Reaching for Yield: Income-Chasing Investors Getting It Wrong; Part 1

May 24, 2016

Arm Chopped

Countless investors throughout the world are reaching for yield. After many years of near zero interest rates, income driven investors both big and small are chasing income of any kind, and too often, get their arms chopped off.

When interest rates plunged during the 2008 global financial crisis, major Central Banks dropped short term rates to around zero. By mid 2016, most short term interest rates are still there; while longer term bond rates in major economies offer little more than 1%-2%. Investors have responded with a variety of income-chasing behaviors, some of which can deliver reasonable results, while many others produce net losses, some of them quite severe.

The negative results so many investors experience when reaching for income cash flows stems from a number of complex factors, but in most cases, individual income and retirement investors suffer losses because they simply don’t understand how income investments actually work.

Income producing investments are influenced by a variety of factors, not the least of which are market rates for government bonds, highly variable expectations for central bank policies, credit worthiness perceptions, economic growth forecasts, hedge fund wagering activity among many other variables.

But too many investors, even many professionals, simply buy assets they think are paying the highest current  rate. They are either unaware of the many complex underlying risk factors for income investments, or choose to be indifferent. Either way, millions of investors attempting to gain income in the past several years now have less money than they started with. How did this happen?

First, let’s look at a few of the types of investments both professional and individual income and retirement investors have been chasing in recent years:

1-High Yield Junk Bonds: These have been a favorite of income investors for many years. When cheap, investors fear them, when expensive, investors stampede to buy them. Net total results are often disappointing due to an excess of buying high and selling low . 

2-MLPs: (Master Limited Partnerships) These curious structures can pay good dividends, many of them with various tax benefits due to energy exemptions and certain return of capital rules. Their hazard is similar to junk bonds, lots of buying high when the group is hot and selling low when the sector is under pressure. Your accountant will fume when you receive (or worse, do not receive) an incomprehensible K-1 tax reporting form for these things.

2-REITs: (Real Estate Investment Trusts): These investments can be good income payers and reasonable performers over time. The problems investors often face with these are variable, but can stem from the REIT not performing in line with the real estate sector it is supposed to track. For example, apartment REITs can go down in value while apartment house prices and rents are going up. This is because REITs trade like other income investments, influenced more by bond rates, rapidly varying perceptions of Fed policy, trading dynamics not related to real estate and other factors. And like the other income assets, they tend to be favorites when expensive and shunned when cheap.  

3-Variable Annuities: These insurance type products are have proven to be a problem for many investors. Annuity sales people push these hard as commissions they earn can be 8% or more of investor money just to get started. Add to that, these contracts (yes, you’re pretty much locked in) often contain no real life insurance other than the investor’s own money. They charge substantial additional annual fees, and can often contain below average mutual funds. If markets gain very substantially during the holding period, net results can be positive, but probably substantially less than an average portfolio of mutual funds during the same period.

In the second installment of this essay, we’ll look at other investments that can pay income but produce mixed results, and why so many income-investor mistakes continue to recur.