Regard risk in reach for investment yield
Kyle Tetting: Kendall, with the persistence of low interest rates, it seems only natural that investors might be looking for ways to get a little more yield out of their portfolio. We talk about the idea of yield, but maybe give me a little background on what builds into this idea.
Kendall Bauer: I think first, start with the easy definition of what yield is. An easy way to think about it is simply the earnings or income generated on an investment or account over a particular period of time — whether that’s the interest on CDs or bonds or even the dividends paid by stocks.
Kyle: So let’s focus for a second on that interest component of yield. And in particular, I’m struck by this idea that so many investors want to look for an opportunity to go from maybe some of those less risky areas, the savings accounts or CDs, where they’re not getting much in terms of return, not getting much in terms of interest, and moving into some of those areas that may be perceived as a little more risky.
How do you see investors trying to find ways to get more interest in their portfolio?
Kendall: I think oftentimes when we look at the total portfolio and percentage of stocks and bonds, people see bond rates maybe less appealing than what they’re getting on the stock side of things. So they’re looking to reach for yield when maybe it’s not best strategy for them, based on their investment objectives. I think you have to be careful when you’re looking to reach for yield in a low interest rate environment that we are in. It may be tempting to try to go for something below investment grade, a little farther out on the time spectrum, but you really expose yourself to more risk, in the event that interest rates rise.
Kyle: So let’s talk about that interest rate issue. We have this tool called duration that measures the kind of bond price response to movements in interest rates. And we know that bond prices and rates move inversely. So, if in a normal environment you can get paid a little more interest to invest further out, to take the time risk, there’s a tendency for investors to do that. But obviously that’s one component. The other is credit quality. And we see investors often asking, “Could I reach for a little lower quality bond to try to get a little more interest?”
Kendall: I think, when talking about credit quality, look back at last year as an example of why it made sense to be in short-term or even medium-term, but high-quality bond funds.
When money ran from the stock market last March, it didn’t run to below-investment-grade long-term bonds. It ran to short-term high-quality U.S. Treasurys, and that drove up the prices of those bonds that clients held. So it’s important not to overreach into long-term below-investment-grade bonds but to have that balance that fits what your individual investment objectives are.
Kyle: And I think the risk, of course, for those lower quality bonds is that the corporations that are paying that interest don’t survive in an event like we saw with the pandemic. And I think that’s the fear, that’s the reason why people have focused on some higher quality, but it also speaks to the role that bonds play in our portfolio.
Kendall: Bonds are your safe money. When you’re looking at building a properly balanced well-diversified portfolio, you want to take your risk on the stock side of the portfolio.
The bonds are there as your safety net. Like last year, when the stock market has a correction, it gives you a place to take withdrawals from. Many investors or clients that are in retirement and that count on the income from their portfolio, it gives them the safety net to draw and let the stock side of their portfolio recover, in the event we have a correction.
Kyle: And so if it doesn’t maybe make sense to take risk in bonds at certain times, how should we think about return within our portfolio, if not to look at the income that it can produce?
Kendall: I think you need to take a step back and look at the total return.
So you need to look at yield, but there’s often an overlooked second component to that, being price appreciation. And given that we’re in a low interest rate environment, price appreciation has been the driving factor for many clients’ returns over the last 10 years or so, being that interest rates have been so low. So, often yield gets the focus and people want to hone in on that, but it pays to take a step back and look at the total equation, being yield and price appreciation.
Kyle: Kendall, thank you so much for joining us.
Kendall: My pleasure.
Kendall Bauer is an investment advisor at Landaas & Company.
Kyle Tetting is research director at Landaas & Company.
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(initially posted November 26, 2021)