Scrambling for Income? Avoid Being Carried Away by the Crowd

Tuesday, August 24, 2010

The search for income is in high gear. With short-term investments providing little yield, investors are seeking out alternatives. There are large flows into all types of bonds, including riskier emerging market (third world) and low quality (junk). Even specialty securities like royalty trusts are finding wider appeal.

Are these moves unhealthy and signs of a bubble? Perhaps, although using that term has led to some semantic bickering. (For example see the Barron’s article, “Vacuous Bond-Bubble Talk” by Randall Forsyth – August 23, page 7.) There is another way to view the current situation.

Where investors seem to be making mistakes

The age-old advice for enjoying investment success is to avoid making mistakes. This doesn’t mean having perfect foresight. Rather, it means not committing well-known errors, usually the result of letting emotion take over the investing process.

So, where are investors going wrong?

  • First, by judging an investment based on one number: yield. Chasing yield, like chasing performance, can lead to investing in too much risk. This happens especially when there is a performance record that is tantalizing (e.g., with junk bonds).
  • Second, by believing bonds have higher quality than stocks. While it is true that bondholders have first claim on assets ahead of stockholders, it is not true that a low quality bond is safer than a high quality common stock.
  • Third, by not having a good understanding of bonds. I have seen investors get confused by the basic fact that when yields rise, bond prices fall. More challenging are call provisions, subordinated issues, mortgage securities behavior, non-US currency exposure and pricing spreads.
  • Fourth, for those investing in a fund or managed portfolio, not understanding that average characteristics can be misleading, that the maturity dates keep changing, that the fees and expenses significantly reduce today’s low yields (with bonds, gains should not be projected) and leverage, if used, can ramp up risk inordinately.

A new sign that investors are overreaching for yield

A current development shows investor activity moving further out on the limb. The Wall Street Journal had an article discussing the return of 100-year bonds (“Bankers Pitch 100-Year Bonds,” by Katy Burne, August 23, page C-1). The lead paragraph provides important information for investors (highlights are mine):

Bond investors are buying almost anything the market throws at them. Now some [investment] bankers want to put those appetites to a full test. They have begun sounding out investors about 100-year bonds.

“Such long-term bonds are considered some of the most exotic available because they are issued only by the strongest companies—those that are expected to be around a century from now.”

There are three key points:

  • When “investors are buying almost anything,” a fad has developed. That doesn’t imply it’s a bubble about to pop. Rather, it means prices are up making valuations poor. Therefore, potential returns are muted and risk is higher than normal.
  • When “[investment] bankers want to put those appetites to a full test,” Wall Street has the creative engines working on new products to deliver what investors are clamoring for and that look safe (“issued only by the strongest companies”).
  • To bolster sales, Wall Street brings in its marketing prowess, “sounding out investors” while dazzling them.

What about dividend yield?

Many investors (individuals and institutions) have shifted some or all of their US equity holdings to other investments, including bonds. There are many reasons given, but beneath most is an expectation that US stocks cannot or will not provide a decent return for quite some time – and they could fall a lot.

As a result, dividend yields now are attractive relative to bond yields. Currently, 10-year US Treasury bonds yield 2.6%, and the Dow Jones Industrial Average yields 2.8%. Moreover, there is the potential for company dividends to increase over time.

Will companies do well over the next ten years? Probably yes. And that probability is one reason why investors should not forsake common stocks, even when investing for income. In addition, there are risks that can slam bonds, but aid stocks – inflation and/or economic growth are the two most well-known. Looking at history, we see those two factors are also the most prevalent ones.

So… The search for income is even more challenging today. With no immediate signs of interest rates rising soon, more and more investors are taking on added risks to increase their yields. As everyone should know, however, this is the very action that can produce disappointment, distress and loss in the future. Investors need to avoid making that mistake – again. The focus should be on having a sound, diversified investment approach that includes common stocks.

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2 Responses to “Scrambling for Income? Avoid Being Carried Away by the Crowd”

  1. scanlin

    If you are seeking income, why not buy some large cap dividend payers and then write at-the-money or slightly in/out of the money covered calls?
    MikeS
    http://www.borntosell.com

    #44
  2. MikeS,

    It’s appealing: Collect a fat dividend plus a nice option premium. And, a higher dividend yield tends to support a stock’s price, so downside risk could be cushioned.

    That strategy’s desirability really depends on the investor’s objectives and risk tolerance. There are at least three factors that need to be considered:
    1. The stock is desirable, not just a dividend payer. Many have been trapped by a sweet looking dividend yield going in, only to be foiled by a company turning sour.
    2. The recognition that option premiums adjust for the dividend, so there is no double counting. Because the option seller retains the dividend and the stock price automatically adjusts down when the stock goes ex-dividend, the premium is likewise adjusted down in advance.
    3. Selling calls near at-the-money (i.e., the stock’s price is close to the option’s strike price) means the investor will see little or no gain beyond the premium received. If the stock moves up, the call will be exercised and taken from the investor at the strike price. However, the loss is wide open since the call will not be exercised if the stock price declines, leaving the investor with the holding.

    So, if the investor understands and accepts these factors, then the strategy could be okay. Personally, I prefer to select stocks of companies I believe will do well and not swap a small premium for a large upside potential. A bonus in today’s stock market is the high dividend yields. They provide a good return even if it takes a while for the stock market to improve.

    Hope that helps. Thank you for the comment.
    John Tobey

    #45

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