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Chasing Investment Yield or Total Return

Which is More Prudent in a Low Yield World?

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As investors pre­pare for the grad­u­al “lift-off” in inter­est rates, it is worth review­ing the impact of excep­tion­al­ly low rates on the fixed income mar­kets. The last time the Fed­er­al Reserve raised the Fed­er­al Funds Rate was June 2006, almost a decade ago. One-mon­th T-Bill yields have been close to zero since Lehman Broth­ers col­lapsed in Sep­tem­ber 2008 and ten-year Trea­sury bond yields have most­ly been in the 2%-3% range for the last five years.

1-Month and 10-Year Treasury Yields - Swan Blog - Chasing Yield

Faced with the biggest chal­lenge to the finan­cial sys­tem since the Great Depres­sion and with­out the abil­i­ty to take inter­est rates any low­er, author­i­ties imple­ment­ed untra­di­tion­al means of stim­u­lat­ing demand in the econ­o­my. Open mar­ket oper­a­tions, or quan­ti­ta­tive eas­ing, were used to keep cred­it arti­fi­cial­ly cheap. The Fed­er­al Reserve Bal­ance sheet bal­looned from under $1 tril­lion in assets pri­or to the cri­sis, to an esti­mat­ed $4.5 tril­lion today.

Fed Reserve Bank Balance Sheet - Swan Blog - Chasing Yield

We’ll leave the dis­cus­sion of the impact of the­se deci­sions on the equi­ty mar­ket for anoth­er day. The focus of this dis­cus­sion is the fixed income mar­ket and invest­ment yields. Cer­tain­ly the impact upon investors seek­ing income was very neg­a­tive. With invest­ment grade rates bare­ly keep­ing pace with infla­tion, investors start­ed ‘chas­ing yield’ wherever it might be found…high yield bonds, emerg­ing mar­ket debt, world bond funds, bank loan funds, “non-tra­di­tion­al” and “mul­ti-sec­tor” bonds funds, et cetera. The graph below shows a cumu­la­tive esti­mat­ed flow of $550bn into the­se “spread” asset class­es since Jan­u­ary 2007.

Cumulative Flows into Spread Asset Classes - Swan Blog - Chasing Yield

 

Of course with all the new mon­ey flow­ing into the­se asset class­es, the spreads over Trea­suries have come down, so on an absolute basis investors are still strug­gling to find invest­ments with enough income for their needs.

 Rolling 12-month Returns: Barclays Yield Indices - Swan Blog - Chasing Yield

Chasing Investment Yield

This habit of ‘chas­ing yield’ could lead an investor straight off a cliff. Mort­gage REITs have offered very seduc­tive yields over the last sev­er­al years, hov­er­ing in the dou­ble-dig­it range. How­ev­er, such invest­ments depend upon lever­age and a steep yield curve in order to provide such gen­er­ous yields. When those con­di­tions turn unfa­vor­able, mort­gage REITs have been very volatile and have seen steep, rapid draw­downs in val­ue. Dur­ing the “taper tantrum” of 2013, the Dow USA Mort­gage REITs All Cap index lost almost 25%, with a loss of over 14% com­ing in the mon­th of May 2013 alone.

Drawdown July 2008 to July 2015 - Swan Blog - Chasing Yield

We would argue that the quest for yield is a bit short-sight­ed and that real­ly investors should be focused upon the total return of an invest­ment. Too many investors focus just on the yield com­po­nent of total return and miss the impor­tance of cap­i­tal gains. At the end of the day, a dol­lar gained is a dol­lar gained and one shouldn’t care how that dol­lar is gen­er­at­ed. More­over, by leav­ing gains invest­ed one could reap the ben­e­fits of com­pound­ing returns

Another Way to Pursue Returns and Endure a Low Yield World

Below we see the the­o­ret­i­cal dai­ly NAVs for an imag­i­nary fund. Although the NAVs here are fic­tion­al, the impact that a dis­tri­b­u­tion has on NAV is not. The NAV will always decrease by the amount of the dis­tri­b­u­tion. The NAV bars high­light­ed red show the post-dis­tri­b­u­tion of tak­ing a dis­tri­b­u­tion. While the yield-focused investor might be hap­py to be receiv­ing their income they are no bet­ter off in terms of total wealth.

Theoretical Impact of Distributions on NAV - Swan Blog - Chasing Yield

This kind of return pro­file — a slow increase in the val­ue of an invest­ment, cou­pled with reg­u­lar dis­tri­b­u­tions from the val­ue of the account — can eas­i­ly be repli­cat­ed by cre­at­ing a sys­tem­at­ic with­drawal plan. With a sys­tem­at­ic with­drawal plan the investor liq­ui­dates a small por­tion of their port­fo­lio every mon­th or quar­ter in order to meet their spend­ing needs.

In a way, a sys­tem­at­ic with­drawal plan is sim­i­lar to the dol­lar-cost aver­ag­ing and reg­u­lar 401(k) pur­chas­es many savers are famil­iar with dur­ing their work­ing years when they were build­ing up their nest eggs. The sys­tem­at­ic with­drawal can be explained as the reverse of that. Dur­ing the accu­mu­la­tion stage, investors saved what they could every pay­check peri­od. In retire­ment, a sys­tem­at­ic with­drawal plan sim­ply revers­es that flow.

When it comes to tax­a­tion, a sys­tem­at­ic with­drawal plan may actu­al­ly be prefer­able to a pure income-based plan. After all, income is taxed at reg­u­lar income rates, where­as sys­tem­at­ic with­drawals out of a long-term hold­ing would like­ly be taxed at a long-term cap­i­tal gains rate. Although many dif­fer­ent vari­ables
come in to play when cal­cu­lat­ing after-tax returns, a sys­tem­at­ic with­drawal plan does have its advan­tages.

In the wake of this extra­or­di­nary, post-cri­sis envi­ron­ment, it does seem unlike­ly that fixed income can ful­fill its tra­di­tion­al role of cap­i­tal preser­va­tion and income with­in a port­fo­lio.  It is impor­tant to remain focused on the big pic­ture: wealth and the preser­va­tion of it, not invest­ment yield, will deter­mine whether or not an investor will be able to meet their retire­ment goals.

 

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsAbout the author: Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.

 

 

Impor­tant Notes and Dis­clo­sures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®). All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com.   047-SGI-100615