Risks in the Search for Yield
Advisors Capital Management
By Charles Lieberman
September 4, 2012
Interest rates are so extraordinarily low that investors have pushed up prices (and pushed down yields) of all the traditional investments used for income, so they have even forced into more esoteric or risky investments. This search for yield has created significant risks that may not be well appreciated. This Commentary discusses these risks.
Utilities have long been a traditional asset choice popular among income investors. Utilities offer higher yields than other common stock, lower volatility and slow appreciation potential. Their lower risk makes them well suited for widows and orphans. In fact, they have become somewhat more risky now. Because of these high income-low risk characteristics, investors flocked to the sector, driving up prices. Over the past two years, the Dow Jones Utility Index has risen by just over 20%, about 10% per year, in addition to the typical 5% dividend that was paid out. But dividends increased only slowly over this two-year period, so yields fell. For example, Con Ed’s stock price rose from around $47 per share two years ago to about $61 today, but the dividend barely increased from 59.5 cents per quarter to 60.5 cents, so the yield declined from 5.1% to 4.0% today. Similarly, the dividend yields on Duke Energy, SCANA, and Pinnacle West have fallen from 6.2%, 4.9%, and 5.3% to 4.7%, 4.2%, and 4.1%, respectively over the same period.
Most utilities now yield between 3% and 5%, with only a few outside this narrow range, while the likely growth rate for these types of companies remains quite low. This was a more reasonable tradeoff when utility yields were above 5%. Even now, if someone wants a safe investment, a 4% yield on Con Ed or 4.7% on Duke isn’t bad when compared to 10-year Treasuries yielding only 1.65%. Superficially, utilities still look good. But what if Treasuries revert to a more normal 5% yield? Utilities would then likely revert to their more normal yields, which would require they fall in price by almost as much as they rose over the past couple of years. Such a recalibration would imply large utility stock price declines. In effect, utilities would give back some of their extraordinary outperformance of the past several years. But, this event would be highly shocking to most utility buyers, who own these stocks for their low volatility and low perceived risk of losing asset value.
The decline in yield on Treasuries and investment grade bonds has also pushed investors into high yield bonds, foreign sovereign bonds, emerging market debt, sometimes denominated in dollars but sometimes in the local currency, or high yield municipal bonds. Each of these other investment selections has its own risk issues. Events surrounding Greece and other sovereign borrowers have already been unusually punishing to most investors, who were surely largely unaware of the underlying budget issues that created havoc. Yet, this lesson has not entirely deterred investors from flocking into other foreign issued debt. Flows into foreign bond funds have been strong. Municipal bonds are rather illiquid and this illiquidity will trap investors who will have a very hard time getting out at any kind of reasonable price when interest rates begin to rise. This problem is also severe for those who buy bond funds or bond ETFs, especially for illiquid bonds, like municipals. Those who exit early from such funds will be hurt very little, if at all, since they will find sufficient liquidity to be able to sell easily. Those who follow will find the going much rougher. The early departures will force the bond fund managers to sell off bonds to pay off departing shareholders. The more illiquid the underlying asset, the greater the decline in the underlying asset value of those who retain their shares and the greater the loss on the bonds that are sold. Late sellers may find they are unable to withdraw from these investments without taking severe losses, exactly what has happened to such fund investors in every sharp bond selloff.
Real estate investment trusts are one class of specialized assets commonly used by investors who seek income. In fact, REITs were designed for income seekers, since they are not subject to corporate income taxes if they pay out at least 90% of their profits as dividends. Thus by statute, these kind of investments are well designed for those who need income. Unfortunately, buying has been so aggressive that prevailing dividend yields have fallen to historically low levels. The average REIT provided a yield of almost 9% at the beginning of 2000, when these investments were shunned in favor of tech stocks. Today, REIT yields are almost down to 4.0%. In 2000, the difference between the average yield on REITs and the Russell 2000 was close to 8%; today, that difference is less than 3%. Specific examples of the low yields on such investments include Avalon Bay (2.7%), Boston Properties (2.0%), Simon Property (2.6%) and Vornado (3.4%), all major, highly regarded companies in their respective segments of the business. (Hence, we own none of these securities.) REITs were an investment backwater for a very long time, which is one reason they were once so attractively priced. They are undiscovered no longer. REITs now have far above normal interest rate risk, more like long term bonds today. If interest rates were to revert to more normal levels, these shares would likely retreat quite sharply.
Preferred stock is another investment vehicle that has become more popular as investors search for yield in new places. Such investments have their own peculiar risks. Most preferred shares give the company the option of turning off the dividend in the event the company needs to retain cash. Many preferred shares can resume paying preferred dividends at some future point without ever being required to pay the missed dividends. In other cases, they are required to pay all of the unpaid amounts. Another class of preferred shares, trust preferreds, are issued mostly by financial companies and treated like bonds, so the company does not have any discretion whether to halt paying dividends. (The trust owns the bonds of the company, so it has no excuse or ability to halt its dividend payments.) We made extensive use of these securities during the credit crisis to protect clients who needed cash flow against the possibility that their dividend payments might be suspended. They were also particularly attractive when held in a tax deferred account, like an IRA, since they provided higher yields to compensate investors for the less favorable tax treatment of their dividends.
More recently, trust preferreds were reclassified under Basel III, so they will no longer qualify as tier one capital. This change severely damaged the attractiveness to the banks that issued them, so banks have been calling them early. (Indeed, we were active buyers of any such securities when they traded below par and were active sellers when many traded at meaningful premiums above par. That market opportunity is now gone, unfortunately.) Many banks are now issuing perpetual preferreds, which do qualify as tier one capital, to replace the trust preferreds that are being called. These securities pay qualifying dividends that also receive better tax treatment maxed out at 15% (for some unknown time period). But as perpetuals with no maturity date, they are effectively extremely long-term issues, so their prices will decline particularly sharply when interest rates revert to normal, even more than the preferred shares they replace. Also, as regular preferred shares, companies that issued them have the right to suspend the dividends should they need to do so. Thus, their dividend payments are not as certain as was the case with the trust preferreds. These important distinctions have changed the risk profile of these securities in a significant, mostly unfavorable, way for investors.
So, how do we cope with these enhanced risks? One key idea is that we must evaluate the yield offered versus the risk inherent in each of these different asset classes. Each situation is different, of course. If the yield is insufficient, we have already exited these assets. We do own a few utilities, but have focused on situations where we think there is some upside to offset the potential damage that will occur when interest rates increase. Our overall exposure here is also below what we would consider normal. On the fixed-income side, we remain selectively involved in certain preferred shares. In bonds, we have accepted more credit risk to avoid interest rate risk. We have minimized our exposure to municipal bonds as much as possible. We have already reduced considerably our exposure to REITs, except for a few isolated segments that we think offer solid value, either with adequate yields or with meaningful appreciation potential. In fact, we own no office buildings, apartment, shopping mall, shopping center, or industrial REITs and haven’t for some time now.
Unsurprisingly, managing an income producing portfolio is a particularly difficult challenge today, given prevailing interest rates. We will consider ourselves successful if we can continue to grow the income produced by our income oriented accounts over time, even if interest rates increase and this has a negative effect on asset values. But, our effort to minimize that negative impact on asset values is a critical part of our asset management effort.
(c) Advisors Capital Management