Rick Welch: Dollars and $ense
The Search for Yield
Yield (yēld) v.t. & i. 1. Produce in payment 2. A rate of return for a security
In a world of low interest rates, investors continue to search for yield that is safe, dependable and not subject to wide swings in underlying principal value. Investors looking to retire soon may also demand a yield that can keep pace with inflation. In the current environment in which a 10-year US Treasury bond is yielding just 2.5% many investors face a familiar dilemma: accept less income, or take on more risk in the search for yield. The question they must now ask is not “Where do I find yield?” but, “Where can I find yield without taking on excessive or unknown risk?”
Dividend yield is an important factor in every equity selection we make for our clients. A good dividend yield can be found in many US Large Cap stocks as seen in the dividend yield of the S&P 500 which was 2.03% at the end of 2016. We like blue chip stocks like AT&T, Altria, Eli Lilly, Kimberly-Clark, P&G and Wal-Mart which each pay a dividend over 2.8% and have a low beta (β is market risk or the tendency of an investment’s return to respond to market swings). It comes as no surprise that most of our blue chip, low volatility dividend payers are in the consumer staples or telecommunications sectors. Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) are entities that pass-through earnings, which are not taxed at the corporate or partnership level, in the form of rich dividends to investors. At the end of 2016 we saw the following yields for REITs and MLPs indices: FTSE NAREIT All REITS Index (4.32%) and Alerian MLP Index (6.73%). MLPs (typically midstream energy transportation and distribution assets) have struggled along with the broader energy sector over the past two (2) years.
Most portfolios are designed so that the fixed income asset classes are the main source of income. Bonds, the largest sector within this asset class, come in many shapes and sizes including treasuries, US Agency, municipal, investment grade corporate, high yield, global and emerging market. While bonds are often purchased for their income that is not the only function they serve within a portfolio. The low correlation (a measure of how the share prices of two securities move in relation to each other) of stocks and bonds improves portfolio diversification while dampening volatility. Treasuries, with a correlation of -0.17, offer the best diversification. Corporate bonds, with a correlation of 0.25, offer medium diversification and high yield bonds, with a correlation of 0.61, offer impressive yields, but less diversification.
As we move into 2017, we expect the Federal Reserve to continue on its set path of interest rate normalization which could include 2 rate hikes each of 25 bps. As interest rates rise, prices of fixed income securities, like bonds, fall. If the 10-year rate were to rise 50 basis points (0.50%) this year, the prices of all bonds would be impacted. Feeling the greatest impact would be long term treasuries which could fall over 8.0% in value. Investment grade corporate bonds would likely fall about 3.5%. It may surprise you to learn that high yield bonds would perform the best in these conditions suffering a loss of just 2.0%. In our search for yield we must consider the risk of rising interest rates along with the credit risk associated with any debt security. An investment grade rating, above BB+ by S&P and Ba1 by Moody’s, implies a low credit risk of the issuer. With yields of just 3.0% for investment grade corporate bonds, many investors will continue to look to the high yield sector which offers a higher yield to compensate for the higher associated risk of default.