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High yield, high hopes?

Everyone wants income these days

I have long been a fan of income-orientated strategies. Not because the returns from income are necessarily always superior to total market approaches – though at times they can be – but rather because a focus on chasing capital gains can be so ruinous.

Not every decision in investing needs to be about maximising your theoretical return – there are other risks and rewards to think about, such as the risk of getting carried away, or the reward of being better motivated to reach your goal.

Accordingly, I believe in normal times many people would do better focusing on investment income rather than their net worth when calibrating their financial freedom plans.

But these are not normal times. Now it is expensive to have a taste for income:

  • Cash was yielding 5-6% half a decade ago, provided you were happy to chase the best rates. Now it pays 2% at best.
  • Long-dated UK government bonds will get you less than 2% a year. Gilt yields above 6% were the norm in the 1990s, and 5% was still possible before the financial crash.
  • The only shares the market truly loves are dividend paying shares, which has brought the yields down on many of the HYP favourites

Today’s low yields may prove to be rational, and we’ve warned before you may come a-cropper if you eschew cash or bonds in disgust at their miserly yields.

Personally I’m happy to take the risk of holding zero bonds (I’m a more than semi-active investor, remember, unlike my nobler purely passive co-blogger).

I do maintain a larger cash war chest than I otherwise would though (and indeed am about to add more to Zopa).

Coke is it

As yields have been pushed down across the fixed income classes, some safety-first investors have tiptoed into equities.

I suspect this is what has led to the most defensive-looking shares – utilities and the big consumer staples companies, as well as healthcare – doing so well.

You can also see the popularity of dividends in investment trust premiums and discounts. The equity income investment trusts long ago moved to a premium, whereas many global growth trusts still sit on big discounts. I’m just working through the update of my demo high-yield portfolio for next week, and I’ve already noticed my comparison basket of income trusts has truly been on a tear.

When a supposedly safer investment gets more popular, the price appreciation means it’s probably become more risky.

Sure, companies like Diageo and Coke will always be more predictable than miners or metal bashers.

Whether the shares are a safer investment comes down to the price you pay. If people are paying too much for boring dividend stocks, then they will get lower returns than usual in the future.

Hunting high and low

Active investor David Schwartz touches on this theme in his article in the Financial Times. (The link leads to a search list, the article should be up top).

Schwartz writes:

At first glance, a high-yield strategy looks to be worth pursuing. Profits from a steady investment within the high-dividend universe rose by 123 per cent in the past 15 years, assuming dividends were quickly reinvested.

In contrast, a low-yield investment approach resulted in a gain of just 41 per cent.

But the trend was reversed when a 10-year timeframe was used. Low-dividend shares gained 179 per cent since May 2003, against just 135 per cent for higher yielding shares.

Low yield shares did particularly poorly around the time of the dotcom crash, because so many tech firms blew up. In addition, steady ‘old economy’ companies had been shunned for years, which meant they were relatively cheap and sported high yields in 2000.

But very different conditions prevail today.

I’m not suggesting you should now blindly buy low yield companies instead of high yield ones. Passive investors should as always follow the principles of strategic ignorance and simply stick to their asset allocations. Active investors should be wary of any cut-and-dried ‘rules’ at all.

However the steady media and adviser commentary that’s pushing investors towards dividend-paying stocks does seem like an accident waiting to happen:

  • Firstly, all share prices decline from time to time. How will bond investors turned reluctant dividend-chasers cope when this bull market finally ends and their portfolios wobble?
  • Secondly, according to Schwarz low-yield shares are actually outperforming since 2009, despite the fad for income.

The dividend-chasing I’m discussing here has been most evident over the past 6-12 months, and is mainly a blue chip phenomenon, rather than a market wide one. I don’t think high yielding cyclicals are being targeted, for instance, which may explain that post-2009 result.

I also suspect Schwartz’ short-run data may be skewed by BP’s problems, and by the scrapping of bank dividends during the crisis.

