Sometimes it pays to state the obvious, which is what the Financial Industry Regulatory Authority did in a recent investor alert. The crux of the alert: higher yield means higher risk.
This is almost always true, and it’s so universally understood that you wonder why it has to be said at all. But with millions of income-starved retirees now funneling tens of billions of dollars into high-yield bonds and complicated structured notes, perhaps a reminder is in order – and some decent alternatives, too.
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First, the reminder. Treasury securities and the mutual funds that invest in them have historically low yields now in large part because – the recent S&P downgrade notwithstanding – these are the safest investments on the planet. Investors who are not satisfied with the income they get from T-bonds can find richer payouts in many other investments. But their principal will be at greater risk, and they may incur nasty fees to boot.
That’s the way it works. So FINRA advises you to ask these questions before any attempt to capture a higher yield:
- Does the higher return from the investment come with increased risk? Invariably the answer is yes.
- Do you understand how the investment operates? The quest for higher return could lead you to complex investments. If you don’t understand them you might wind up surprised by the investment’s illiquidity, exit fees, loss of principal or the return of your money in a form other than cash.
- What are the costs and fees associated with the new investment? Hedge funds and structured products can be costly, and since some of the costs are built into their return, it can be difficult to know what you are paying.
- Is the product callable? Some investments the issuer can redeem at any time. So if interest rates fall, the issuer can save money by “calling” an investment from you and issuing a new investment at a lower rate. You may find it difficult to find an equivalent investment paying rates as high as the original rate.
- Could the new investment be fraudulent? Legitimate investments that promise returns of 30% or more without risk to your principal simply do not exist. Always verify whom you are dealing with.
Now, for some alternatives. With fixed-income yields at historic lows you can find decent income through the dividends of blue chip companies whose shares have fallen far enough that the cash dividends they pay equal 4% or so on your investment. That’s pretty enticing in today’s fixed-income environment.
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Stocks are one place where higher yields do not necessarily signal greater risk. Many companies simply have a strategy of paying more cash to shareholders. Look skeptically on any stock that has fallen so far the yield is 7% or more. There may be a good reason for the stock to have fallen that far, as in the company is struggling and the dividend may be cut.
But blue chips like Con Edison, International Paper, Pepsico, Kimberly Clark, Procter & Gamble, Johnson & Johnson, Emerson Electric and others have a strong record of maintaining and raising their dividend over a period of decades. Their stocks will fall if we trip into another recession. But they won’t fall as hard as the broader market and likely will be among the first to recover.