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Yearning for Yield

Economic uncertainty continues to fuel the strong demand for investment products that provide regular income to investors. Levi Folk looks at the various yield-paying investment strategies, the potential returns, the risks and where to find the best value opportunities

The search for yield continues to bedevil the average Canadian investor ever since he or she started fretting about deflation back in the early 2000s. That crash in equity prices and bond yields was a precursor to an even bigger boom and bust that has left bond yields at or near long-term absolute lows. What is an investor to do?

Some choose to focus on the real yield — that is the yield earned after inflation — and when you compare returns using that benchmark, which is the right thing to do, the cloud has a silver lining. In other words, even a miserly yield isn’t that bad when prices are low or — dare we say it — falling.

At the end of the day, some investors are accepting the pay cut in retirement income caused by falling interest rates. Teresa Black Hughes, CFP, CLU, R.F.P, FMA, CIM, a securities-licensed advisor in Vancouver, says it boils down to the values of her mostly-retired clientele of investors. “The older clients, the ones who have lived through the War,” says Black Hughes, “know what it is like to live with less; they have more control over their spending.”

Then there is the camp of investors who have decamped, so to speak, to higher yielding securities such as high-yield bonds, call option writing, or even emerging market debt. All of these securities share the allure of greater potential return under the promise of just a bit more risk. The pivotal question here is just how much more risk investors are taking and what the potential costs are.

Investors today need to adjust their expectations to better reflect both the current economic reality and the long-term average returns from the various asset classes, looking back over the past century.

First we must recognize that yield is not necessarily a good indication of expected return to bond investors. It is a funny thing about the bond market that yields and prices are inversely related: high yields equate to low prices and vice versa. Therefore, it is the direction of yield that determines whether prices will rise or fall and hence the capital return to the investor.

Investors may have scoffed at four per cent bond yields on Government of Canada 10-year bonds back in January 2008, but would have laughed all the way to the bank as yields fell by roughly one-quarter to date, amounting to a roughly 25 per cent return.

The moral here is that yield should never be considered in isolation except for the most riskless of riskless securities: the GIC. Annual yields of less than one-half of one per cent on these types of securities do not add up to a smart investment once inflation is factored into the total return. In fact, one would need to expect a period of falling prices over the next year or two to justify buying these securities.

The same goes for government bonds, especially U.S. Treasuries, where five-year bonds offering a measly 1.5 per cent annual yield look like a poor bargain to all but the most dour prognosticators of the U.S. economy.

Bill Gross, CEO of Pacific Investment Management Company (PIMCO), the man who steers PIMCO’s US$252-billion Total Return Fund like he is driving a Mini Cooper through a slalom course, states, in his most recent newsletter, that the 30-year bull market in interest rates has ended.

The silver lining to these low-yield securities is that even if we do not experience deflation for a prolonged period, it would seem that an adjustment in inflation expectations is in order.

Advisors might want to adjust their long-term inflation expectations down. That’s right — down! The average rate of inflation in Canada was 8.23 per cent over the unleaded decade that was the 1970s; then, in the 1980s, inflation dropped precipitously to 5.76 per cent, on average; fast forward another decade to the high-productivity era of the 1990s and inflation was exactly two per cent.

Inflation shot back up between 2005 and 2010, thanks to the ridiculously misguided central bank policy of keeping interest rates too low for too long, but that proved only temporary (the inflation, not the misguided central bank policy).

Now consider that between 2005 and 2010, inflation registered a further drop to 1.52 per cent on average, thus boosting the real return to bond holders over that period. Lower inflation means every dollar of interest earned is worth more in spending power, so a comparison of nominal interest rates over time often presents a misleading picture.

If it seems absurd to expect deflation when the stated goal of the U.S. Federal Reserve Bank is to create inflation, consider that these experiments are likely to end in bust as they did with the credit crisis. In other words, we may experience a period of higher inflation, but the end result may be low inflation or deflation.

So the low yields on government bonds don’t look that horrible in a period of very low or falling inflation. Nevertheless, most investors don’t want to take the pay cut implied by the 1.5 per cent yield on a five-year Treasury bond. For anyone but the most stoic of war-era mentalities, it means taking on more risk to make ends meet. The question is one of how much risk and where?

Investment-grade corporate credits are the first stop out on the risk curve; unfortunately, the view from this milieu is pretty dim. Investors might expect to pick up a two to three per cent total return on investment grade corporate credits over the next year, says Ben Cheng, CFA, president and CIO of Toronto-based Aston Hill Financial and longtime denizen of the corporate credit space.