As banks like Lloyds and RBS start paying dividends again, these low-yielders may deliver strong returns as they move back to being the higher yielders of tomorrow.

Consensus is costly

Let’s not get carried away with any of this. Schwartz’ analysis only covers 15 years – a blink of an eye in market terms. It doesn’t prove anything in particular.

Also, a big bonus of income-focused strategies is they substitute trying to trade for profits or even going for total return for simply building up your income streams. When you’re ready to spend the income instead of reinvesting, you just start to spend it.

In my experience income strategies also tend to be less volatile, with reinvesting the higher income helping to further cushion the downside.

All this has advantages (mainly psychological) that may even outweigh the pursuit of the greatest total return that is theoretically available from buying the entire market. Some people may therefore still rationally choose to buy equity income trusts on a premium, for instance, or income-orientated ETFs that may contain relatively overvalued dividend paying shares, even if returns prove to be a bit lower than from racier alternatives – especially if they’re refugees from the bond market.1

Tastes wax and wane. Back when I first got seriously interested in investing, a company’s shares sometimes got dumped for initiating a dividend payout! Growth was everything to a lot of people. Today the opposite seems to be true.

I don’t think even the blue chip consumer-focused dividend payers that are now so popular are in a bubble, exactly, although their multiples look quite stretched in many cases.

But if you’re buying higher-yielding stocks in this market – especially the so-called ‘aristocratic’ dividend payers – because you expect them to deliver higher returns than equities overall, well watch out.

Being in with the popular crowd has never been a route to investing riches.

  1. Personally I would prefer certain of the larger global trusts still on reasonable yields and discounts, but each to their own. []
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{ 14 comments… add one and remember nothing here is personal advice }
  • 1 John @ UK Value Investor May 16, 2013, 3:29 pm

    Blimey, we seem to be quantum entangled today… I have written the exact same article and posted it about 20 minutes before I saw this one.

    Great minds think alike and all that.

    My conclusion was that only some blue chip dividend growth stocks are overvalued. As an asset class I don’t think they are. They are of course trading at a premium, but not an especially excessive one.

    My guess is that their valuations will fall when the fear factor begins to fade over the next year or three…

    Will be interesting to see how Terry Smith does in that environment.

  • 2 Frugal May 16, 2013, 4:38 pm

    What about the European Dividend Aristocrats… I’ve been buying because they are solid concerns with good cash flow but much unloved.

  • 3 The Analyst May 16, 2013, 5:56 pm

    Dividend shares have certainly become increasingly popular in recent years and investor assets have flooded into dividend-focused investment vehicles. At first glance, this seems to suggest that dividend shares are overvalued.

    But this would suggest that dividend shares are a monolith. Of course this isn’t true as there are many different types of dividend-paying shares that attract various clientele.

    An ultra-high yielder (say, 8%-plus in today’s market) will attract far different clientele than a share that yields 2%. The former may be a deep value investor seeing the high yield as a sign of a depressed share price or even a “speculative income” investor hoping that the payout is sustainable. The latter share, on the other hand, would likely be avoided by the deep value group and could attract growth-oriented investors.

    I do agree with you, however, that there seem to be fewer out-sized opportunities in the so-called “quality income” group today.

    It’s important to remember that longer-term expected return is equal to starting dividend yield + dividend growth +/- re-rating. Looking at some of the quality shares today, a good number of them are trading with well-above historical P/E ratios so they’re more likely than not to find headwinds from the third factor in the equation over the next ten years or so. Further, as the quality shares have been bid up, their starting yields have declined. So that really leaves us with dividend growth as a tailwind. Ideally you want all three working for you — shares with a high starting yield, good dividend growth prospects, and are undervalued.

    Might the quality income shares maintain and grow their payouts over the longer-term? Absolutely. If you’re focused solely on income, fine, but remember that these are not bonds that will return par value at maturity. If your share falls 20%, your 3.5% yield is of little comfort.

