Reaching for yield, taking on risk

By Scot Blythe | April 25, 2012 | Last updated on April 25, 2012
4 min read

This Special Report is sponsored by:


The temptation to stretch a little further has never been greater. These days an investor is lucky if they can find a 1-year GIC for 2%. More likely, they will see five-year GICs at 2.75%, which may beat the Government of Canada 5-year bond, at 1.5%, but it’s still paltry against an inflation rate of 2.5%.

Worse, it hardly stacks up against portfolio withdrawal rates of 4%, a typical figure used for estimating the sustainability of a retirement income portfolio.

Thus the temptation to reach for yield. There are many vehicles that seem to promise almost effortless yields that are higher than Canadian government bonds. Dividend-growth stocks come to mind, and what remains of the income trust market, particularly REITs. Then there are preferred shares. Even within the fixed-income sector, there are alternatives: high-yield bonds, and lately, emerging market bonds.

All can be good investments, so long as investors understand the risk-return trade-off. But it pays to look beneath the labels, lest one mix apples and oranges. Different kinds of yield have different kinds of risk.

Indeed, many investment advisors are wary of the whole notion of reaching for yield. “I believe it is a mistake to chase after yield by including junk bonds or heavily tilting towards dividends,” says one bank advisor, who requested anonymity.

Adds Justin Bender, an advisor at PWL Capital in Toronto: “Everybody’s doing something silly. Some are going into dividend stocks…I have phone calls from people asking why they can’t do that: ‘The banks are safe.’ Well maybe, maybe not. They’ll go down if the market goes down.”

The key issue is the risk of the yield; the higher the yield, the higher not just the risk, but the risks. For example, high-yield bonds can offer as much as 800 basis points over government bonds.

“Going into high-yield bonds and assuming those are part of their fixed income component I think is a big mistake in itself,” says Bender. “They’re more equity-like.”

With yield portfolios, one can envisage a tree of risks. At the root, government bonds keep a portfolio grounded. They protect capital because they are backed by the “full faith and credit” of governments. In other words, taxpayers will foot the bill.

“You still have to view bonds for what they are,” says Dan Hallett, director of asset management at Highview Financial Group in Oakville. “Even though the income is a lot less, they still are dependable source of income—low income today—and they are still preservers of capital, by and large.”

Within the government category, one could reach for yield by going higher up the tree trunk for longer maturities. A 30-year Government of Canada bond yields 2.6%. Is that worth the reach?

“Normally we try to keep the maturities under five years,” says Bender. “Historically—not over the past 10 years or so, but over the long term—going long doesn’t actually add too much of a benefit.”

Higher up the trunk we find investment grade corporates, which are primarily subject to duration risk—the impact of a change in central bank lending rates. Corporate bonds do offer a bit of a yield pickup, without necessarily adding a lot of risk, even though investors are now taking on more credit risk.

“I don’t see them as extremely risky as long as you’re broadly diversified, and buying investment grade. Higher investment grade is always better, so you can get double-A bonds, some A and triple-B for a small portion of it. I don’t see them as being overly risky,” says Bender, noting that most bond funds include healthy doses of corporates. “Now, buying individual bonds, that’s a totally different story.”

Up in the branches, there are better yields out there. Just don’t call them fixed income; high-yield bonds are subject to higher credit risk, while dividend stocks, with their inherent equity risk.

Bender advocates a total return approach.

“I find a lot of people are just obsessed with yield to income and not on total returns. I think that’s a big issue that needs a lot of education; you have to understand that it’s okay if the bonds aren’t earning the income. Hopefully the equities will make up for that and vice versa,” he says. “When the equities aren’t up, the bonds will probably stabilize the portfolio and probably increase it as well. People don’t see it that way. They look at a portfolio and say ‘what’s the yield, 3%, 5%, 6%?’ They don’t see the risk in that 6% or 5%. If it’s low risk, it’s not going to be yielding that.”

Hallett agrees, warning that investors may get caught unaware by two yield vehicles. The first are systematic withdrawal funds that pay a fixed yield. It may be that they’re paying a higher yield than is warranted by their investing prowess.

“You have to assess the sustainability, whether it’s a structure like an income trust, where it happens to be over-distributing or borrowing just to keep the payments going, or whether it’s actually really supportable.”

He also cautions on emerging market bonds. While emerging markets seem to be flush with cash reserves, historically they have defaulted at far lower debt to GDP ratios than advanced economies. Hence, there’s a heightened degree of political, creditor or liquidity risk.

“I think you have to attack it from a goals-based framework. What is it that a client needs? You keep working backwards and figure out roughly what kind of return rate you’re looking at and then design the asset mix,” he says. “Otherwise, you risk getting caught up in these things by reaching for yield, buying gimmicky stuff that maybe has a higher blow-up risk, or at very least just a higher risk of disappointing a client.”

Click here for the PAYBACK Report PDF

< Back to the PAYBACK Report

This Special Report is sponsored by: iShares

Scot Blythe