Now that interest rates have risen, investors need to know where it’s best to look for yield.
Listen now and learn:
- The market higher yields makes investing most attractive
- The shortfalls of relying on dividend stocks as a bond replacement
- Why a total return approach is better than focusing on just income
Listen to the show below or read my detailed show notes.
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Show Notes
With the exception of a brief period at the start of my career, I’ve otherwise spent my entire career in a low interest rate environment in which I’ve generally had to educate people on the dangers in reaching for yield.
Risk and return are related – so anytime someone asked me a question about an investment with a yield above 6%, I immediately knew to start looking for the risk.
But now that interest rates have risen, I may still raise my eyebrows a little bit at a 6% yield, but the investment case typically supporting a product with that type of yield is quite a bit different.
But it’s actually short-term yields rising that seems to be causing an uptick in yield-related questions, so for this episode, I wanted to address a few of the asset classes that are coming up most frequently in my conversations.
Before starting, though, I think it’s really important to share that I’m an avid believer in taking a total return approach rather than the yield approach most income investors tend to gravitate towards.
In my opinion, the research is pretty clear that a total return approach is more effective, so I don’t want to dwell on it too much. Otherwise, this will simply turn into an episode on total return vs income approaches. But the primary reasons that the research supports a total return approach is that it is more diversified, more tax efficient, and allows for more control over the size and timing of portfolio withdrawals.
Vanguard: Total Return Investing: A Smart Response to Shrinking Yields
Knowing that I believe a total return approach is what investors ought to be using should provide a good deal of context to how I view the attractiveness of yield in the asset classes discussed today.
Cash
Savers of the world rejoice because you can finally earn something on your cash, especially if you utilize an online savings account. I’m seeing yields from 1.75% to 1.85% online, which I realize doesn’t inspire much confidence for Baby Boomers and most Gen Xers who remember earning as much as 5% on their cash once upon time.
Beyond online savings accounts, people whose balance sheet justifies holding more cash than the $250,000 FDIC insured limit at a typical bank account might turn to Federally Insured Cash Accounts, which allow you to earn a higher yield that is in line with these online savings accounts, but comes with substantially higher FDIC limits (for reference, some go as high as $25M).
But the title of this episode is where to invest for yield, and cash is not a great long-term investment. I’m a strong believer in maintaining a cash reserve of as much as 12 months’ expenses if you’re working and as much as 24 months’ expenses if you’re in retirement.
But I’m not a believer in a meaningful cash allocation within your portfolio. Mostly because, over the long-term, cash offers a negative after-tax real return.
That said, cash is still an asset class that isn’t perfectly correlated with traditional asset classes like stocks and bonds, and it will even occasionally outperform your other holdings for very short periods of time. So there is reason to hold cash from an asset allocation/portfolio construction perspective, but I’d say the percentage ought to be in the 1% to 3% range depending on your situation.
Dividend Stocks
Since the Financial Crisis, people seeking to live off the income of their portfolios often felt the need to replace a portion of their bond portfolio with dividend stocks. As I mentioned at the start of the episode, this singular focus on income is typically not optimal.
But even with that point aside, using dividend stocks as a fixed income replacement has always rubbed me the wrong way because dividend stocks experience bad losses in bad times, and the primary role of fixed income is not income generation; no, the primary role of fixed income is to reduce volatility in your portfolio.
I think everyone knows that dividend stocks aren’t immune to losses, but as I pointed out in the prior episode (Episode 63: Should You Invest in Individual Stocks?), individual stocks (regardless of sector) come with an enormous amount of risk.
To share just a few of the statistics from a study that I covered in episode 63:
- 40% of all stocks in the Russell 3000 suffered a permanent decline of 70%+ from their peak value
- Two-thirds of all stocks underperformed the Russell 3000 Index
- The average stock’s relative performance vs the Russell 3000 was -54%
- 40% of all stocks had negative absolute returns
So (again) the idea of dividend stocks being a bond replacement for income investors really misses the point of why you would own fixed income in the first place, which is to lower the overall volatility of your portfolio.
Another issue with dividend stocks as a bond replacement is that dividends are not guaranteed. In fact, the largest yields tend to come with the largest risks, and an outsized dividend yield is often a signal of a dividend cut in the future is possible.
Finally, and perhaps most importantly, dividend yields aren’t materially more attractive today than what is traditionally considered to be risk-free assets. With U.S. Treasury yields higher, the case for dividend stocks in arguably the weakest it has been in a few decades. Think about it: Cash at online savings accounts are at 1.75%. The 30-Day Treasury Rate is 2.5%. 2-Year Treasury Yields 3.5%.
Compare that to popular dividend indices like the S&P Dividend Aristocrats (about 2.03%) or the Dow Jones U.S. Select Dividend Index (about 3%), I just don’t see the case for buying dividend stocks explicitly for the yield.
