The High Yield Trap

The High Yield Trap

Opportunities for a Low Yield World PART 1

Everyone wants their investments to make more money, but we have to be careful to avoid the High Yield Trap. Since the Coronavirus Crash, central banks have been lowering interest rates to near zero. Last year, I was buying CDs at 2-3%. This week, I’m looking at the same CDs with yields of 0.1% to 0.2%. To which, my client innocently asks: What can we buy that will make more than a couple of percent with low risk?

Nothing, today. The five-year Treasury Bond currently yields 0.22%. That’s unacceptable for most investors, and it will push them out of safe fixed income, like Treasuries, CDs, and high quality municipal and corporate bonds. The yields are just too darn low.

Where will they go in pursuit of higher yields? Oh, there are plenty of bonds and bond funds with higher yields today. Credit quality has been plunging, as rating agencies are trying to keep up with downgrading firms that are being devastated by the shutdown or low commodity prices. In fact, through June 16, $88 Billion in BBB-rated bonds were downgraded to Junk Bond status this year. Each downgrade causes selling, which lowers the price of the bond, and the yield goes up (at least for new buyers).

Why It’s Called Junk

Before you get too excited, there are reasons to be concerned about buying lower grade bonds. In an average year, 2% of BB bonds and 4% of single-B rated bonds will default. That’s why high yield bonds are called junk bonds.

When those companies file for bankruptcy, the bond holders won’t be getting paid back their full principal. They will have to wait for a bankruptcy court to approve a restructuring plan or to dissolve the company. According to Moody’s, the median recovery is only 24 cents on the dollar when a bond defaults.

And while a 2-4% default rate might not sound too bad, that’s in an average year. In a crisis, that might rise to 8-10% defaults. In 2009, global high yield bonds had a 13% default rate in that year alone. These are historical rates, and it could be worse than that in the future. Additionally, the possibility of default increases as a company gets downgraded. If your BB-rated bond gets cut to CCC-rated, the chance of default is now a lot higher than 2%. And the price will probably go down, which creates a difficult choice. Do you sell for a loss or hold on hoping that the company can pay off your bond?

Here in Dallas, we are seeing a lot of companies go bankrupt, pushed over the edge by the Coronavirus. Big names like J.C. Penney, Neiman Marcus, Pier One, Chuck E. Cheese, Bar Louie, and others have filed for bankruptcy in 2020. Most of these companies were issuers of high yield bonds and had a lot of debt. When they got into trouble, they could not keep up with their debt payments and had to fold. Expect more retailers, oil companies, and restaurants to go under before the end of 2020. Bond holders in those companies could lose a lot. (In all fairness, stock holders will do even worse. There is usually zero recovery for stock holders in bankruptcy.)

Funds versus Individual Bonds

If you are investing in a high yield bond fund, you may own hundreds or thousands of bonds. The fund may have a 7 percent yield, but don’t get too excited. A high yield fund is not a CD. You are not guaranteed to get your principal back. It’s likely (even more likely in the current crisis), that your return will get dinged by 2-4% in defaults and losses due to credit downgrades.

If you own individual high yield bonds, it can be even more precarious. Either the bond defaults or it doesn’t. Having the potential for an 75% loss, while earning an average 5-7% annual yield, is dangerous game. Everything is fine until you have a default. A single loss can wipe out years of interest payments. That’s why I generally don’t want to buy individual high yield bonds for my clients.

The quoted yield of 5-7% for high yield bonds does not reflect that some of those bonds will default. If you consider a 2-4% default rate, your net return might be more like 3-5%. That’s the High Yield Trap. Your actual returns often fall short of the quoted yield.

High Yield bonds are issued by companies. Stocks are companies. If companies do poorly – really poorly – both the stocks and bonds can get walloped at the same time. That’s the opposite of diversification. We want bonds to hold up well when our stocks are doing poorly. In finance jargon, we would say that there is a high correlation between high yield bonds and stocks. We want a low correlation.

Instead of High Yield?

