“I can’t remember the last time we reached for yield and it worked out in our favor.”
That was the first thought shared in a recent discussion at our office about the current market environment. All things being equal, investments that pay bigger dividends or higher interest rates sound more attractive. The problem, of course, is that things are almost never equal. There’s a reason certain stocks and bonds offer larger yields than others, and it’s imperative you understand those reasons before making investment decisions.
We understand investors’ desire for more yield. Thanks in large part to historic amounts of bond buying by the Federal Reserve, interest rates have never been lower. When the 10-year U.S. Treasury yields around 0.7%, it’s hard to earn an attractive return on conservative investments.
That said, putting too much emphasis on yield can be dangerous. The benefit of higher yield comes with a trade-off. If a particular bond (or bond fund) has a higher yield than another, you can expect it has either a lower credit quality or longer duration. Greater yield is meant to compensate for that additional risk, but how much more yield one receives depends on market conditions.
The spread between investment-grade bonds and high-yield bonds (those rated “BB” or below) is a helpful tool in this regard. For most of the last three years, that spread has oscillated around 4%. When a global pandemic sent markets into a panic in March, the spread exploded to nearly 11%. At that point, investors willing to accept greater risk of default were compensated generously (11% more interest each year than they could get on higher-quality bonds).
Since then, however, the investment-grade vs. high-yield spread has fallen below 5%, the lowest since late February. It’s true the Fed’s willingness to buy corporate bonds reduces the likelihood of corporate bankruptcies, but the rewards of taking on lower-quality credit are also lower.
Bonds with longer maturities and longer duration, meanwhile, bring more sensitivity to interest rates. If the Fed remains committed to avoiding negative rates, which have proved problematic in Europe and Japan, that will prevent yields from falling much lower. Rates could on the other hand increase significantly when inflation eventually accelerates. Rising rates and longer duration will be a toxic combination for bond investors, and one that leads to losses in what is supposed to be the conservative slice of investment portfolios.
Stocks that pay larger dividends likewise do so for a reason. The payouts are usually offset by lower earnings growth or exposure to distressed market sectors. Lots of stocks carry supersized yields not because cash flows are improving but because their share prices have been crushed. While some companies will bounce back from this recession, others that seem like bargains may never fully recover from the pandemic.
The businesses most capable of adapting and innovating will be the biggest winners in a post-COVID economy. With corporate earnings growth likely to remain suppressed well into 2021, we consider high-quality growth stocks an attractive alternative to dividend payers.
It’s understandable to feel frustrated by low rates and low dividends, but reaching for yield carries more risk than reward.
Ben Marks is chief investment officer at Marks Group Wealth Management in Minnetonka. He can be reached at firstname.lastname@example.org. Brett Angel is a senior wealth adviser at the firm.