To help prevent the next Great Depression, in 2008, the Federal Reserve increased the “price” of avoiding risk.
Fearful investors seek the safety of Treasury bonds (as well as government agency bonds and FDIC-insured CDs). When they do so, they forgo the risk premiums available from non-Treasury debt and equity investments. Driving the rates on Treasury bills to virtually zero led many investors who rely on a “cash flow approach” to investing to frantically search for higher yields.
Higher bond yields can be achieved in two ways. The first is to take incremental maturity risk, which would increase the volatility of the portfolio and subject you to increased risk of unexpected inflation. The second is to take incremental credit risk.
Another way to increase yield is in equity investments, such as stocks with a high dividend yield, real estate investment trusts (REITs) and master limited partnerships (MLPs). This route was the one chosen by many.
All three strategies are in conflict with the main role of fixed-income assets in portfolios—to reduce the overall level of portfolio risk to an acceptable level, allowing you to hold the amount of equities that is appropriate given your ability, willingness and need to take risk. Therefore, fixed-income instruments should be limited to only those of the highest investment grade.
Investors Fail To Learn Market Lessons
Spanish philosopher George Santayana famously proclaimed: “Those who do not remember the past are condemned to repeat it.” Unfortunately, far too many investors have short memories, forgetting the lessons the market has repeatedly provided, and as recently as 2008. Investing in risky high-yield assets works until it doesn’t!
It stops working when equity markets fall, exactly when the safety of high-quality bonds is needed most. Investors in such “alternative” fixed-income investments—such as high-yield bonds, convertible bonds, emerging market bonds, preferred stocks, MLPs and stocks with high dividend yields—all suffered large losses in 2008.
A few municipal bond funds even lost more than 40% in 2008, including Oppenheimer’s Rochester High Yield Municipal Fund (ORNAX), which lost 48.9%. Oppenheimer’s Total Return Bond Fund (OPIGX), which investors presumably used as a core bond holding, lost nearly 36%. And that return looks great compared to the loss of more than 78% for Oppenheimer’s High Yield Champion Income Fund (OPCHX).
Stretching For Yield Comes With A Price
Investors who stretched for yield paid a severe price. Following are other examples of the returns to higher-yielding investments in 2008: the Vanguard Real Estate Index Fund ETF (VNQ) lost 37.0%; Vanguard’s Convertible Securities Fund (VCVSX) lost 29.8%; the Vanguard High Dividend Yield Index Fund (VHDYX) lost 32.5%; the JPMorgan Emerging Markets Debt Fund (JEDAX) lost 29.0%; MLPslost 36.9%%; and the iShares US Preferred Stock ETF (PFF) lost 23.9%.
While all these risky investments were experiencing large losses, Vanguard’s Intermediate-Term Treasury Fund (VFITX) returned 13.3% and Baird’s Quality Intermediate Municipal Bond Fund Class (BMBIX) returned 6.4%. While these high-quality fixed-income assets were helping to dampen the losses created by a portfolio’s equity holdings, the other risky assets were contributing to the problem. In addition, investors in high-quality assets were able to rebalance, selling some of their high-quality bond holdings at higher prices in order to buy riskier assets at lower prices (and then benefited more from their eventual rebound).
Key Lessons From 2018
Investors should learn two lessons from the experience of 2008. The first is to never confuse yield with return. The second is that credit risk is correlated to equity risk—when the risks to equities show up, credit risk tends to rear its ugly head.
Thus, credit risk and equity risk don’t mix well in a portfolio. That is why I recommend limiting fixed-income investments to only Treasuries, government agency debt, FDIC-insured CDs and the highest-investment-grade municipal bonds (AAA/AA that are general obligation or essential service revenue bonds).
A column I wrote in November 2018 provided the evidence to support the recommendation to avoid corporate credit risk because there are superior alternatives (such as certificates of deposit, CDs). However, if you are going to take corporate credit risk, limit it to only high-investment-grade and short-term bonds. Investors who did so avoided the severe losses many experienced in 2008.
Don’t Repeat The Mistakes
If you made the past mistake of stretching for yield because safe investments offered low returns that did not allow you to meet your spending objectives or needs, remember that, while smart people make mistakes, they don’t repeat them.
Using the total return approach, which I recommend instead of a cash flow approach, can help you avoid the mistake of stretching for yield. It’s also the approach that Vanguard’s Investment Counseling & Research team recommended in its 2007 paper written by Colleen Jaconetti, “Spending From a Portfolio: Implications from a Total-Return Approach Versus an Income Approach for Taxable Investors.”
