Looking for yield in all the wrong places
Every investor is looking for the goose that lays the golden eggs, but these days, they might have to settle for a pigeon.
For income investors who pay their bills with cash flows from their portfolio, finding investments that preserve their principal and pay out enough to cover expenses has been a challenge in the four years since the financial crisis. The sluggish recovery, combined with Federal Reserve efforts to stimulate the economy by pushing down interest rates, has kept yields on investment-grade bonds and other fixed-income investments at minuscule levels.
In fact, it's been two years since the 10-year Treasury constant maturity rate, a key benchmark for bonds, was more than 3 percent, meaning that lending the federal government $100 for 10 years pays a yield of substantially less than $3 annually. Investment-grade bonds aren't paying much more, with the Bank of America Merrill Lynch US Corporate BBB Effective Yield index currently around 4.17 percent after a recent bounce.
Nothing relieved investors' desperation for yield quite like a bond offering from Apple in late April. Investors snapped up the record $17 billion offering, which included $3 billion worth of 30-year bonds paying just 3.85 percent.
There's little doubt that low yields are causing some investors to reach for yield in riskier assets, says Joel Redmond, a senior financial planner for KeyBank.
"When the federal funds rate is at zero or 0.25 percent for years and years and years, people want to make something for tying up their money and lending it, and when they can't get a specific amount or the amount they expect, they tend to modify or maybe even relax their normal attitudes toward risk," Redmond says.
To get that specific yield they seek, fixed-income investors are using three tactics that could come back to haunt them later, says Tom Kersting, an investment strategist for Edward Jones.
Going long with bonds
Buying bonds with extended maturities will earn investors higher yield, but those bonds will likely see their market values fall the most when rates rise, making them a risky play in a time of historically low yields, Kersting says.
"I don't think taking on longer-term bonds in this interest rate environment is the wisest move," Kersting says.
Experimenting with junk bonds
Junk bonds rank below investment-grade bonds, which are typically rated BBB- or higher. Junk bonds carry a greater risk of default, which is when a bond's issuer stops paying the required interest or principal payments to investors. Unfortunately, many investors may overlook that higher default risk, trying to earn the higher yields of yesteryear, Kersting says.
"Five years ago, you could get north of 6 percent for a long-term bond. Today, you're getting 4 percent for that same bond. I understand that that's tough for investors, but you can't go trying to replace that 6 percent with another 6 percent bond. To do it, you have to take substantially more risk -- default risk, credit risk -- and go with a longer maturity," he says.
Default risk is the scenario under which investors can't make payments on their debt obligations. Similarly, credit risk is the potential loss of principal on an investment. Theoretically, the greater the credit risk, the higher the potential return.