What I would suggest, if suitable for an investor, would be a 5-year fixed annuity at 3% today. That would give you a guaranteed rate of return and a guaranteed return of your principal. That’s not super exciting, but it’s what investors need from fixed income: stability and dependable income. Don’t buy bonds for speculation. And above all else, Bonds should avoid the possibility of massive losses.

Be wary of the High Yield Trap. The yields appear attractive in today’s super low interest rate environment. But let’s be careful and not take unnecessary high risks. All bonds are not created equal. When you reach for yield, you are taking on more risk. Defaults have the potential to drag down your performance in a fund. In individual bonds, they could almost wipe out your original investment.

High Yield bonds are not inherently bad. If you bought at the bottom in 2009, they recovered very well. But I am very concerned that today’s yields are actually not high enough to compensate for the potential risk of defaults. We’ve already started to see corporate bankruptcies in 2020 and it’s possible we will have above average defaults in the near future. Until we have a real fire sale in high yield bonds, I’d rather stay away.

We will discuss ways of improving your yield next week. Yes, it’s a low interest rate world, but there are ways we can incrementally improve your portfolio while maintaining good credit quality. We will also discuss financial planning strategies for low rates in an upcoming post. If you’d like a free evaluation of your portfolio, to better understand your risks, please send me a message for an online meeting.

Retirement Income at Zero Percent

Retirement Income at Zero Percent

With interest rates crushed around the world, how do you create retirement income at zero percent? Fifteen years ago, conservative investors could buy a portfolio of A-rated municipal bonds with 5 percent yields. Invest a million dollars and they used to get $50,000 a year in tax-free income.

Not so today! Treasury bonds set the risk-free rate which influences all other interest rates. Currently, the rate on a 10-year Treasury is at 0.618 percent. One million dollars in 10-year Treasuries will generate only $6,180 in interest a year. You can’t live off that.

You can do a little better with municipal bonds today, maybe 2-3 percent. Unfortunately, the credit quality of municipal bonds is much worse today than it was 15 years ago. A lot of bonds are tied to revenue from toll roads, arenas, or other facilities and are seeing their revenue fall to zero this quarter due to the Coronavirus. How are they going to repay their lenders?

Debt levels have risen in many states and municipalities. Pension obligations are a huge problem. The budget issues in Detroit, Puerto Rico, Illinois, and elsewhere are well known. Shockingly, Senator McConnell last week suggested that states maybe should be allowed to go bankrupt. That would break the promise to Municipal Bond holders to repay their debts. This is an appalling option because it would cause all states to have to pay much higher interest rates to offset the possibility of default. And unlike Treasury bonds which are owned by institutions and foreign governments, Municipal Bonds are primarily owned by American families.

With Treasuries yielding so little and Municipal Bonds’ elevated risks, how do you plan for retirement income today? We can help you create a customized retirement income plan. Here are three parts of our philosophy.

1. Don’t Invest For Income

We invest for Total Return. In Modern Portfolio Theory, we want a broadly diversified portfolio which has an efficient risk-return profile, the least amount of risk for the best level of return. We focus on taking withdrawals from a diversified portfolio, even if it means selling shares.

Why not seek out high dividend yields and then you don’t have to touch your principal? Wouldn’t this be safer? No, research suggests that a heavy focus on high yields can create additional risks and reduce long-term returns. Think of it this way: Company A pays a 5% yield and the stock grows at zero percent; Company B pays no yield but grows at 8%. Clearly you’d be better off with the higher growth rate.

When you try to create a portfolio of high yield stocks, you end up with a less diversified portfolio. The portfolio may be heavily concentrated in just a few sectors. Those sectors are often low growth (think telecom or utilities), or in distressed areas such as oil stocks today. The distressed names have both a higher possibility of dividend cuts, as well as significant business challenges and high debt.

The poster child for not paying dividends is Warren Buffett and his company, Berkshire Hathaway. He’s never paid a dividend to shareholders in over fifty years. Instead, he invests cash flow into new acquisitions of well-run businesses or he buys stocks of other companies. Over the years, the share price of BRK.A has soared to $273,975 a share today. If investors need money, they can sell their shares. This is more tax-efficient, because dividend income is double taxed. The corporation has to pay income taxes on the earnings and then the investor has to pay taxes again on the dividend. When a company grows, the investor only pays long-term capital gains when they decide to sell. And the company can write off the money it reinvests into its businesses.

