or two. Yield, even reliable yield, can't always make up for share losses.

In general, corporate bonds are considered a bit less risky than company shares. That said, when a company struggles, you'll often see it begin the process of suspending interest payments up the capital structure. Eventually, if things get bad enough, a company might declare bankruptcy, and bondholders might not get back their investments.

Much of the default risk in bonds can be mitigated by holding only those that are highly rated. Ratings agencies, such as Moody's and Standard & Poor's, regularly issue, track, and update bond ratings, but they each have their own grading standards, so investors need to educate themselves before buying.

Another way to potentially avoid some risk of high-yielding bonds is to buy a fund that invests in many of them at once. The more bonds in a fund, the better chance there's diversification that can sometimes help investors during tough times.

If you buy a high-yield bond fund with 1,000 bonds in it versus a high-yield bond fund with a portfolio of 30 bonds, you're increasing the breadth of your exposure. But with the 30-bond fund, if one of those companies defaults, you're likely to see a material loss of capital.

The challenge for some investors is that more risky bond funds and dividend stocks tend to pay higher yields, and that's sometimes hard for people to pass up. If something is yielding 10%, ask yourself why that is and what could be driving it. Make sure that the data and analysis can support that yield and try to understand what's driving the yield. Consider whether that yield is sustainable or if there's some risk it could disappear.

One consideration for checking whether a particular yield might be too good to be true is to measure it against the yield of a well-known stock or bond index. For instance, if you're considering a mutual fund that invests in "value" stocks with a focus on providing yield, check the yield of the S&P 500^® index, which is easy to find online. If the yield of the fund you're looking at is a lot higher than the index, start reviewing the investment carefully to see if it's sustainable.

If you're trying to get a sense of bond yields, consider checking the yield of your prospective investment with the iBoxx Liquid High Yield Index or the Bloomberg Barclays US Corporate High Yield Index. You can see if the high-yield bond fund you're looking at is in the same yield ballpark as those widely followed indexes. If you see another fund with a higher yield, investigate why. Is it higher because there are riskier bonds in that fund? Will it have higher default rates? As always with investing, it comes down to your due diligence.