Real Estate
I think generally everything I’ve just said for dividend stocks applies to real estate. You shouldn’t invest in real estate just for the yield.
A diversified real estate exposure as part of a diversified portfolio? Fine. A diversified Real Estate Investment Trust (or REIT) fund might get you a yield above 3%.
Private real estate funds will likely yield you a bit more, but I’d urge caution of allocating to private investments without a thoughtful strategy.
To achieve proper diversification within a private investment allocation – that in my opinion should include more than just real estate – you probably ought to have a liquid portfolio of around $10 million.
But I’d argue that the additional compensation you earn versus the next category of assets isn’t wildly attractive compared to historical averages.
Investment-Grade Corporate Bonds
Investment-grade corporate bonds are earning relatively attractive yields these days.
A corporate bond yield is composed of U.S. Treasury yields plus a spread that compensates investors for the additional risks of a corporate bond.
When you see or hear the financial media talking about yields rising, most are talking about the yields of U.S. Treasuries. Corporate bond yields have benefited from those rising Treasury yields, but the spread an investor earns for owning a corporate bond versus a Treasury has risen, too. As a result, corporate bond yields are near their post Financial Crisis highs.
Something else corporate bonds have going for them (that U.S. Treasuries do not) is that the corporate bond yield curve is positively sloped.
Again, let’s level set with some definitions:
A positively sloped yield curve means that longer-term bonds have higher yields than shorter-term bonds. That extra yield is compensation for taking on the additional interest rate risk of a longer-term bond.
Unlike the corporate bond yield curve, the U.S. Treasury yield curve is not positively sloped. Yields on 2-year bonds are higher than 10-year bonds, which is a reflection of the bond market’s concerns about economic environment.
Learn More: What You Need to Know About Bonds
If you aren’t all that familiar with yield curves, I think this may be a difficult concept to fully appreciate verbally, but here is the simplest implication: corporate bond investors are being compensated with higher yields when taking on the additional interest rate risk of intermediate- and long-term bonds; Treasury bonds are not.
For investors that have been waiting since the Financial Crisis for yields to rise, the wider credit spreads and positively shaped yield curve for corporate bonds make this seem like as good a time as any to extend duration a little bit by moving a bit further out on the investment grade corporate bond yield curve.
The key distinguishing part of that statement is “investment grade.”
One more time, a quick primer to make sure this point lands. Credit risk is simply the risk that an issuer defaults on a bond, or that the bond is downgraded and experiences a drop in price. Investment-grade corporate bonds are those with a BBB rating or better. Bonds with a rating below BBB are commonly referred to as “high yield” or “junk” bonds.
Investment-grade corporate bonds with maturities in the 3-5 year range are earning about 3.75%, and investment-grade corporate bonds with maturities of seven years and beyond earning 4% or more.
You can find yields around 6% when you dip into the non-investment-grade universe – or what we refer to as the high yield or junk bond space – but doing so comes with what I feel like is materially higher risk, a point that you can see being reflected in the activity of credit rating agencies…
According to Charles Schwab, within the investment-grade corporate bond market, credit upgrades accounted for more than 60% of the ratings changes each month from November 2021 to July 2022. High-yield corporate bonds, on the other hand, have seen downgrades represent the majority of ratings changes three of the past four months.
And this makes intuitive sense. We don’t know where the economy or corporate profits are heading in the next 12 months; but I hear the cautious commentary from CEOs on earnings calls talking about rising labor costs and tighter financial conditions leading to sharp increases in borrowing costs; and we can all still see weird supply and demand dynamics disrupting businesses at different points of the supply chain.
With all this uncertainty, you would expect high-yield bonds to offer compensate you with more yield, and they do, but not that much yield. In fact, the additional spread on high-yield bonds versus investment-grade bonds is below the 10-year average. Plus the yield curve for non-investment grade is flat and negatively sloped (meaning that you don’t get compensation for taking on interest rate risk).
Investment-grade companies have stronger balance sheets and more stable cash flows, so they ought to be more likely to weather any economic difficulties that lay ahead. Again, that doesn’t they are riskless, but price declines for investment-grade corporates should be less impactful than what high-yield bonds would experience.
This is all to say that I’m pretty excited about the value investment-grade corporate bonds offer right now, especially relative to other areas of the fixed income market.
That’s all I have for this week. If you haven’t already, be sure to subscribe on whatever podcast platform you are using. I have some awesome shows lined up for this fall that you don’t want to miss.
And I’d be especially grateful if you too the time leave me a review and written comment wherever it is you are listening to this podcast.
Thanks again for listening, and to long-term investing.
Resources
- Vanguard: Total Return Investing: A Smart Response to Shrinking Yields
- Episode 63: Should You Invest in Individual Stocks?
- What You Need to Know About Bonds
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Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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