    All this is to say that there are indeed overvalued areas of the dividend market today, but pockets of opportunity do exist. Trick is that they are likely found in the lower-quality/higher uncertainty areas of the market.

  • 4 ermine May 16, 2013, 8:17 pm

    The volatility of the income for a given set of HYP shares seems to be a lot less volatile than the SP too. It’s a shame that it’s hard to see what to get into this year because everyone else seems to be charging into the sector 🙁

    @Frugal Europe is a funny old game at the moment, isn’t it. Always a hair’s breadth from disaster, I bought the HSBC EU index fund, expecting it to stay low and carry on drip buying. Largely on a similar rationale – there are some great European big firms if you look at the top holdings in the index fund. They aren’t going to go bust any time soon. Contrary to my expectation it’s drifted up, before I could accumulate a decent holding size…

  • 5 SG May 16, 2013, 9:39 pm

    @Analyst, >If your share falls 20%, your 3.5% yield is of little comfort.

    Actually, I think the yield is a great comfort in that situation unless you have a compelling reason to realise your capital loss in the short term. You only need worry if you think that a dividend cut is likely. If it looks sustainable, buying more of your income producing asset *may* be the best course. Falling shares, as long as they are not knives, are the investor’s friend.

  • 6 Neverland May 16, 2013, 9:54 pm

    “Being in with the popular crowd has never been a route to investing riches.”

    Not so, buying houses in the UK has been a winner for a generation

  • 7 The Analyst May 17, 2013, 2:28 am

    @SG Fair observation. I should clarify. I didn’t mean to imply that investors shouldn’t take advantage of dips in the market or that dividends can’t diminish some of the market’s volatility. On the other hand, permanent losses of capital (i.e. losses other than temporary market fluctuations) are important to avoid and overpaying for shares increases the likelihood of this occurring. Ultimately, investors need to consider valuation in addition to income.

  • 8 ermine May 17, 2013, 9:27 am

    > whereas many global growth trusts still sit on big discounts.

    Sounds like the genesis of an interesting article perhaps 😉

  • 9 The Investor May 17, 2013, 9:34 am

    @SG — Indeed, fluctuating share prices are the reinvesting income investor’s friend.

    @ermine — They certainly are. Equity income trusts have easily beaten the index and my demo HYP over the past 12 months or so, as we’ll see next week. As I commented on your sight recently, with new money I’d far rather be a buyer of global trusts like Hansa (HANA) at this point.

    @Frugal — Haven’t investigated those euro dividend payers specifically, but I have been buying in Europe. I own Banco Santander, for example, but I’m rolling up the scrip dividend there. (Equivalent to a roughly 10% yield).

    @Neverland — Yes, fair enough, there are always exceptions that prove the rule. In fact, if we’re going to be picky then perhaps most investing requires a phase where you run with the crowd, in order to get your gains before getting out — even if you’re not *explicitly* following the crowd — though income investing to some extent may be an exception.

    That said, the UK property market is a weird outlier that exists I believe to taunt me for never buying, and to keep me humble. 😉

    @The Analyst — Great to have your insights, which we really miss around here. Hope we can have a new article from you soon! (For those who haven’t read the Analyst’s super articles on dividends, here’s the link).

  • 10 The Investor May 17, 2013, 12:14 pm

    @John — Sorry, forgot to reply to you. In short: indeed! Obviously no coincidence that you, me, and The Analyst are all seeing similar. I think you need to go cyclical (eg Rexam et al) if you want dividend payers that are still keenly priced in this market. Or perhaps financials.

  • 11 Luke May 17, 2013, 12:46 pm

    Interesting article, should:

    ‘Today’s low yields may prove to be rationale’ say ‘rational’?

  • 12 Paul Claireaux May 17, 2013, 1:38 pm

    Thanks The Investor

    This is a beautifully articulated piece describing the ebb and flow of sector favouritism.

    My own portfolio is heavily loaded with active and passive income funds (particular fan of Vanguard UK Equity Income Index) right now but I recognise this area is benefiting from central bank yield distortions.