2. Create a Cash Buffer

Where a total return approach can get you into trouble is when you have to sell stocks in a down market. If you need $2,000 a month and the price of your mutual fund is $10/share, you sell 200 shares. But in a Bear Market when it’s down 20%, you’d have to sell 250 shares (at $8/share) to produce the same $2,000 distribution. When you sell more shares, you have fewer shares left to participate in any subsequent recovery.

This is most problematic in the early years of retirement, a fact which is called the Sequence of Returns Risk. If you have a Bear Market in the first couple of years of retirement, it is more likely to be devastating than if you have the same Bear Market in your 20th year of retirement.

To help avoid the need to sell into a temporary drop, I suggest keeping 6-12 months in cash or short-term bonds so you do not have to sell shares. Additionally, I prefer to set dividends to pay out in cash. If we are receiving 2% stock dividends and 2% bond interest, and need 4% a year, we would have to sell just two percent of holdings. This just gives us more flexibility to not sell.

Also, I like to buy individual bonds and ladder the maturities to meet cash flow needs. If your RMD is $10,000 a year, owning bonds that mature at $10,000 for each of the next five years means that we will not have to touch stocks for at least five years. This approach of selling bonds first is known as a Rising Equity Glidepath and appears to be a promising addition to the 4% Rule.

3. Guaranteed Income

The best retirement income is guaranteed income, a payment for life. This could be Social Security, a government or company Pension, or an Annuity. The more you have guaranteed income, the less you will need in withdrawals from your investment portfolio. We have to be fairly conservative in withdrawal rates from a portfolio, because we don’t know future returns or longevity. With guaranteed income, you don’t have to fear either.

We know that Guaranteed Income improves Retirement Satisfaction, yet most investors prefer to retain control of their assets. But if having control of your assets and the ability to leave an inheritance means lower lifetime income and higher risk of failure, is it really worth it?

I think that investors make a mistake by thinking of this as a binary decision of 100% for or against guaranteed income. The more sophisticated approach is to examine the intersection of all your retirement income options, including when to start Social Security, comparing lump sum versus pension options, and even annuitizing a portion of your nest egg.

Consider, for example, if you need an additional $1,000 a month above your Social Security. For a 66-year old male, we could purchase a Single Premium Immediate Annuity for $176,678 that would pay you $1,000 a month for life. If you instead wanted to set up an investment portfolio and take 4% withdrawals to equal $1,000 a month, you would need to start with $300,000. So what if instead of investing the $300,000, you took $176,678 and put that into the annuity? Now you have guaranteed yourself the $1,000 a month in income you need, and you still have $123,322 that you could invest for growth. And maybe you can even invest that money aggressively, because you have the guaranteed annuity income.

Conclusion

It’s a challenge to create retirement income at zero percent interest rates. Unless you have an incredibly vast amount of money, you aren’t going to get enough income from AAA bonds or CDs today to replace your income. We want to focus on a total return approach and not think that high dividend stocks or high yield bonds are an easy fix. High Yield introduces additional risks and could make long-term returns worse than a diversified portfolio.

Instead, we want to create a cash buffer to avoid selling in months like March 2020. We own bonds with maturities over five years to cover our distribution or RMD needs. Beyond portfolio management, a holistic approach to retirement income evaluates all your potential sources of income. Guaranteed income through Social Security, Pensions, or Annuities, can both reduce market risk and reduce your stress and fear of running out of money. The key is that these decisions should be made rationally with an open mind, based on a well-educated understanding and actual testing and analysis of outcomes.

These are challenging times. If you are recently retired, or have plans to retire in the next five years, you need a retirement income plan. We had quite a drop in March, but recovered substantially in April. The economy is not out of the woods from Coronavirus. I think global interest rates are likely to remain low for years. If you are not well positioned for retirement income, make changes soon, using the strength in today’s market to reposition.