Evaluating the Risks and Rewards of Chasing Yield
Exencial Wealth Advisors
Exencial is a leading independent wealth management firm providing leadership to our clients.
By Tim Courtney , Chief Investment Officer
For about a decade, from 2009 to 2021, the topic of investing for yield went through a relatively quiet period. Investors who were looking for yield didn’t go away, but because the Federal Reserve (Fed) kept closely watched rates almost continuously at zero and actively purchased bonds, yields on cash and bonds were quite low.1 It was very difficult to generate a positive return in investments like money markets, CDs and short-term bonds after accounting for inflation and taxes.2 These low rates also put downward pressure on yields in other markets such as stocks and real estate.
It wasn’t until 2022 and 2023, when interest rates began to rise, that we started seeing cash accounts and bonds offering meaningful yields again. In October 2023, the 10-year Treasury yield topped 5%, an impressive yield for recent times but still 0.8% lower than the average rate for those Treasuries since 1962.3 This shift brought yield back into focus and renewed investor interest (both kinds). It’s important though for us to determine if yield is itself a goal we should be striving to achieve.
There are a few primary reasons yield appeals to investors. First, there is comfort and familiarity in receiving regular payments. It resembles the predictability of a paycheck, something we spend much of our lives working to produce. There’s also the philosophy of “a bird in the hand is worth two in the bush” and the preference for taking income today rather than accepting a potentially higher but uncertain level of income later. Not least, consider that the whole reason we own investment assets is to generate cash flow, or yield, to meet our goals.
While we want yield, or cash flows, to help us meet our goals, there is a risk in focusing on generating high current yields. Investors seeking much higher yields than what’s available in broad equity and bond markets often end up in narrow (REITs, MLPs, BDCs) or troubled (companies desperate to obtain capital) segments of the market. Because of this, many investors who believe they are taking on less risk by “locking in” a current high yield actually accept much greater amounts of concentration risk and default risk. High-yield investments are also often tax-inefficient if held in taxable accounts.4 Income from these investments may generate a substantial tax bill, even if the income isn’t immediately needed.
The fact is that yields in the 5%+ range today are rarer and often are associated with higher risks. As the Fed has favored lower rates and corporate management has decided that lower dividends are preferable (tax efficiency5, reinvestment opportunities) to higher ones, market yields have fallen.6
In the current market environment, building a diversified portfolio with a yield of 5% to 7% is no longer realistic. A diversified portfolio that better balances risks will average a yield closer to 2% to 3.5% from equities and 3.5% to 5% from bonds.
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All things being equal, as investors we would prefer higher yields to lower ones. However, it is still possible to construct a functional and diversified portfolio that meets most needs with current market yield levels without having to reach into odd corners of the market for higher yield. If you have any questions, please reach out to your Exencial advisor. Please share your thoughts on the hunt for yield in the comments section below!
Sources
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The 10 Yr U.S. Treasury is a debt obligation issued by the U.S. government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate every six months and pays the face value to the holder at maturity. This index is not available for direct investment; however 10 Yr U.S. Treasuries can be purchased individually.
The S&P 500® Index (S&P 500®) is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.