The Yield Dilemma

Editor’s Note: Each year in our summer issue, we ask a group of the region’s leading wealth managers to help our readers navigate financial waters by responding to a question. This year, the question is: Many investors are hungry for yield as the Federal Reserve has kept interest rates very low; what strategies can investors consider that won’t expose them to undue risk?

James Armstrong
Henry H. Armstrong Associates

Unfortunately, the yield and prices in today’s bond market are a carbon copy of the Internet bubble of 1999— a gigantic accident waiting to happen. When the Federal Reserve ceases its artificial measures to keep interest rates low, unsuspecting bond investors will lose a lot of money—especially if they have “reached” for yield with bonds that mature in 10, 20 or 30 years. We believe that the safest way to achieve a decent yield today is through the purchase of very-high-quality stocks, which now pay dividends higher than 10- or 20-year Treasury bonds. In addition, certain companies are likely to increase their dividends steadily in the future, providing some protection against inflation and rising rates.

Donald Belt
Hefren-Tillotson

Investors should approach the generation of investment income using a diversified approach that looks beyond traditional sources and includes areas such as international dividend paying stocks, Master Limited Partnerships (natural gas pipelines), floating rate strategies, non-core bond strategies, and U.S. blue chips with a history of growing dividends. Together, these strategies can boost return potential and current income, while offering a longer-term hedge against the risks of rising interest rates and inflation. These strategies should complement traditional bond allocations through which the use of individual bonds can mitigate interest rate risks if bonds are held through maturity. The use of individual issues can be a particularly effective strategy with municipal bonds, which continue to offer competitive tax-equivalent yields.

Carrie Coghill
Coghill Investment Strategies

Conservative investors may want to consider Series “I” Savings Bonds (I Bonds). I Bonds offer a fixed interest rate, plus an inflation-linked rate based upon changes in the consumer price index. Currently, the fixed rate is zero percent and the semi-annual CPI rate is 0.88 percent. This equates to an annualized rate of 1.76 percent. One of the advantages of I Bonds is that the interest rate has the ability to increase as inflation rises, thereby, preserving purchasing power. Interest rate adjustments are made every six months. This is a significant advantage considering that the current interest rate on a five-year CD is averaging 1.21 percent (as of 4/1/13), with no protection against inflation or rising interest rates. After one year, I Bonds can be redeemed with a modest penalty of three months interest.

Greg Curtis
Greycourt & Co.

Conditions of “financial repression” (when central bankers are keeping cash and bond yields artificially low) are rare, but they can be excruciating for income-oriented investors. Many investors are tempted to “reach for yield” by extending duration (buying longer bonds), going down in credit (buying “junk” bonds), or taking currency risk (buying non-US bonds). But when rates finally rise, the principal loss on these investments may far outweigh the income they have provided. If you don’t absolutely need the income now, you should avoid these risks. If you need the income, try this: during 2013, buy high-quality junk (BB or better); in 2014 divide your bonds between high-quality junk and bank debt; in 2015 go back to investment grade bonds.

Linda Duessel
Federated Investors

Wer’re in an unusual period of financial repression with rates being artificially held down by central bankers. This creates two problems: low Treasury yields that punish savers; and over time, inflation caused by all this printing of money. Inflation will eat away at any returns on these paltry Treasuries. Studies show investors can’t imagine they’ll lose money on Treasuries, nor do they appreciate the losses they are exposed to when rates rise. So what is the yield-hungry, risk-averse investor to do? Diversify into high-quality dividend-paying stocks, corporate debt securities and emerging-market bonds. These may push you out of the risk spectrum, but diversification dilutes that risk. Marrying that with an advisor and professional money manager capable of adjusting allocations as conditions change helps further reduce risk.

Robert Fragasso
Fragasso Financial

Yield from fixed income securities is low and not expected to rise soon. Even if we earn interest at historic 5 percent levels, we then pay taxes and suffer inflation, which has averaged 4 percent—so we are doomed to eat our principal. Principal spent now doesn’t earn income tomorrow, so we spend more principal. We spend as much in retirement as before, plus some for special things like travel. So we must earn a rate of return above the combined rate of taxation and inflation to protect investment principal during retirement. Investors should utilize all appropriate investment sectors and consider their goals, time frame, tax bracket, risk tolerance and family responsibility. Evaluate, using a professional advisor, what portfolio of fixed income and growth investments is needed for sufficient income, and to help offset taxes and inflation. The time to begin this evaluative process is now, because today is the first day of the rest of your life.

