It can be tempting to seek out yield for your retirement-planning strategy. Learn how that can be a risky move.
With 10-year Treasury yields plunging anew to sub-2% levels, we figure many retirement planning strategists and investors may erroneously be searching far and wide for yield to fund their withdrawals. We say “erroneously” because many times, doing so introduces entirely avoidable risks into your portfolio.
10-Year Treasury Yields
Since the Fed cut interest rates overnight to zero on December 17, 2008, 10-year Treasury yields have averaged 2.55%—more than four percentage points lower than the 6.85% average in the half century preceding that date. Since Treasury yields are often a benchmark tracked by other bond yields, this meant yields on other bond types--like Corporates--followed suit and plummeted.
The resulting ultra-low-rate environment had many searching for yield throughout this bull market and, as a result, investing in some rather complicated and undiversified places. Other investors turned to the equity markets, seeking high-dividend-paying stocks. That, in and of itself, isn’t hugely problematic, but many investors seemingly sought securities based solely on high yields. Wittingly or unwittingly, many plowed into Master Limited Partnerships (MLPs), Real Estate Investment Trusts (REITs) and Mortgage REITs (e.g., Annaly Capital), and Business Development Companies (e.g., Ares Capital), equity-like securities typically carrying lofty—sometimes double-digit—“dividend” yields.
Dividend Yields and Retirement Planning
We use scare quotes in “dividend” yields because the yields are often not just dividends. Each of the security types listed above is legally required to pass profits to investors--but they often pass through other stuff, too. The “dividend” you are getting is actually a “distribution,” which may include some capital gain, some dividend, some interest and some return of capital.
That last part--return of capital--is a key factor. This is not investment return in any way. It is your money coming back to you, and your cost basis in the security is reduced for it. You can’t just plug the ticker into Google Finance to see this, either. You need to do more research to determine the breakdown of the distribution you are getting.
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How a dividend is sourced will impact how you are taxed on the income, if you own it in a non-retirement account. What’s more, if you own MLPs, you may be subject to income tax on certain distributions even if you own it in an IRA! Talk to your tax adviser before you click “buy” based on a lofty yield alone.
In short, don’t buy a security--bond or stock--because of a lofty yield. Doing so eschews diversification principles, as some sectors, industries and classes of stocks don’t pay dividends at levels likely to hit a yield-chaser’s radar screen.
MLPs, BDCs, Mortgage REITs and REITs tend to pay high yields because of their business structures, which allow them to operate free from corporate tax by passing nearly all profits through to shareholders. Hence, a screen of markets based on dividend yield will inevitably return a list top-heavy with REITs, Mortgage REITs, BDCs and MLPs. In small doses, investing in traded versions of these is acceptable. But centering your entire retirement-planning portfolio on, or allocating a huge slice to, these types of securities because they sport lofty yields ignores the fact all are small slices of the global market. All trade like stocks. All are undiversified. All are very sector-specific, with three of the four (BDCs, Mortgage REITs and REITs) engaged in financial activities. (MLPs are almost exclusively Energy securities.)
Securities Are Not Bulletproof
There is nothing special about these security types which shields them from volatility. Dividends don’t imply safety. All four of these were hard hit during the financial panic--especially REITs, given their exposure to real estate, and Business Development Companies. Both fell more than 70%. MLPs held up much better in 2008, but they have collapsed since mid-2014 alongside oil prices. Narrow, undiversified portfolios and indexes tend to experience far greater volatility—so it is with these small subsets of sectors.
Again, we aren’t saying there is anything inherently wrong with these securities.iWe are saying that building a retirement-planning strategy centering on these assets is not viable. That may leave you wondering how to get the cash flow you need. Simple! If you focus on total return (price movement plus dividends) and realize that it isn’t a sin to sell securities to generate the cash you need, the problem is solved.
The local Piggly Wiggly will not reject any withdrawn principal you offer. Dollars in your retirement accounts, friends, are dollars. Pure and simple. Hence, if you need withdrawals, you don’t really need yield. You need return over time, and that is very different. Instead of focusing on yield, we suggest focusing on making sure your strategy is adequately diversified. In our next post, we’ll cover a professional investor’s approach to just that.
i To the extent you target the listed versions of them. Nontraded REITs, BDCs and partnerships are illiquid, opaque, and carry high sales commissions. We don’t believe there is a rational reason to buy one of those versus a listed version.