Many of us may remember the opening scene of Indiana Jones and the Raiders of the Lost Ark when Dr. Jones, played by Harrison Ford, makes it through a maze of booby traps in search for the Golden Idol. He dodges arrows and rocks and ultimately makes it to his glimmering prize. Carefully, he reaches out for the Golden Idol, switching it with a sand-weighted bag as a look of relief comes across his face. Then as he turns, the cave begins to quake, and our hero must quickly make his exit as even more perilous dangers befall him.
Like this adventure of Dr. Jones, consider the investor that has appropriately and carefully been building a portfolio to allow her to retire comfortably (or pay for college expenses, weddings, give to charity, etc.). Over the years, she has allocated to high quality bonds and stocks in a manner that aligns with her investment risk profile and has weathered the ups and downs in the market with an eye on the long-term goal. But now, with current interest rates at historic lows (and for quite some time), many investors are turning from their safer bond holdings and reaching out for higher-yielding investments. And while those investments make the promise of increased return, often the underlying risks are not appropriately assessed. Should the markets start to quake like the treacherous cave in the Indiana Jones film, the increased risks taken on by these investments could cause financial ruin to her portfolio and goals.
This article will highlight the pros and cons of three investments that offer higher yield than traditional investment grade fixed income but come with increased risks. A smart investor is an informed investor, so the goal is to give you the information you need to make educated investment decisions in 2020.
High Yield Bonds
As the name suggests, high yield bonds are fixed income securities with higher yields than investment grade fixed income and are issued by companies with lower quality financials. These non-investment grade bonds can pay off to an investor in several different ways, most notably from the higher stated interest rates. The higher the rate, the more interest the bond holder will receive. Additionally, these bondholders would also see the principal value of their investment increase should the issuing company improve its credit standing.
However, these bonds are considered “junk bonds” for a reason, and it is important to consider the downside risks involved when investing in these securities. Though the interest rate is higher, that is for a reason – investors demand higher rates of return to bear the risk of a company defaulting on its bond obligations. When a company defaults, the bonds may fall precipitously in value. Additionally, just as a credit rating improvement can boost performance of the bond, a credit rating downgrade could prove devastating to a bond already considered in the “junk bond” status.
High yield bonds tend to have similar risk characteristics to those we see in equities. As such, replacing the ballast of your portfolio, high quality investment grade bonds, with high yield bonds adds additional equity-like risk to your portfolio. If mitigating risks is a primary concern, it would be prudent to avoid high yield/high risk securities.
Emerging Market Debt
Developed economies around the world are posting extremely low to negative interest rates on government bonds. As a result, many investors have turned to the debt markets of less-developed countries, the “Emerging Markets,” whose governments are offering superior yield to their developed counterparts. Which nations does this category refer to? Looking under the hood one can see what comprises the index: Kuwait, Qatar, Uruguay, Colombia, Peru, Russia, Ukraine, etc. Yields range anywhere from 3% to 7%+.
While there are diversification benefits to adding Emerging Market Debt to the portfolio, and surely the greater yield is an added pick up, one must acknowledge the higher risk associated with these securities. Simply looking at the list of countries should give a sense of the geopolitical risks involved investing in some of the least stable regions and countries of the world.
The value of the US Dollar also can weigh on the performance of these securities. Because many of these emerging market countries cannot borrow money in their own currency, they turn to the US Dollar to issue debt. As the dollar strengths against their local currency, it makes it more difficult for that country to service the debt they issued, decreasing the value of the debt holding to the investor.
Preferred stocks are often referred to as “hybrid securities” because they have features that put them somewhere between bonds and common stocks. They have steady dividends paid out in perpetuity but are typically taxed at the qualified dividend rate rather than as interest income for bonds. Unlike bonds, any skipped payments are not deemed defaults but accrue and are due before any common shareholders receive their dividends. Preferred stocks have a higher claim on assets relative to common shareholders, and their prices are less volatile than stocks. If we stop here, this investment sounds quite attractive. But we must consider the negatives of this investment vehicle.
First, preferred shareholders have a lower claim on assets than creditors and bondholders. Should a company declare bankruptcy, preferred shareholders will only receive a payout after all creditors and bondholders are paid. Secondly, and certainly the bigger risk, while preferred securities are less volatile than common stocks, they are more volatile than bonds. During the 2008-2009 Great Recession, the S&P 500 returned -33.3% for the 18 months ending June 2009 (source: Morningstar). US Treasuries returned +8.9% (source: ICE BofAML U.S. Treasury Index). Income investors who had turned to the higher yielding preferred shares saw their holdings drop -23.2% (source: ICE BofAML Fixed Rate Preferred Securities Index). Not quite the stable, sleep-well qualities an investor would expect from their fixed income allocation.
Lastly, preferred stocks are highly sensitive to interest rate changes. Since preferreds typically have no maturity, and rate sensitivity rises as the maturity gets longer, preferreds typically are more sensitive than bonds. As rates increase, preferred stocks lose their value. While we expect rates to hold steady in the near term, the long-term picture is more difficult to assess. Given the volatile nature of rate policy when looking out ten years, the preferred stock’s performance is certainly less predictable than a high quality investment grade bond.
As we begin this new year with bond yields around the world as low as they’ve ever been, it would be easy to consider adding higher yield securities to the portfolio in lieu of traditional investment grade fixed income. But a smart and prudent investor must understand and consider the underlying risks associated with these securities before adding an allocation to his or her portfolio.
IMPORTANT: Point View Wealth Management, Inc. (“Point View”) is an SEC registered investment adviser (Registration of an Investment Adviser does not imply any level of skill or training) and a subsidiary of Peapack-Gladstone Bank. This publication is only intended for clients and prospective clients residing in the states in which Point View is qualified to provide investment advisory services. Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product including the investments and/or investment strategies recommended or undertaken by Point View, or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Point View. Point View is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of Point View’s current written disclosure brochure discussing our advisory services and fees continues to remain available upon request.
Securities and mutual funds are not FDIC insured, are not obligations of or guaranteed by Peapack-Gladstone Bank, and may involve investment risk, including possible loss of principal. Information provided for educational purposes only.