In todays low interest rate environment, it is difficult to find asset classes that represent an outstanding income opportunity. It is easy, however, to point to popular income-producing investments that are bad ideas. Below are some investments and strategies investors should be wary of including in their portfolios. We recommend investors accept a lower level of income today rather than push the envelope in their search of yield.
Low Quality Stocks
Some of todays highest dividend paying stocks are companies with poor balance sheets that issue debt to support their dividend distribution. These stocks are especially risky in some cases because yield-hungry investors have bid them to unattractive valuation levels.
Risky Money Market Alternatives
Unsatisfied with near zero rates on money market instruments, some investors have turned to alternatives such as short-term bond funds. These vehicles can make sense in certain situations, but we would avoid them as money market alternatives. They offer marginally higher yields than money markets, but have significantly higher potential downside.
Mortgage REITs depend on a wide spread between short-term and longterm rates. We believe this highyielding sector could suffer if the Fed raises rates. More broadly, investors should be wary of situations where the Feds policy has arguably kept companies or investment strategies alive that normally would have failed.
Many firms have capitalized on the low interest rate environment to issue fixed-pay
securities with no maturity. Perpetual preferred equities have been particularly popular among real estate companies. These are a great deal for the issuer, but a lousy deal for investors.
Sacrificing Too Much Credit Quality
Investors should limit to a reasonable level their exposure to low quality fixed-income instruments. In many cases today, taking on additional credit risk does not translate into significantly higher yields.
Extending Maturities Too Far
Investors can get into trouble by reaching for yield in long-dated bonds. For example, as of April 30th, the Barclays Treasury Index had a 6 year maturity, 5 year duration, and 1.4% yield to maturity. By comparison, the Barclays Long Term Treasury Index had a 27 year maturity, 18 year duration, and 3.4% yield to maturity. Both indices offer modest yields, but the longer maturity involves significantly more interest rate risk for a modestly higher yield.
Some Leveraged Vehicles
Vehicles that borrow at short-term rates are vulnerable should rates rise. Leverage may amplify losses, and distributions may need to be cut as funding costs rise.
Return of Capital Schemes
Some investments return capital to investors as a way to artificially boost yield. This approach depletes the assets of the fund over time and is common among nontraded REITs and some closed-end funds.
Annuity Issuers with Poor Credit Ratings
Some fixed-rate annuities offer seemingly attractive yields today, but are issued by companies with questionable creditworthiness. Yields that seem too good to be true often come with a significant catch.