With interest rates at all-time lows, investors are desperate for yield.
But focusing only on income can often lead to a bad outcome.
Investors have a lot to worry about these days but if you’re trying
to live off the proceeds of your portfolio, one concern trumps all
others: low interest rates. As of mid-August, 10-year Government of
Canada bonds were paying about 1.8%, not even enough to outpace
inflation.
“I feel for people,” says Alan Fustey, portfolio manager at Index
Wealth Management in Winnipeg. “Fifteen or 20 years ago, you could
always find a coupon around 10%. Then it went down to 8%, then 5%, and
now if your portfolio is largely fixed income, you just can’t get that
yield anymore.”
The appetite for yield has spurred many Canadians—especially those in
retirement—to modify their investment strategy. That’s understandable:
after all, a retirement portfolio is supposed to generate cash flow to
meet your expenses. The problem is many have lost sight of the big
picture, and that can lead to poor decisions. “People are blindly
looking for yield and not really understanding the consequences,” says
Fustey.
Most investments deliver some combination of yield (income from
interest or dividends) and price appreciation. Both are equally
important and together add up to an investment’s
total return.
What’s often forgotten is that one usually comes at the expense of the
other: bonds with higher coupons can bring a capital loss, stocks with
higher dividends may experience slower growth, and so on. Investors run
into trouble when they look at only one side of the equation.
“Right now the flavour of the month is yield, yield, yield,” Fustey
says. “But at the end of the day there is always a price. You are always
giving something up.” Here are four common examples that can help you
avoid eating tomorrow’s lunch today.
Bonds
Say you’re comparing bond funds and notice the iShares 1-5 Year
Laddered Government Bond Index Fund (CLF) pays a distribution of 4.5%.
That sounds awfully tempting when you consider that a ladder of one- to
five-year GICs (which has the same level of risk) yields about 2%.
Indeed, this difference is what prompted one well-known financial writer
to recommend CLF because it offers “better returns than GICs.” But this
simply isn’t true.
Bond math is tricky, but the most important idea is that when
interest rates fall, bond prices go up. To understand why, imagine a
five-year bond with a face value of $1,000 that pays a 4% rate of
interest (or
coupon), which is $40 annually. Now imagine a year
later rates have fallen one percentage point. Our original bond now has
four years left to maturity and is still paying $40 in interest, while
new four-year bonds are paying just 3%, or $30. If you want to buy a
four-year bond today, which would you choose: the old one paying 4%, or
the new one paying 3%?
Obviously, you’d want the one paying more interest—but so does
everyone else. So the bond paying 4% will now carry a premium: it would
sell for about $1,037. When it matures, the investor will get back only
the face value of $1,000, so he suffers a capital loss of $37. That will
offset some of the higher income he’ll receive over the four years.
Overall, the bond’s total return will work out to 3% annually—exactly
the same as if he’d bought a new bond at current rates and paid face
value.
OK, back to our government bond fund from iShares. The reason it pays
that hefty 4.5% distribution is that all the bonds in the fund were
issued several years ago, when interest rates were higher. They were
purchased at a premium, and when they are eventually sold the fund will
incur a series of capital losses that will offset most of that 4.5%
coupon.
That’s why investors need to make decisions based on a bond fund’s
yield to maturity.
This figure—which should appear on a bond fund’s website—estimates the
fund’s total return based on interest income minus any capital losses.
In the case of CLF, the yield to maturity today is about 1.5%—and that’s
before subtracting management fees. An investor who puts $100,000 into
this fund might collect $4,500 in income from the 4.5% yield, but he
will also lose more than $3,000 of capital.
You’ll notice CLF’s yield to maturity is significantly
less
than the yield on a five-year GIC ladder. That’s what you should expect,
since GICs usually pay more interest than government bonds. Bottom
line: an investor who considered only the income component of these two
investments would have chosen the one with the lower total return.
Dividends
Many investors take for granted that they need to focus on
dividend-paying stocks in retirement, as opposed to using a more
diversified strategy that also includes growth stocks with little or no
yield. There’s nothing wrong with focusing on dividends, especially if
you’re investing outside an RRSP or RRIF, since the tax advantage of
Canadian dividends can be enormous. However, just like bond buyers,
dividend investors sometimes forget there’s a trade-off.
Take the idea that spending $1,000 of dividends is “living off
income,” while selling $1,000 worth of shares is “depleting capital.”
Academics have spent decades arguing that these two actions are
essentially the same, but the message hasn’t sunk in. “That’s a hard
one, because it’s totally behavioural,” says Steve Lowrie, portfolio
manager at Lowrie Financial in Toronto. “People think that dividends are
found money: they don’t realize it’s just money coming out of the
company that could have been used to buy back shares or expand the
business.”
