Managing Risk & Being Careful While Doing Something Fundamentally Foolish
As old CDs, treasuries and similar very low risk investments continue to mature, one can hear the groans from investors and savers everywhere at the prospect of extremely low rates being offered on new bonds and CDs. In many cases, investors and savers are finding that the rates offered are so low that they cannot accept such low rates and still meet their minimum return required. This problem does not appear to be going away any time soon as central banks all over the world continue to do their utmost to keep rates on safe instruments very, very low. Those who refuse to accept current rates offered on low risk bonds and CDs will continue to have the same quandary for the foreseeable future: what do you do with the money? Many will choose to throw caution to the wind and adopt a strategy that has been the source of untold sums of lost money, chasing yield. This is a dangerous environment in which to do so because lots of people are doing the same thing. As a handy indicator, junk bond funds have been attracting enormous amounts of cash even as yields stay low and Vanguard recently decided to close its junk bond mutual fund to new money after being flooded with cash. Yet many people will chase yield anyway since some are effectively forced to do so due to needing higher returns than they can get from safe instruments. If you choose to chase yield, how can one manage the risk that inevitably arises from this strategy? How does a sensible person add some yield in a judicious fashion?
First and foremost, anyone chasing yield should be very honest with themselves about risk. If you start chasing yield and moving away from the very safest investment options, you will be taking more risk and the chance that you will lose money (principal) will increase materially. Time for a gut check: are you willing to risk losing money to boost yields? Can you afford to lose a chunk of principal in the event that one or more of your investments does not perform well? How much are you willing and able to lose? These are critically important questions you should have clear, honest answers for. Too many people simply start buying whatever yields the number they have in mind without a thoughtful consideration of the risk they can stomach. This usually ends poorly.
Once you have determined how much risk you are willing to take (and the answer may well be zero), you next need to do a bit of navel-gazing about the returns you require. How much do you really need to earn? The answer probably has a lot to do with what the money is intended for. If you are living off of portfolio income, you probably have a clear idea of how much money you need to earn in order to cover your expenses. If you are saving for a specific goal (college fund, retirement, major purchase, etc.), you likely have an idea of what return you need to make in order to meet your goal. If you don't know how much you need to make to meet your goals, then it is time to break out a spreadsheet and spend some thoughtful time figuring out where you are, where you are headed and how you plan to get there. Whatever your return goal, make sure you use that number as a means to discipline yourself from reaching too far for yield. The higher the stated yield, the greater the risk. If you need 6%, don't get seduced into thinking 9% is that much better. Chances are you will be taking a vastly increased amount of risk that ultimately isn't necessary to meet your goals.
Next, you will have to decide where you want to chase yield and how far you wish to spread your bets. There are several types of investments that offer higher yields and you may wish to diversify a bit to try to reduce risk. The downside of diversification is that with every additional investment there is more to watch, keep track of, make decisions about, and make mistakes with. Still, spreading your yield chasing capital around to as many as 6 different types of cashflowing types of assets should be easy enough to keep track of.
So where will you get yield from? There are a number of "usual suspects" when investors chase yield and all of them have been getting bid up as more and more people throw money at anything with a generous yield (caveat emptor). Below is a description of some of the most common choices along with a brief description of the risks involved:
- Mortgage REITS: There are a number of these, with one of the largest and oldest being Annaly (ticker NLY). These investment vehicles typically offer eye-popping yields (in the teens) which have attracted many investors. They make money by using investors' capital to buy government backed (and other) mortgage backed securities and they typically use significant leverage (commonly borrowing 5 to 10 times their equity). This works fine as long as interest rates stay level or drift lower, but if they start rising again mortgage REITs will get hurt badly in short order.
- Junk Bonds: I have detailed the risks, rewards and how-tos of this asset class here http://lifeinvestmentseverything.blogspot.com/2012/01/dumpster-diving-in-junk-bond-market.html in brief, junk gets you lots of credit risk, relatively little interest rate risk, and at the moment is offering 6 to 10% yields depending on the "junkiness" of what you buy.
- Bank Loan Funds: Bank loan funds resemble junk bond funds in many respects an in fact may include credit exposures to some of the same obligors. However, loans have even less interest rate risk than bonds and tend to fare somewhat better in the event that the creditor defaults owing to loans' higher position in the capital structure of most junky borrowers. The trade-off is that yields tend to be lower, generally in the 3 to 7% range.
- BDCs: Business development companies, or BDCs, are somewhat leveraged investment vehicles which lend money to and sometimes take equity stakes in smaller companies. They are publicly traded (see AINV, TWO, etc.) and usually have generous (10+%) stated yields. Unfortunately, it is difficult to ascertain the health of the underlying companies which the BDC has lent money to or bought part of, so the sustainability of these hefty payouts can be tough to judge. These vehicles generally have ample credit risk which is magnified by the use of leverage. BDCs tend to get badly hurt in economic downturns.
- Preferred Stocks: Preferred stocks are oddball securities that have features of both bonds and equities. They typically have a fixed payout/coupon, a stated par amount and are callable much like a bond, yet the payout is considered a dividend (and can be cut) and most preferreds trade on an exchange like any common equity. While preferreds usually offer yields north of 5%, they have a lot of interest rate risk and can be called away just as the yield they offers moves above market. Preferreds also have greater credit risk than senior unsecured bonds issued by the same obligor. A great source of data on preferred stocks is http://www.quantumonline.com/
- Closed End Funds: Closed end funds include a wide variety of asset classes, ranging from equities to municipal bonds to more esoteric strategies such as covered call funds. I have detailed how to evaluate closed end funds in detail here http://lifeinvestmentseverything.blogspot.com/2012/01/how-to-buy-dollar-for-90-cents.html
- Commodity Futures Funds: Commodity futures funds (such as PCRDX) aren't really a traditional yield vehicle, but because they must pay out income and short term gains and sometimes do so at eye-popping stated yields people do buy them for yield. In general, I would suggest that commodity futures funds are a poor choice when seeking yield, although they have other merits (such as hedging inflation risk).
Finally, let me again underscore the fact that chasing yield is a dangerous thing to do and I don't recommend it, especially for conservative investors and savers. If you can at all afford to do so, stick with your chosen asset allocation and leave the "safe" money in the lowest risk places (CDs, treasuries, etc.). The above detail is provided for those who choose to take the significant risk that comes with chasing yield or cannot meet their goals with the yields offered on low risk vehicles and are forced to take these risks.
Please consult your advisor. The above is not intended as investment advice. These are all risky investments and you can (and probably will at some point) lose money with them. Be careful.