The Risks of Yield-Seeking Strategies

In the past few years, some investors have asked us whether they should replace a portion of their high-quality bonds or bond mutual fund holdings with strategies ranging from high-dividend stocks to oil and gas master limited partnerships because “rates are low.” We have generally counseled investors that every one of these strategies involves substantially more risk than high-quality bonds and that a much better way to increase the level of risk that you are taking is to increase your allocation to a diversified, low-cost stock fund portfolio.

In this piece, we review the risk characteristics of the strategies we have been asked about the most. The analysis clearly demonstrates that all of these strategies have substantially higher risk than high-quality bonds and bond mutual funds.

The simplest way to get a sense for the risk of these strategies is to look at their performance when the stock market has done poorly. The table below shows the performance of high-dividend stocks, preferred stocks, oil and gas master limited partnerships and high-yield corporate bonds during the three most recent quarters when the stock market performed poorly.

As an example, the above table shows high-dividend stocks were down more than 21 percent in the fourth quarter of 2008. On average, these strategies lost almost 9 percent during these quarters when the stock market did poorly, which isn’t surprising because each strategy either has direct exposure to the stock market or contains stock-like risks.

An even more useful analysis is comparing how each of these strategies did relative to U.S. Treasury bonds over these same quarters. This gives a sense of the additional risk an investor in these strategies would have experienced relative to high-quality fixed income.

Each negative number represents underperformance relative to U.S. Treasury bonds, making the risk of these strategies abundantly apparent. On average, these strategies underperformed high-quality fixed income by more than 13 percent in these periods. This clearly demonstrates that these strategies do not provide the diversification and risk reduction benefits of high-quality bonds and that they are more like stocks than high-quality bonds.

We continue to believe the primary and most consistent strategy for reducing risk in a portfolio is to use high-quality bonds and bond funds. Certainly, near-term expected returns on these strategies are low, but they still are important tools for reducing risk within a diversified portfolio. Further, for those who do need to take more risk to achieve their financial goals, we continue to believe that increasing the allocation to a diversified stock fund portfolio is the best strategy.

Copyright © 2012, Buckingham Family of Financial Services. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.