    However when the interest rate tightening eventually comes (which is likely to be late if one listens to leading economist argument about there being more slack in the labour force than official unemployment data suggests – because people (like me) are taking time out rather than declaring themselves unemployed) then my guess is we’ll seem a triple whammy of bonds, smaller companies and high yielders being hit hard.

    The higher the pressure in your bubble the louder the burst.

  • 13 The Investor May 18, 2013, 12:44 am

    @Paul — Thanks for the generous review! 🙂

    Personally, I am much less worried about Central Bank tightening than most seem to be, provided it isn’t prompted by inflation suddenly taking off in an uncontrollable looking way (that was the fear I *did* share with many, especially at the start of QE).

    I personally think the impact of Fed and BoE in the markets has been widely exaggerated and perhaps misunderstood. In my view hasn’t created a giant flood of money, it has to some extent replaced money that has drained out of the economy due to the financial crisis / destroyed. As such it’s cushioned the downside (which was already pretty steep!) at the price of slightly lower growth over the long term (although the counterfactual is arguably a great depression that we’ve avoided). And that money in my view hasn’t poured into the stock market, rather it has nudged everyone along the risk curve.

    I dare say there could be a sudden kneejerk reaction like you describe, although it’s hard to say we weren’t warned, so you’d think it would be in the price?

    Interesting times! (Aren’t they always? 🙂 )

    @Luke — Thanks for that, fixed now.

  • 14 Paul Claireaux May 19, 2013, 3:10 pm

    I don’t think the effect of QE has been exaggerated – indeed if anything i think it’s understated.
    Take corporate bond investors like those sitting in the Co-op’s 5.55% PIB for example. Money Week actively encouraged people into this stuff last summer and is holding to it’s guns (perhaps concerned about admitting any fault?) http://www.moneyweek.com/investment-advice/how-to-invest/strategies/right-side-co-op-great-bond-for-the-brave-63913?comment=1#comments
    But let’s be clear – even if the Co-Op PIB holders are bailed by the parent group (and that’s a BIG IF) there’s a good chance of a further 50% capital loss. See FS accountant’s comments on the MoneyWeek update article.
    And if they’re not then the potential loss is 100%.
    My sense is that very few retail investors in these and other corporate bonds have any clue about the risks they’re running. Most simply compare the running yield to their local building society deposit rates!! Yes, QE has certainly driven investors up the risk curve in search of yield but my guess is that many investors (retail and institutional) will come scuttling back down the risk curve after a few more banks start to fail (Curiously this is also a possibility outlined by Money Week in their major missive of recent weeks)
    And then we’ll see some serious reverse travel back into perceived safe havens of cash deposits – and perhaps some increased flows into Gold also.
    Either way I can only see upward pressure on medium and long term debt yields in the medium term – and this will have negative effect on equity valuations.
    What could the BOE do about this? This is really outside my expertise domain but I’m guessing they might, like the FED in the USA, start loading up on riskier assets like Mortgage backed securities. Indeed – the government is effectively already doing this via the back door with its help to buy scheme. And the BOE governor (on his way out) has warned of the risks of this. Of course we have an election coming so governments will do anything to prop up house prices at these times.
    I guess the big unknown we’d all love to predict is when Governments and major central banks call a halt to asset purchases to prop up prices and hold down rates. I sense the time is coming when long term rates get beyond their control. When debt is only attractive again at very juicy yields.
    Bernanke said recently he was concerned about bubbles – which is curious given he didn’t see the big one coming in 2007-08 and that his actions and those of his predecessor (Greenspan) have driven all the bubbles of the past 20 years (Stocks, Tech, Property and now bonds)
    But does that mean he’ll actually apply the brakes on this one if it runs any further?
    Who knows – I sure don’t but I do know that when bond markets turn they can turn aggressively. And let’s face it – we’ve never been at these highs (yield lows) before so it’s worth making sure you have a good mattress for when the Minsky moment arrives – as it surely will.

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