Many investors believe they should focus on income rather than growth when they retire. In an extremely low interest rate environment, however, the traditional sources of yield investments such as bonds or high-yield bank savings accounts may not be as attractive. Hence, investors may look to invest in dividend yielding stocks, real estate investment trusts (REITs), mortgage REITs (mREITs), master limited partnerships (MLPs) or shares of preferred stocks for regular investment income. Investors may believe high-yield investments will boost their income, which they feel is a necessity in retirement. Although these investments may play a useful role in a properly diversified investment portfolio, chasing yield can have unforeseen consequences.
What lures investors into seeking yield? It often stems from an aversion to selling securities to generate needed cash flow. There is a belief that cash flow should come from dividends and interest, or income, and the principal portion of your portfolio should be untouched. In an environment with ultra-low rates, dividend-paying investments tend to gain attention. We urge caution and an eyes-wide-open approach. It is imperative you know what you are investing in and understand how these different types of investments work.
Types of High-Yield Investments
There are different types of high-yield investments. Here are a few that tend to attract investors who are either in or approaching retirement:
- Dividend yielding stocks. A dividend yield is the quarterly or annual payment shareholders receive from a stock. This yield can change over time and isn’t guaranteed. Just like all stock categories, dividend yielding stocks come in and out of favor. Some investors believe a dividend is a sign of a healthy firm and, as a shareholder, expect to receive regular dividend payments—something they can rely on as a source of income. But dividends are a “distribution,” and if times are tough, a company may decide not to pay a dividend in order to cover costs. Think of dividends as a different way a company generates shareholder value.
- Real estate or mortgage REITs. These investments focus on real estate or real-estate-related assets and are may trade like stocks. REITs are required to pay out at least 90% of profits in the form of dividend. You can purchase shares of publicly traded REITs through a broker or you could invest in them through mutual funds or exchange-traded funds (ETFs). REITs typically invest in physical commercial properties whereas a mortgage REIT (mREIT) may invest in mortgages or mortgage-backed securities. When the real estate market is hot, investors may flock to REITs or mREITs.
- Master Limited Partnerships (MLPs). (MLPs) are concentrated in the energy sector and tend to be sensitive to oil prices. This can be a benefit when the energy sector is hot, but when it isn’t, it could be detrimental to your overall portfolio returns.
- Preferred stock. Think of these as similar to investing in stocks but without voting rights. Their dividends are paid out before common stocks’ dividends and are generally less likely to be cut, although preferred dividend cuts and suspensions do happen. If the company goes bankrupt, preferred shareholders have a greater claim on the assets and might get something out of the liquidation. For this reason, many consider preferred stocks to be “safer” than common stocks, but that may not necessarily be the case. They have their share of risks. First, preferred stocks may have pre-set maturities. Similar to bonds, preferred stocks can be callable after a certain number of years. This means the issuer can repurchase them at par value. If interest rates fall, the issuer may find it advantageous to replace the preferred stock with something cheaper. Preferred stocks are subject to interest rate risk, inflation and reinvestment risks.
Potential Pitfalls of Chasing Yield
- You may have concentration risk. If you allocate a big slice of your portfolio to high-yield investments, you may not have a well-diversified portfolio. MLPs, mREITs and REITs are all sector specific and, on their own, would not be sufficient to build a diversified portfolio. If you invest in only a few sectors, your portfolio returns may be tied to a narrow set of drivers such as interest rates or oil prices. That can be great when those areas are doing well, but if they aren’t, your portfolio returns will suffer. That is the price you may pay for not diversifying your assets among various sectors.
- High yield does not mean safer. While REITs, mREITs and MLPs may pay high dividends, concentrating your retirement portfolio on these types of securities could have a negative impact on your total rate of return. REITs and MLPs are sector specific and they can be volatile. They can be hit hard when the real estate or energy sectors decline. Their dividends may decrease or cease at any time. We recommend you talk to your tax adviser before you trade any security based on its high yield.
- Focusing on yield alone may hurt you total return. Whether in retirement, approaching retirement or 40 years out, investors should care more about total return rather than just dividend yield. Focusing solely on dividend yield can mean lagging what you would have gotten investing in a more diverse investment portfolio. That is because high-dividend stocks go in and out of favour, and dividends periodically shrink or get cut. Rather than relying on dividend-paying securities, you may be able to generate cash flows from a more-diversified and tailored investment portfolio.
Focus on Total Rate of Return and Homegrown Dividends
Focusing on total rate of return means you may be able to maintain a tailored, more-diversified portfolio and generate cash flows by strategically selling securities from your portfolio periodically. We refer to this strategy as taking “homegrown dividends” to meet withdrawal needs. This entails selectively selling stocks for cash flow. This strategy can be supplemented by dividend and interest income, but would also likely include sales of securities from time to time. This allows you to manage how and when cash flows are generated and, if you have a taxable (non-IRA) account, your potential tax liability associated with withdrawals may be lower if you strategically sell securities than if you rely solely on high-yielding securities.
Meeting Your Investment Objectives
Whether interest rates are high or low, investing in high yield assets may not be the best way to meet your long-term goals and objectives. Our wealth advisers can help you define your investing goals and set up a financial plan to meet your needs. We can also help you understand the value of focusing on total rate of return.