Since 2008, as authorities worldwide have used aggressive monetary policy to try to boost their flagging economies, investors have found it increasingly difficult to find income from traditional sources such as cash or fixed income. At first central bank base rates were slashed, followed by the introduction of quantitative easing, which has then been extended to lower rates ever further along the yield curve. The consequence for investors is that they must either accept a lower income from their investments or move to traditionally riskier assets, or some combination of the two. For many, the former option is behaviourally difficult to take, particularly when the cost of living is rising, and therefore they may have ended up taking more risk, which brings with it consequent uncertainty.
Returns from income-yielding assets higher up the risk spectrum have been stellar so far in 2012, with high-yield and investment grade bonds significantly outperforming gilts, as can be seen below:
While such returns may reflect a more positive investment outlook, it is also likely that investors are being enticed by higher yields in such asset classes and taking on more default risk in order to access it. In this light, products with a high yield are being increasingly advertised to investors, and while many offerings may be a solution to their search for income, there are many other factors investors should consider other than just the headline yield.
Yield is Not Income
Yield is the income distribution from an investment as a proportion of the capital value of that investment. Therefore an increase in yield means there has been an increase in income if the capital value of an investment stays the same or rises. However, should the value of capital fall over time then investors will receive less income even if the yield is constant.
Importance of Total Return
Although investors may be choosing to invest in a product with the principal objective of receiving income, they must consider the total return from the product and how that, along with the yield, helps them to achieve their investment objectives both in terms of the effect on their capital and their income.
A product that has a low total return relative to the yield it is paying out can create problems in the longer term
A product that has a low total return relative to the yield it is paying out can create problems in the longer term. The graph below compares two fictional products, one with a high yield of 6% p.a. but a consistent total return of 5% p.a and one with a lower yield of 4% p.a. but a higher consistent total return of 6% p.a. The diagram shows the effect on income and capital over time:
Given these assumptions, the investor in the higher yield product does receive a higher income (blue dash line compared to green dash line) for a long period of time. However, what is the price they pay for this benefit?
Firstly, because the annual yield is greater than the total return, the capital base of the investment is eroded (blue solid line), indeed after ten years the capital loss would have been 10% compared to a capital gain of over 20% (green solid line) in the lower yielding product.
Secondly, because the capital base is being eroded, even though the yield is unchanged, the income payments for the higher yielding product fall over time (blue dash line). This compares to rising income payments from the lower yielding product (green dash line).
Thirdly, such erosion of capital and income in the higher yielding product is even more significant when the effect of inflation is considered. Assuming 2% inflation (remember that target?!?!), the 4% yield product provides an income level which keeps pace with inflation and protects the real capital value of the investment over time, whereas the income and capital in the higher yielding product is falling significantly in real terms.
This is not to suggest that all high yield products necessarily have disappointing total returns, but it is suggesting that investors should consider the effect of the total return and not just focus on the yield and short-term income.
Capital Risk
In many cases higher yield investments carry a greater risk of capital loss. Clearly this is the case with fixed income, where the higher yield attached to non-investment grade bonds is to compensate investors for buying issuances from more risky companies. The capital drawdown from such products can be severe and in times of economic stress can more than wipe out the benefit of the higher yield. This can be seen in the diagram below which shows the total return from fixed income in 2008.
This raises the question as to whether investors who currently feel they need to invest in higher yielding assets in order to gain sufficient income have the necessary risk tolerance and length of investment time horizon to accept the risks that come with such investments. Meanwhile, it should be noted that not all higher yielding assets are more risky, for example, many equity income funds have historically lower volatility and lower drawdown than non-income equity funds.
Liquidity Risk
High yielding assets may also exhibit low liquidity levels. Fixed income is again a good example of this. At one-end of the spectrum is the gilt market where liquidity is plentiful (although it could be argued that this is currently artificially high due to quantitative easing) whereas high-yield issuances have far less liquidity and particularly so if the credit worthiness of an issuer is being questioned. Property is another asset class that many investors own for yield. By the very nature of the assets, liquidity is low and many direct property funds will have high cash balances to help manage fund flows, which itself reduces the yield from such funds when compared to the pure asset class.
Investor Aims, Objectives and Risk Tolerance
For many investors a high yield product may be the best option, but before investing they are well-advised to consider all the facets of a product, only some of which are outlined above, to assess whether it will help their portfolio meet their investment objectives while providing an appropriate level of risk.