Think of it this way: if a company pays you a $1,000 cash dividend,
it must be worth $1,000 less than it was before. That’s why you’ll often
see a company’s share price decline a few days before an announced
dividend is paid. That confuses many investors. As one finance professor
wrote: “I once heard a fellow say, ‘I don’t understand it; every time
this stupid stock pays a dividend, it goes down. You would think it
would go up.’” That’s a classic example of the income illusion at work.
Investors who gobbled up income trusts fell into a similar trap
several years ago. Thanks to a tax loophole the government has since
closed, these companies paid out generous distributions, often 8% to 10%
or more. But often more was going out than coming in. “Generally these
were depreciating assets, so you were getting some return, plus a piece
of your principal back,” says Alan Fustey. “People would call it yield,
but that makes no sense, because you’re depleting your original
capital.”
Another common misunderstanding arises when investors measure their
“yield on cost.” Say you bought a stock 10 years ago for $20, when it
was paying a dividend of 4%, or $0.80 per share. The dividend increased
8% annually, so a decade later it’s grown to $1.73 per share. Some
investors will divide the current dividend by their
original cost and say their investment is yielding 8.6% (1.73 ÷ 20 = 0.086). But a stock’s true yield is its dividend divided by its
current
price, not the price you paid for it. Yield on cost is an almost
meaningless figure that can lead investors to badly overestimate their
total return.
None of this means dividends are irrelevant. “With all of the
accounting shenanigans that have gone on, dividends are something that
can’t be masked—at least not entirely,” says Dan Hallett, director of
asset management at HighView Financial Group in Oakville, Ont. He argues
dividends can signal management’s confidence in the business and its
earnings outlook, and there is evidence to suggest that companies with
strict dividend policies are less likely to squander their profits on
ill-advised acquisitions. “But I would agree it is largely a
psychological love affair with dividend strategies in general.”
Return of Capital
Some of the most popular mutual funds around are those that pay
unitholders a fixed distribution each month. The BMO Monthly Income
Fund, for example, pays out $0.06 per unit every month, which currently
works out to about 10% per year. That juicy yield helps explain why the
fund has attracted some $5 billion in assets.
The thing is, this distribution far exceeds what the fund can produce
in bond interest and dividends. So in order to maintain its monthly
payout, the fund has to sell some of its assets and pass along the
proceeds to investors in the form of “return of capital.” This is
essentially giving you back your own money and calling it income.
There’s nothing wrong with generating cash flow from a combination of
interest, dividends and dipping into capital. (In fact, that’s exactly
the approach we recommend in “
A better way to generate cash flow,”
below) “In the same way that there’s no difference between receiving a
dividend and selling a few shares to generate cash flow, there is no
difference between having your mutual fund automatically pay a
distribution and you selling a few units,” says Hallett. “The problem is
with investors’ perceptions of what’s really happening, and with how
these funds are sold.”
The fact sheet for the BMO Monthly Income Fund says the fund is
appropriate if “you want regular monthly cash flow with the potential
for capital gains.” But as Hallett points out, “With that level of
distribution, there’s no way you can get capital growth.” This is a fund
of half stocks and half bonds, paying almost 10% and charging 1.57% in
fees. It would only enjoy capital growth if the stocks appreciated by
about 20% a year.
In fact, the price of the BMO fund has fallen from $9.30 in mid-2003
to about $7.30 as of mid-August, a decline of more than 20% over 10
years. Its total return over this period was much lower than its payout:
5.3% annually, which is about what you’d expect from a balanced
portfolio of bonds and dividend stocks. It’s a perfectly good balanced
mutual fund, so long as investors understand that about half the
“income” is just their own money being returned to them.
Return of capital isn’t just a feature of monthly income mutual
funds: even dividend ETFs use the technique to smooth out their payouts.
From 2009 through 2011, for example, about one-sixth of the cash
distributions from the iShares Canadian Dow Jones Canada Select Dividend
Index Fund (XDV) were return of capital. To see whether this applies to
your own ETFs, visit their web pages and click the “Distributions” tab
for details.
Covered Calls
If you need proof that many Canadian investors are blinded by their
search for yield, look no further than the extraordinary popularity of
ETFs that use covered calls to generate income. There are now 19 of
these trading on the TSX, and in about 18 months they’ve gathered about
$2 billion. Given that these ETFs boast yields in the range of 9% to
more than 18%, it’s easy to see the appeal. But once again, investors
may be setting themselves up for disappointment.
A call option is a contract that gives the holder the right to buy a
stock at a certain price within a specified period. Imagine you own
1,000 shares of BigBank, currently trading at $50. You might sell
(or write) call options on those shares with a
strike price
of $52 and an expiry date six months from today. The person buying the
call will pay you a premium of, say, $1.20 per share. Over the next six
months, if the stock never increases to $52, the call options will
expire worthless: you get to keep your shares in BigBank, any dividends
the company paid, and the $1,200 premium.
