In today’s low interest rate environment, don’t let the search for yield cause you to take on more risk than you were bargaining for. In fact, it could be argued that the higher an investment’s yield, the higher its risk and the higher the chance this investment could produce a negative return.
This sounds ludicrous as it used to be that an investor could collect the income on an investment and this yield would literally represent the investment’s return. However, it is rarely the case for most of the income investments out there today. Most of today’s income-based investments attempt to capitalize on investor’s thirst for yield in the current low interest rate environment. When you are considered to be hitting the jackpot on a CD with a 1% yield-to-maturity, it is not surprising that investors are looking for better yields elsewhere.
There are a number of high-yielding investments available, so investor choice is certainly not a problem. The problem is that higher yield very often implies higher risk to principal. In fact, a decline in your principal not only becomes a possibility with higher-yielding investments, but a high likelihood event. The income yield of most investments today will come nowhere close to approximating their future returns. It doesn’t mean they are bad investments. It just means that investors must perform due diligence on the quality of these investments irrespective of their yield. They then must evaluate how this yield is being generated.
Here are some of the most common risks and features associated with high-yielding investments:
Some of the yield may be a return of principal. If you were to give me $100 and I were to pay you back $6 a year until the $100 is returned to you, would you look at this as a 6% annual yield or a cheap parlor trick? I’m not providing you a return on your money but rather a return of your money. There are a large number of high-yielding investments where a portion of the yield represents a return of investor principal.
The yield is magnified by leverage. Sometimes investments are leveraged by the issuer. This leverage can magnify the investment’s yield by 2 or even 3 times. While the higher yield will attract more investors, does the leverage make the underlying investment any better? Leverage cannot take a poor investment and make it good. It will actually greatly magnify the investment’s poor results. Always evaluate whether the high yield you are seeing is a result of leverage and make sure to evaluate the quality of the underlying investment.
The yield is high because of credit risk. Higher yields often accompany securities that have an above average risk of default. A yield of 5% means very little if you lose 50% or more of your principal in the process. Always evaluate the credit risk of any investment and make sure that the yield is properly compensating you for your risk of losing principal.
The yield is high because of interest rate risk. Many income investments with long maturities have higher yields because they are very sensitive to long-term interest rates. While the yields appear attractive in a vacuum, even small increases in long-term interest rates can cause a significant drop in the value of your principal. With long-term interest rates near historically low levels, the elevated risk of rates heading higher over the next several years should be considered when buying an income investment having a long maturity.
All of the above factors should be considered when purchasing an income-based investment. In general, a higher yield means higher risk. There is no such thing as a high-yielding investment that is also safe and an investment’s yield will generally be a very poor approximation of its future returns.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Please consult with your advisor to select the proper investments for your situation.