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THE BUY SIDE / INCOME GENERATION

Don't let your search for yield blind you to risk

Headshot of Tom Bradley

Tom Bradley is president of Steadyhand Investment Funds. tbradley@steadyhand.com

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There's no question about it. The defining feature of the capital markets right now is the search for more yield. Individuals are doing it. Institutions are doing it. And new product development is totally focused on it.

I get an e-mail almost every day announcing a new fund with income in the name. I'm trying to convince my partners that we need to come out with a product that has it all - the Steadyhand Enhanced Global High Yield and Growing Dividend Weekly Income Fund, or SEGHYGDWIF for short.

Before I discuss some issues around yield seeking, it's useful to pull back and look at what's happening here.

With low-risk securities yielding next to nothing, investors are moving up the risk scale. Instead of a guaranteed investment certificate that yields 3 per cent, they're buying Brookfield bonds, BCE preferreds or BMO shares that yield 5 to 6 per cent. This is an asset mix shift that brings with it credit risk - the risk that the issuer of the bond or preferred can't make the payments - and equity risk. Trusts, real estate investment trusts and dividend-paying stocks all have the potential to go down in price.

Holding a diversified portfolio decreases the chance that a default or stock market decline will meaningfully affect long-term returns, but it still brings with it more volatility. For investors in the accumulation phase, volatility is not a risk, but rather an opportunity - when stocks are down, they can buy more. For investors living off their portfolio, however, it's a different matter. Making withdrawals when markets are down means eating into capital, which leaves a smaller asset base to ride back up with and generate future income.

In most cases, "reaching for yield" is appropriate and works out well, but the expression always makes me uneasy.

That's because the risks attached to "reaching" are not always obvious and tend to creep up on investors. If income is flowing and the strategy is working, they don't see the risk. They only know it's there when things stops working. A few years ago when fixed-income investors shifted from bonds to income trusts, they were ecstatic about the extra income until they ran into distribution cuts and price drops.

Also, when there's a lot of reaching going on, it usually means that high-yielding securities are getting overpriced. Again, the early trust market was an example of this. These securities were getting priced off their yield - the higher the better - with little regard to what the underlying businesses were worth.

So when you go on a yield-seeking mission, there are a few things to consider.

First off, it's likely that fixed-income returns are going to be lower going forward. If your portfolio isn't providing enough income, taking more risk may be a viable option, but learning to live on less has to be the first priority.

Secondly, we have just had a "once-in-a-career" run in the credit market and as a result, it's harder to find value in corporate bonds today. There is still extra yield to be gained by owning corporate over government bonds, but you have to ask yourself two things: Is the spread wide enough to justify the added risk? And is the basis of the spread calculation fairly valued? If you believe that Canada bond yields are artificially low as a result of problems in the U.S., then the spread is not as generous as it appears.

Thirdly, money managers who took full advantage of the opportunities in 2009 have gaudy numbers to advertise, but they can't keep it up. Our Income Fund, which has a diversified mix of income securities, was up 22.5 per cent last year. But with lower bond and stock yields, and recent cuts to the high-yield bond allocation, it's now yielding less than 5 per cent (pre-fee). Even with favourable markets, there is no potential for our manager, Connor Clark & Lunn, to replicate the 2009 return in the coming years. Suffice to say, if products are making promises based on last year, it's best to steer clear.

And finally, when taking more risk is appropriate to meet your investment needs, it shouldn't be done by searching for yield to the exclusion of other strategies. There are many ways to generate an income. It doesn't have to come from a coupon payment or monthly distribution, especially if high-yielding securities are poor value. An alternative is to combine a short-term savings product with a portfolio of high-quality stocks. High-interest bank accounts are being used as loss leaders, so they can be of reasonable value at times. And there are still lots of low-yielding stocks that are underpriced. With one or more years of cash needs parked in savings, the investor is liberated from owning just high-yielding securities to enhance returns.

As the old saying goes, "More money has been lost reaching for yield than at the point of a gun." Income-oriented securities are no different than other types of investments. The price has to make sense, no matter how great the need.

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