(this post originally publisehd on December 8, 2011)
A recent cover story in Barron’s Magazine “How to Get Safe Annual Payouts of 7%” illustrates some of today’s challenges in the fixed income world. The article offers that “yields of 5% and 7% are attainable, but you have to look globally and across asset classes that may seem unfamiliar, such as emerging-market bonds, global infrastructure stocks, master limited partnerships and mortgage real-estate investment trusts.”
To be sure the author adds that while “some risks are obvious…more often risk is difficult to spot.”
The Barron’s piece is good, and does offer some intriguing alternatives, but after more than twenty years in the finance and investment arena, I feel compelled to add: Caveat Emptor.
I am continually amazed at the number of investors who only ask one question when it comes to potential fixed income selections: What is the yield? What is even more amazing is the response if the yield does not meet an investor’s perceived needs.
To make matters worse still, many fixed income investors are over allocated to just one or a few holdings, as they have been taught to avoid bond mutual funds.
Income investors need to keep the perspective that for every $100,000 invested a full percentage point yields an extra $1,000 per year. On a monthly basis that works out to $83.
While I have no way of quantifying it, I would venture to say that an exponentially greater amount of money has been lost than gained when reaching for incremental amounts of yield.
Some recent historical examples of yield shopping gone wrong include: ultrahsort bond funds, auction rate preferreds and the First Reserve Money Market Fund. Even more horrifying is the fact that these disasters occurred when investors/money managers where reaching for maybe an extra 25 basis points of yield. So for every $100,000 the extra risk (which proved ruinous) brought in about $20 a month.
Income investors should ask themselves what all investors ask. What is the potential total return in relation to the risk?
For investors who need income to pay the bills, it may better to drawdown a small portion of principal than to risk a bigger if it in hopes of higher yield.
Absent the stomach to drawdown some principal, the fixed income investor needs to be sure that he or she is utilizing a prudent allocation to higher yield (and risk) investments.
This may require the use of the often shunned bond fund (or mix of funds), but as I discussed in Bond Ladders vs. Funds, it might be the best option.
DISCLAIMER: Nothing in this article should be construed as a personal recommendation or investment advice. Nor should anything in this article be construed as an offer, or a solicitation of an offer, to sell or buy any particular investment security. Investors should conduct their own due diligence and seek the advice of a financial and/or investment professional before making any investment decisions.