The Federal Reserve takes a lot of flack from a lot of corners. But you gotta give Ben Bernanke props on a gem of investing advice from this week’s testimony before lawmakers.
Bernanke went on Capitol Hill to talk about monetary quantitative easing, economic risks and so on. But he also — in a roundabout way — talked about the No. 1 risk to junk bond and dividend stock investors right now: a “reach for yield.”
Listen up as Big Ben talks about how the benefits of a low-yield environment also come with costs, and think about how this applies to investors like you:
“For example, portfolio managers dissatisfied with low returns may ‘reach for yield’ by taking on more credit risk, duration risk, or leverage. On the other hand, some risk-taking — such as when an entrepreneur takes out a loan to start a new business or an existing firm expands capacity — is a necessary element of a healthy economic recovery.
Although a long period of low rates could encourage excessive risk-taking, and continued close attention to such developments is certainly warranted, to this point we do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery and more-rapid job creation.”
On a macroeconomic level, easy access to capital for qualified buyers boosts the economy … but easy access to capital can also result in irresponsible lending. That’s especially true when investors see the dollar signs associated with the higher yields that accompany bigger risk, and when qualified borrowers can command rates that are essentially on par with inflation.
Sound familiar? This is the same scenario facing you — whether you should settle for a sub-2% yield in Treasuries or a 0.9% “high-yield” CD or whether to take on the risk of the stock market. Whether to invest in a consumer staples stock with a 2% yield that matches inflation or whether to chase yield in an mREIT that offers a volatile but juicy dividend over 7%.
How Much Yield Is Too Much?
The idea of a “reach for yield” is a common one in today’s market, and we often forget that a bigger return can come with bigger risks.
One clear example is the junk bond market. Because investors need a 2% yield just to tread water against inflation, there has been a rush to lend cash to corporations with riskier credit profiles and thus they command a return of 5%, 6% or more. As a result, companies raised a record amount of capital in the junk bond market last year — well more than $300 billion.
Sure, some of these companies might put that debt to good use and restructure their business or find growth. But others? They could default and leave investors holding the bag.
After all, that’s why the yield is so high on junk — to mitigate the very real risk that the investment could go bad.
The same thing is true for dividend stocks, in a way. Investors are clamoring for big yield but sometimes don’t realize that the easiest way for a stock’s dividend yield to go from 5% to 10% is for share prices to be cut in half. Typically, when a stock is returning 10% of its share price in dividends, it’s not because it has a reliable revenue stream but because the stock has imploded.
So who cares if you get a 10% return via dividends if shares slide 25%?
Here’s proof: Thornburg Investments did a great long-term study of dividends, dividing the market into 10 slices based on yield. The best-performing long-term plays based on total return were not the highest-yielding segment of the market, but rather the eighth decile — that is, the stocks that were in the third tier from the top.
The logic is simple: Dividends are powerful drivers of long-term returns, but only if they are sustainable and only if the underlying company doesn’t collapse. Typically, the top 10% as measured by dividend yield have gotten there based on fading share prices that will continue to collapse, so the best strategy is to seek a robust yield but not get greedy.
There is no magic bullet here to determine how much yield is enough and when the tipping point makes an investment too risky.
But Bernanke was right to warn about “reaching for yield.”
- Bernanke downplays risks to economy in testimony and remains committed to stimulus policies. (Reuters)
- Neil Irwin has a great take on how the easy money of junk bonds is powering a buyout boom. (Washington Post)
- Dan Freed warns, “Beware the junk bond bubble.” (The Street)
- Joshua Kennon says you should never just buy the highest-dividend stocks you can find. (About.com)
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP.