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Pension plan sponsors require higher income to pay pension promises and higher returns to close the gap between their assets and liabilities. It’s not a surprise that investors are increasingly focusing on investments that provide a higher yield (or current income return) due to the historically low interest rates on government bonds.

Judging by the prevalence of articles and advertisements for yield and income products in the business media, it’s clear that marketers are wise to this trend and are creating a virtual siren call, beckoning investors and their assets. By and large, it has been working.

Inflows into ‘safe’ income oriented investments have attracted 91% of Canadian retail investor’s long-term investments in mutual funds during the first half of 2012. Though the same level of detail is not currently available, a similar (but less pronounced trend) toward seeking higher yields is also apparent in institutional markets.

Income generation
From an investment perspective, a strong argument can be made that equities, which offer high dividend yields, can be beneficial to overall portfolio performance. The same can be true in the bond market, where studies have shown that the extra return provided by riskier credits will usually more than compensate for the default experience (at least when these markets are not overvalued at the time of investment).

However, too narrow a focus on current yield rather than total return (income and capital gains/losses) over the entire holding period can be dangerous.

Income generation can be a good thing, but it should be a focus not necessarily the focus of investors. Investors should also remember that just because you require a certain level of return to fund your objective does not imply that you should invest in riskier investments to achieve those return objectives. It would be wise to heed historical economist Peter Bernstein’s caution, “The market’s not a very accommodating machine. It won’t provide high returns just because you need them.”

Read: Pension funds rethinking risk, investing models

This type of reaching behaviour can lead to chasing both past returns and higher yielding investments (i.e. if I can’t get the return I require from government bonds any longer, I’ll invest in corporate bonds and if corporate bonds are not going to return enough, I’ll invest in high yield bonds).

Evaluating risk
When reaching for more yield in the bond market, a shrewd investor understands there is likely a very good fundamental reason one bond has a higher yield than another and the reason is that it is riskier.

When evaluating yield enhancing strategies ask your manager if they seek bonds that have high yields or bonds that have higher yields from issuers who are also very likely  to be able to continue to pay those same higher yields into the future.

Also ask your manager if the higher yielding issuer will have the ability to actually pay the bond’s face value as it comes due, or will they be dependent on the largesse of future bond investors to provide the liquidity required to pay back your capital.

The same can be said in the equity market. A company or fund that pays a high dividend is not necessarily a good investment. Again, the focus should be on dividend paying company’s ability to continue paying dividends at current (or increasing) levels out of operating earnings and cashflow. These same companies should also have some kind of sustainable competitive advantage which will give you as an investor, some reassurance that they can continue to pay these dividends over the long term.

Lessons learned
Like an iceberg in the ocean, a high yield may hide the danger that lurks beneath. David Einhorn, hedge fund investor and author of Fooling Some of the People All of the Time, describes a situation where this iceberg analogy played true.

A firm successfully lured investors by offering a high and growing dividend. However, when Einhorn scratched below the surface he found that the firm was “only fooling its shareholders by paying lofty ‘dividends’ partly based on new capital contributions in a classic pyramid scheme format.” Eventually the house of cards collapsed when the dividend payouts became unsustainable.

Junk bond investing that took place in the late 1980’s would also fit this description, as would many of the former income trusts in the Canadian market and the non-bank sponsored asset backed commercial paper (ABCP) market. In all four cases investors were lured to danger by an enticing yield.

Investors in today’s markets would be wise to heed these examples and resist the temptation and remember the following:

  1. stick to sound and time-tested investment principles;
  2. don’t increase your risk if you don’t have the financial ability to weather the possible negative consequences;
  3. understand that missing a short term income/return target is usually much less painful than suffering a permanent loss of capital;
  4. when changing strategies, document the rationale and don’t panic if the investment waters turn rocky; and finally
  5. remember that past experiences have shown, as investment writer Raymond DeVoe, Jr. said, “more money has been lost reaching for yield than at the point of a gun.”

Ryan Kuruliak is a Toronto-based vice-president with Proteus Performance Management Inc. He has more than 13 years experience in the pension and investment consulting industry.

These are the views of the author and not necessarily that of Benefits Canada.

© Copyright 2014 Rogers Publishing Ltd. Originally published on benefitscanada.com

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