Total Return Approach
To meet their spending needs, retirees generally take one of two approaches. The first is to limit spending to the cash flow generated by the portfolio—the interest income from their bonds and the dividends from their stocks. The second is a total return approach, which not only uses the cash flow generated from the portfolio, but considers the sale of financial assets when the cash flow falls short of spending needs.
It is important to note, however, that under the total return approach, the income generated by the portfolio (from interest and dividends) is the first source tapped to meet spending needs. Only when this is insufficient does the investor liquidate some holdings.
Thus, when the total portfolio cash flow is equal to or greater than the annual spending requirement, the total return approach is the same as the income approach. That said, there are three main reasons the total return approach is recommended.
3 Reasons To Consider
First, the main benefit of the cash flow approach is that you won’t run out of money if you limit spending to an amount that doesn’t exceed what your portfolio generates. However, you won’t live forever, and you can’t take your accumulated assets with you. There is even the chance that you won’t reach your life expectancy.
The time value of money assumes a dollar in the present is worth more than a dollar in the future. Thus, limiting spending to cash flow means you’re spending less today than you could using a prudent withdrawal strategy determined by the outcome from a Monte Carlo simulation. I want you to be able to spend as much as is prudently possible so that you can enjoy your retirement.
Second, dividends (and interest) are less tax efficient than capital gains realized when selling assets to generate cash flow. While the full amount of a dividend and interest is taxed, only the gain from sales proceeds is taxed. And if the sale is a loss, you can take a deduction.
Third, when interest rates are low (as has been the case since 2008), investors who purchase higher-yielding assets (such as the ones discussed above) allow their need to take risk to dominate the asset allocation decision, while ignoring—or not providing sufficient consideration to—their ability and willingness to take risk.
Gut Decisions Are Bad Decisions
This can be the greatest mistake investors make, as bear markets can cause the stomach to take over the decision-making process from the head. And I’ve yet to meet a stomach that makes good decisions.
While the cash flow approach may provide more income, it can lead to taking on considerably more risk, because higher-yielding assets have risks that tend to show up at exactly the wrong time—when equities are also doing poorly.
In addition, dividends are not necessarily safe—many companies cut, or even eliminated, dividends during the 2008-2009 financial crisis, and as a more recent example, General Electric cut its dividend to $0.01 in October 2018—and risky corporate credits can default, doing permanent damage to the ability of the portfolio to generate cash flow. These risks increase the odds of outliving financial assets.
Impact Of Dividends On Returns
My new book, co-authored with Kevin Grogan, “Your Complete Guide to a Successful & Secure Retirement,” contains the appendix “Should Investors Prefer Dividend-Paying Stocks?” It covers the financial theory on dividends and their impact on returns, the historical evidence and behavioral finance’s explanations for why investors prefer dividends despite the evidence and logic against having such a preference.
Finally, as readers of my books and blogs have learned, if you need or want to take more risk in search of higher returns, the most efficient way to achieve that objective is to increase your allocation to either stocks in general or to riskier small, value and emerging market stocks—not by stretching for yield.
For investors who have used the cash flow approach that resulted in an increased allocation to risky assets, keep in mind that there are many others like you. Those higher-yielding assets became what are referred to as “crowded trades” (many investors using the same strategy) that caused large losses during reversals.
Given that we have seen a sharp drop in stocks for more than the past two months, and now that five-year CDs are yielding about 3.5%, it wouldn’t be a surprise to see those same cash flow investors retreat to safer assets. And that could lead to a rout in riskier assets.
In fact, it might be one of the causes for the recent sharp drop in equity prices—along with signs of a slowing U.S. economy (such as slowing housing and auto sales), the yield curve inversion, concerns over more interest rate increases, the Fed’s unwinding of its balance sheet, reduced investment due to concerns about tariffs, the possibility of a full-scale trade war with China, uncertainty about government spending and budget deficits, the possibility of a shutdown of the government in December and, with the 2020 election, even the possibility of unwinding the recent tax cuts (which would hit corporate profits hard).
Successful investors know that they should never take more risk than they have the ability, willingness and need to take, and that they must have the discipline to stick to their well-developed plan. This is the most important lesson for investors.
As my October 2018 column discussed, successful investors are always prepared for the next bear market and the losses that accompany them. They know that those who are not are likely to panic and sell, a mistake from which it is often impossible to recover.
Legendary investor Warren Buffett warned investors against the dangers of market timing. And he added this warning to investors: “If they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.” Forewarned is forearmed.
(Full disclosure: My firm recommends Treasuries, government agency debt, FDIC-insured CDs and high-investment-grade AAA/AA municipal bonds that are general obligation or essential service revenue bonds in the construction of client portfolios.)
Larry Swedroe is the director of research for The BAM Alliance.
This commentary originally appeared December 26, 2018 on ETF.com.
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