Weekend Edition – The Perils of Chasing Yield

Income investors, for the most part, look for investments with attractive, and sometimes large, yields. Whether it is with dividend stocks, bonds, or some other sort of asset class, income investors want a good return on their investments, and they will search high and low to find these yields. However, at certain times it can be difficult to find attractive, low risk yields, especially when the central banks in developed countries lower interest rates. In a low interest rate environments like this, income investors will break from their normally risk-averse nature and seek out higher-yield investments in risky assets. While this speculative strategy might work for a short while, it can come back to bite investors if they are not careful. As recent developments in emerging financial markets show, there can be unnecessary perils to this sort of yield chasing strategy.

How Did This Era of Yield Chasing Arise?

Following the bursting of the housing bubble, the financial crisis, and the Great Recession, the Federal Reserve lowered the federal funds rate to near zero, which was a monetary policy tool intended to lower short-term interest rates to stimulate the economy. Furthermore, the Fed eventually started buying up mortgage-backed securities and U.S. Treasuries in an attempt to lower long-term interest rates. By doing so, the Fed had effectively lowered the interest rates on all sorts of financial assets in the United States, like savings accounts, CDs, bonds, etc., posing a difficult challenge to investors and savers who desired attractive rates and yields in their investments. As such, all kinds of investors, both individual and institutional, started chasing yields in various investment vehicles. REITs, MLPs, BDCs, junk bonds, and high-yielding ETFs became sought after by investors, despite some of the risks tied to these assets. But investors didn’t stop there: higher yield investments in emerging stock, bond, and currency markets became an attractive area to put money.

Emerging Markets Take a Hit

While the move worked out well initially, over the past couple months the stock, bond, and currency markets in developing economies like India and Indonesia have been taking a beating. As interest rates started to rise in developed economies like the United States and the United Kingdom due to tighter monetary policies, the investors mentioned above started to pull money from the emerging markets to invest it in less risky assets in more established economies. This bit of rotation has caused the value in the stock, bond, and currency markets of these various countries to plummet. While some investors got out in the nick of time, many passive investors could have been behind the curve causing their holdings to drop in value. In the end, the yield chasing might not have been worth all of the risk and speculation for us retail investors.

Leave the Speculation to the Professionals

This strategy of chasing yield across a variety of asset classes as the financial economic landscape changes may work out for active investors, but it is not easy. As the example of the emerging market situation above shows, only those investors who were on top of the ever-changing developments came out as winners. Typically, these are the professional and institutional investors who do it for a living.

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For us retail income investors who employ a traditional passive, buy and hold strategy, seeking out high yields in all sorts of asset classes can be a difficult, frustrating, and ultimately losing proposition. Instead, we should stick to that buy and hold strategy of well established dividend paying stocks. Leave the speculation and the active investing to the professionals.

High Yields Can Be Misleading

This all goes to show you that yield isn’t everything when it comes to investments. While it is without a doubt nice to see income from our investments month after month, quarter after quarter, if this income isn’t sustainable, is it worth it? With regards to the emerging markets example above, it was more-or-less the decline of the principal that burned investors. With many high-yield assets, the yields themselves are unsustainable due to a number of factors, like unforeseen quarter-to-quarter fluctuations in earnings. Because of these potential downside risks, investing in high-yield assets might not lead to the gains that one might initially think.