How much yield is too much yield? Put another way, at what point does the quest for portfolio income lead to more harm than good?
It’s a question worth asking, especially for those of you who rely on retirement savings for income. Even if the Federal Open Market Committee (FOMC) does decide to raise interest rates next week—and I don’t know if the FOMC will or if it will leave rates unchanged—yields on many assets will be continue to be low. There aren’t great options currently for investors desiring portfolio income and I don’t expect this to change very much in the foreseeable future (though my crystal ball remains cracked).
Given this, how much yield is too much? Brian Meath, a managing director at Russell Investments, puts the number at 3.5%. In a post on the Russell Blog, Meath said his firm’s research found “that yield objectives over 3.5% begin to erode a portfolio’s capital base.” The rate of erosion increases as “forecasted yield increases to 5% and beyond.” By overreaching for yield, investors sacrifice future wealth for current income.
Yield is the amount of cash paid by a security relative to its market value. Depending on the asset and how its payout is structured, yield can represent earnings (in the form of dividend payments), interest (e.g., on bonds) or the return of capital. A multi-asset portfolio will offer some combination of these yield sources.
The danger of overreaching for yield occurs when an investor sacrifices quality for income. It can be helpful, in this instance, to think of yield as a valuation measure instead of as a measure of income. Certain securities and funds have higher yields because investors perceive a greater risk of losing the money spent on the investment (or, in financial terminology, capital.) If an investment is perceived as being riskier, investors will demand a lower valuation as compensation. Since yield and valuations are inversely related, higher yields imply lower valuations and greater perceived risk.
Downside risk can unravel the underlying premise of “never touch capital.” The idea of only living off of dividends, distributions and interest payments is to preserve the underlying value of the portfolio. So long as only income is taken, the portfolio’s value is not reduced, or so the concept holds. If too much income is sought, however, the value of the underlying securities will fall, thereby reducing capital. The investor will have unintentionally “touched” capital by taking on excessive risk.
A better strategy is to sacrifice yield to focus on fundamentally sound securities or funds that target higher quality assets. The lower yield can be offset by using capital gains to supplement income. While using total return may seem like an antithesis to never touching capital, it can actually do a better job of protecting capital by reducing the overall level of risk.
Keep in mind that it’s easy to downplay risk when downside volatility has not fully reared its ugly head. Though master limited partnerships (MLPs) have fallen significantly over the past 12 months, many stocks, bonds and real estate investment trusts (REITs) have not experienced significant downside volatility over the past several years…the last few weeks notwithstanding. Assets in all categories can drop in price, often without much warning. So even if you have successfully been able to realize higher yields without any downside penalty for taking the additional risk, there is no guarantee that you will be able to continue to do so in the future. Downside risk often seems like it’s a scream coming out of Chicken Little until it suddenly smacks your portfolio.
The Week Ahead
Just three members of the S&P 500 will report earnings next week: FedEx Corp. (FDX) and Oracle Corp. (ORCL) on Wednesday and Adobe Systems (ADBE) on Thursday.
The Federal Open Market Committee will hold a two-day meeting starting on Wednesday. The meeting statement and updated committee member forecasts will be released at 2 p.m. ET on Thursday, followed by a press conference with Chair Janet Yellen at 2:30 p.m. There is a large amount of scuttlebutt about an interest rate hike potentially being announced at this meeting, but it is uncertain what the committee’s decision will actually be.
The first economic reports of note will be released on Tuesday: August retail sales, August industrial production and capacity utilization, the September Empire State manufacturing survey and July business inventories. Wednesday will feature the August Consumer Price Index (CPI) and the National Association of Home Builders September housing market index. August housing starts and building permits and the September Philadelphia Federal Reserve’s manufacturing survey will be released on Thursday.
The Treasury Department will auction $13 billion of two-year notes on Friday.
Friday will be a quadruple witching day, meaning that both options and futures contracts will expire.