Mark Luschini
Janney Montgomery Scott

In the fixed income investment space, everything traditionally considered safe—CDs, money market funds and short-term treasury bonds, currently pays close to zero percent interest. To get any yield you must take some risk. We now see opportunity in at least three areas of fixed income. The first is in floating rate bond funds, the second is in non-agency mortgage-backed funds, and the third is in selected areas of the municipal bond market. The first two are not commonly understood investments, and you should talk with an investment professional about what risks you are taking to get the additional yield of 3-4 percent on these products. The benefits of the municipal bonds will vary based on your tax bracket and ability to use the federal tax exemption, but again this also involves more risk.

Bob Kopf
Smithfield Trust Company

Pittsburgh Quarterly’s excellent inquiry about how to find yield in a low interest rate environment without “undue risk” surely resonates with many. The key word here is “undue.” In our view there is no viable strategy to meet this objective. Strategies employed by many managers create too much risk. The purchase of bonds with long maturities saddles one with inevitable erosion of principal when inflation returns, as it will. The acquisition of higher yielding emerging market bonds carries its own risk. How are those Greek bonds working? The substitution of high dividend stocks for bonds, now in vogue, ignores inherent equity risk. With an asset allocation involving fixed income securities, keep your maturities short and move into higher yield domestic bonds later.

Jack Kraus
Allegheny Financial Group

Investors have few options. The best thing investors can do is a segmentation analysis of the cash-flow needs and design a smart portfolio around that analysis. The first bucket is what is needed in the next 12 months. The next buckets would be what is needed in 24-36 months, then 36-60 months and lastly over 60 months. The 12-month bucket needs to include cash-type assets like money markets. The second bucket could venture into short-term bonds or laddered CDs. The 36-60 month bucket could be intermediate bonds or adding to the CD ladder. The 60+-month bucket could be in aggressive bond strategies like multi-sector or high yield or dividend-oriented equities.

Mark Luschini
Janney Montgomery Scott

Most high quality bonds today offer yields that barely match or exceed inflation. Even fixed income securities other than Treasury bonds, such as corporate and municipal issues, are only modestly higher. For investors seeking income, bonds may still play a role, but a choice such as dividend-paying stocks seems to offer greater appeal. Many companies with strong balance sheets have a long history of paying dividends, and produce the cash flow to continue to support that policy going forward. Even more attractive for consideration, though, are the same companies that also feature the propensity to raise their dividend regularly. For the investor, a company that provides a dividend yield that may be higher than the coupon on its own debt, and holds the potential to increase that income steam, allowing the shareholder to maintain purchasing power against the ravages of inflation, is a powerful elixir. l

Peter Mathieson
Fairview Capital

Investors seeking yield today need to be cautious. High-quality government, agency and corporate debt provide very little return relative to sizable downside capital risk. We have added both diversification and risk to client portfolios through the use of selective index ETFs (Exchange Traded Funds). We are using funds tied to the Alerian MLP index on the equity side, and funds tied to emerging market and high yield bonds on the fixed income side. We strongly believe that providing clients a steady growth of income is more important than providing a high current yield. Our best advice for long-term investors is to hold a diversified portfolio of quality blue-chip multinational companies. By example, we project a $1 million aggregate investment in three representative stocks (Johnson and Johnson, Sysco and Intel) will generate over $300,000 more income over the next decade than owning the 10-year Treasury.

Brian McInerney
Staley Capital Advisers

By maintaining interest levels at below the inflation rate, the Fed is purposefully transferring wealth from savers to borrowers. Savers (investors) should remain disciplined and not lose sight of their time horizon or risk tolerance. Within fixed income, the risk-return profile is not favorable. We would recommend that investors, rather than reaching for yield, suffer the low returns of short maturity bonds in anticipation of future re-investment opportunities. Many income alternatives, such as REITs, have attracted investment and generally do not now appear to offer value. As we suggested last year, we would own high quality multi-national companies returning capital to shareholders through dividends and share buybacks. Industry diversification is very important as traditionally safer sectors, such as consumer staples and utilities, seem rich at this time.