The average yield on U.S. junk bonds looks a lot more interesting with their juicy 5.75 per cent spread over five-year Treasury bonds. Cheng, however, offers some much-needed perspective to cool first impressions.

Junk bond prices, like their government cousins, are close to all-time highs. Cheng expects a seven to nine per cent total return to investors over the next year, which is very good, but he also strikes an ominous note.

“The market is distorted by what is happening in the Treasury market,” Cheng explains, and there are some really lousy companies out there that are getting access to financing through the junk bond market that would otherwise be bankrupt. The default rate for high-yield borrowers has plummeted to two per cent from 12 per cent in 2009, he adds, and that is cause for concern because the economy remains weak.

Cheng, ever the expert, does not leave his unit holders empty-handed. He recommends the preferred share market, particularly issues by U.S. banks, forwarding a “lightning never strikes twice in the same place” argument that is highly compelling.

Citigroup preferred shares sport an eight per cent dividend yield, which looks very interesting if you buy Cheng’s argument that the U.S. government will provide a backstop to U.S. banks’ losses. After the fall of Lehman Brothers nearly caused a fatal cascade throughout the financial system, it was sealed that Citigroup is truly too big to fail.

PIMCO’s Gross recommends “emerging market debt with higher yields and non-dollar denominations” as one way of earning what he calls safe spread — additional return over U.S. Treasury securities without taking undo risk.

The emerging markets have surprised a lot of investors by how quickly they got up from the mat after the knockdown punch that was the credit crunch in 2008. Many investors wrote them off as pretenders to the title, but they have proved otherwise, and nowhere has the opportunity been better than on the debt side, both for government debt and corporate credit. Emerging market debt has outperformed all asset classes this year except for gold.

It has been a long journey to respectability for emerging markets, and nothing says so like the investment grade rating for emerging market debt indices. Michael Hasenstab, manager of Templeton Global Bond Fund, is convinced and has invested roughly half the fund’s assets in emerging market debt, both the sovereign and corporate varieties.

Excel Funds, a Toronto-based fund company specializing in emerging markets, recently launched the Excel EM High Income Fund managed by Paris-based Amundi Asset Management. The fund is comprised of sub-investment grade emerging market debt and currency positions with an alluring eight per cent yield.

The caveat to emerging market investments is risk — liquidity risk for one and currency risk for another. When the credit crisis hit, emerging markets resembled an African savannah with herds of investors stampeding to safety. The result was a gap in bid/ask spread and a plummet in prices.

As for currency risk, economic theory supports the long-term appreciation of emerging currencies due to higher productivity in the tradable goods sector. Bear in mind, however, that the long term comprises a lot of shorter, nail-biting episodes.

In these fallow times, you might have to work the fields a little harder to generate that extra yield, and option writing is one low-risk strategy. Done properly, it is a means to an end.

David Salloum, a Certified Financial Planner and broker at RBC Dominion Securities in Calgary, says call option writing works in the context of an overall financial plan. “It’s not about going to Dave so he can generate some extra income for you,” says Salloum. However, a strategy of writing out-of-the-money calls on securities in his clients’ portfolios is both an income-generation and risk-management tool.

On the income side, an investor gets paid for writing calls, which gives the buyer of that call the right to purchase that security from the option writer at a preset strike price, prior to option expiration. Crucially, the strike price is always set above the current stock price, hence the out-of-the-money part.

If the price of the stock does rise above the option strike price before it expires, it’s “money for nothing” for the option seller. Statistics bear out this strategy as roughly 75 per cent of all options are never exercised and expire worthless, according to data from the CME Group.

The only time the strategy does not work is in a long-term bull market because investors will continually receive a haircut on their returns at the option strike price. Looked at another way, explains Salloum, “it’s actually a very conservative strategy because it forces my clients to take profits in cases where the stock price rises and the option is exercised.”

The option writing strategy differs from the other income-generating strategies because it is risk-reducing, rather than risk-enhancing, at the portfolio level. On the other hand, it has the potential to reduce returns over the long term.

Free lunches are few and far between in the world of finance, so investors must recognize that the pursuit of higher yield is accompanied by higher risk. It’s either that or investors will need to adopt a war mentality, buckle down and accept a pay cut in their twilight years.

Levi Folk can be reached at levi@transmissionmedia.ca.

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