However, if the stock rises above the strike price, the holder of the
call option will buy the shares from you for $52. You will still get to
keep the $1,200 premium, but if you still want 1,000 shares of BigBank
you’ll have to buy them back at the higher price. That’s the trade-off
with this strategy: if markets move upward quickly—and they do that all
the time—you could forfeit a big gain.
“What you’re doing is trading some potential return for some
certainty,” says Alan Fustey, who regularly writes covered calls for his
clients. (A call is said to be “covered” if you actually own the
underlying stock. If you don’t, it’s a “naked call.”) “Many of them are
looking for consistent levels of income in retirement and if we’re not
able to generate enough through bond interest and dividends, we can
write calls to get them closer to what they need.” But he’s careful to
ensure his clients understand they’re giving up some upside. “There’s no
free lunch. We know if the market goes up 10%, we might only get 6%.”
In theory, call-writing strategies should lag in strong bull markets
but outperform when markets go sideways, rise gradually, or decline. But
as the past year has shown, covered call ETFs can lag during falling
markets if there is a lot of volatility. The Horizons Enhanced Income
Equity ETF (HEX), for example, currently sports a yield of over 10%, yet
its total return over the 12 months ending in June was –11.8%, worse
than the overall Canadian market. Over that same period, the BMO Covered
Call Canadian Banks ETF (ZWB), boasting a yield of 7%, returned –3.3%.
That’s 0.5% less than if you had simply held those same bank stocks and
not engaged in any call writing.
Fustey is concerned investors flocking to covered call ETFs may
simply be chasing yield. “There has to be some degree of
misunderstanding about how these work.” They may not realize some of
these ETFs write calls on 100% of the stocks in the portfolio, something
he rarely does. (Others do so on only 25% to 50% of a portfolio,
reducing income but giving investors upside if the stock rises in
price.)
He worries some ETFs hold a relatively small number of companies in
just a single sector. “Look at the ones focused exclusively on Canadian
banks—you’re buying a narrow segment of an already narrow market.”
Fustey prefers to write calls on broad-based index ETFs tracking the
entire Canadian and U.S. markets, which provides more diversification
and less volatility.
Hallett doesn’t recommend call-writing strategies. “You’re saying you
will take the cash now and give up some upside but in the fullness of
time, on a total-return basis, I don’t see how that works in your
favour. If history is any indication—admittedly, it might not be for
your investment horizon—you’re probably giving up more than you’re
getting.”
A Better Way to Generate Cash Flow
The idea that retirees should live off the income from their
portfolios without dipping into principal goes back a long way. It made
sense in the 1980s and 1990s, when 10-year government bonds yielded 9%
or 10%, and inflation was less than half that rate. Today, only the
wealthiest Canadians can hope to pull this off. “For most people it’s an
unrealistic expectation that you can live purely off income over a long
period,” says Dan Hallett of HighView Financial Group. “I just don’t
think that most people will have saved enough to do that.”
A more realistic approach is to use a strategy that generates cash
flow using a combination of bond interest, dividends and a dollop or two
of principal. After all, that’s exactly what you do when you buy an
annuity: you turn a lump sum into a regular stream of income that will
last throughout your lifetime, but isn’t expected to last for eternity.
Depending on the risk you’re willing to take, the size of your nest egg,
and how long you live, this approach should allow a withdrawal rate of
about 4% to 6% for 30 years or more. If you keep to the lower end of
that range, you should be able to increase your withdrawals each year to
keep pace with inflation.
But how do you manage the process? Portfolio manager Steve Lowrie
sets aside a cash reserve covering three years’ worth of expenses, and
clients use this account for their regular cash flow. The rest of the
portfolio is invested in a globally diversified blend of stocks and
bonds. When it’s gone up in value, he takes some profits and replenishes
the cash reserve. The three-year buffer usually gives him enough time
to ride out market volatility. “This was really helpful during 2008–09,”
he says, “because my clients could meet their cash flow needs and
ignore the rest of the portfolio. Then when things rebounded, I
rebalanced by selling stocks. It gives you a lot of flexibility.”
Hallett likes that approach too, but warns investors it can be
difficult to manage without an adviser. “This total-return approach is a
bit more high-maintenance, but realistically it’s the best way to
address cash-flow needs. There’s a little bit of timing involved,
because you want to replenish that short-term account when your other
assets are on a bit of a high. Just don’t get hung up on the timing: it
doesn’t need to be perfect.”
With interest rates at all-time lows, investors are
desperate for yield. But focusing only on income can often lead to a bad
outcome.