Christopher S. McMahon
McMahon Financial

We cannot stress enough that an investment in high-yield bonds carries credit risk, but due to high levels of current market transparency, low implied market volatility and wide relative spreads, these risks are not unmanageable for a period of time looking forward. Investors should always work closely with their advisor to align individual goals with accepting market risk. In a diversified portfolio, do not ignore high-yield bond investing, even at historically low interest rates, as spreads are actually at fairly wide levels. To analyze potential investments, use relative value techniques and normalization of return techniques to help drill down and make decisions that fit your investment policy statement. Work closely with your advisor to determine suitability and diversification of your investments.

Kevin Miller
Northwestern Mutual

Northwestern Mutual’s 2013 Planning & Progress study shows that 23 percent of Americans want to be more cautious with their money but feel they have too much catching up to do. Bottom line, if your money isn’t growing in the market, it’s essential to save more and protect it. Financial security means growing, managing and protecting your assets, and this all starts with a comprehensive plan that’s built for the long term. No single product can meet every financial need. Beyond well-diversified investments, as part of a comprehensive plan, consider: permanent life insurance, an asset that’s guaranteed to grow over time, tax deferred and flexible—the ultimate emergency fund; disability insurance to help protect your income from the unexpected; annuities to help provide a consistent paycheck for life; and long-term care insurance to help protect your nest egg from a long-term care event.

Stuart Miller
Private Wealth Advisors

A portfolio of large U.S. stocks, (e.g., the S&P 500, or SPY) has recently yielded approximately 2 percent; high dividend paying U.S. stocks e.g. (DLN) recently yielded 2.5-3.0 percent. Expect short-term volatility. However over five years, investor should see growth in addition to the yield. Senior secured floating rate bonds (there are many mutual funds available) yield approximately 4 percent. Do not be lured by higher yields than this; they have greater risk. If you can buy quality real estate and finance at these low mortgage rates, you can get yields of 7-10 percent. This strategy fits on top of the stock and bond portfolio and has the greatest risk and the least liquidity.

Ron Muhlenkamp
Muhlenkamp and Company

The Federal Reserve has purposely driven interest rates below the level of inflation. It’s actively buying bonds and mortgage-backed securities, driving prices up and interest rates down. As a result, you can’t get decent yields on bonds, which are above the status of junk. This has driven investors to other “income” securities, including REITS, royalty trusts, utilities, etc., driving their prices up and yields down. Some brokers are now recommending securities based on a “payout” which is unsustainable and (even worse) calling it “yield.” We prefer the stocks of well-run, top-quality companies with price-to-earnings ratios below 14 and dividend yields of 3-6 percent. Most importantly, be sure you know how the dividend or interest payment is being earned and whether it’s sustainable.

Jeff Wagner
F.N.B Wealth Management

Fixed income investing carries dual risks: default risk and interest rate risk. Investors who have been searching for yield may have already increased their exposure to both of the above risks without having a sense of the magnitude of their decisions. We believe that now is the time to analyze fixed income portfolios to determine the current level of these risks before stretching further to increase yield. The best approach to control risk is viewing the portfolio on a total return basis. In this process both income and growth are utilized to fund spending needs. This allows allocations to shift to the lower end of an investor’s fixed income range while increasing exposure to income-producing equities and alternative strategies such as market-neutral investments.

Tom Wentling
UBS Financial Services

An income strategy will be effective primarily as a result of your success or failure in predicting inflation or deflation over time. The least likely scenario—an indefinite continuation of the current environment—argues for a balanced portfolio of high-dividend global equities and fixed income. Accelerating inflation would lower the present value of both stocks and bonds, so some diversified hard assets would be essential in the portfolio. Deflation (think Japan) raises the present value of non-callable bonds (Treasuries) and anything else that pays a reliable income stream. Reliability, however, is the rub, as business activity shifts into low gear, casting doubt upon the cash flow. It’s possible we may see a slow grinding up of inflation, which will require diversification into non-traditional asset classes.

Erich Smith
BNY Mellon

BNY Mellon conducts thorough risk audits on the portfolios of potential clients to surface opportunities and to help identify hidden risks that they didn’t realize they had. In the wake of the financial crisis, many investors moved to asset classes they considered historically safe. We believe, however, that there is a cost for that perceived safety. While a long-term approach to asset allocation and investment strategy is still critical, the risks and opportunities in this environment require a more nimble approach to investing. We counsel our clients to take advantage of short-term disconnects between and within asset classes. While that creates both opportunities and risks, we believe the ability to take advantage of market inefficiencies will be critical.