How do rising bond yields impact my investment strategy?

The rapid rise of interest rates over the last year has led some investors to focus on a yield-oriented investment strategy.  The thinking is:

  • I am conservative; I can live on income and never touch principal, or
  • If I can earn 4% to 5% in bonds, then why invest in equities?

It may surprise you though, that whatever your personal investment goals, this approach is not the best strategy to achieve those goals.  Rather, a yield-oriented investment and spending strategy leads to one of two undesirable consequences:

(1) you set a spending target that is lower than you can afford, thereby depriving yourself of certain comforts and pleasures that you deserve, or

(2) you end up with less purchasing power in later years, thus reducing your flexibility for spending, gifting to heirs, or supporting favorite charities.

These unfavorable outcomes occur because a yield-oriented strategy fails to create a properly diversified, tax-efficient portfolio that will have the highest likelihood of meeting your cash flow needs over time.

Let’s first review some of the key problems of an income-oriented strategy and then introduce the preferred approach, commonly called the total return strategy.

Income focus can lead to a riskier portfolio.

Remember that optimal portfolios are well diversified across various sources of returns and risks and that financial markets price risk in terms of total return. A portfolio focused primarily on one component (say, just income) will fail to optimize the risk and return.

With an income-generating focus, you might overweight your portfolio with high-yield (i.e., low quality) bonds and high dividend stocks in aging industries while overlooking sectors with higher return prospects such as health care, infrastructure, technology, and emerging markets.

History reveals many examples of assets promoted as providing high income but which proved to be very risky: low-quality “junk” bonds, high-yield closed-end funds, subprime mortgage securities, and auction rate preferred stocks, to name a few.

Withdrawing the current yield will not preserve purchasing power.

Some refer to U.S. Treasuries as “risk free.” Though they may be free of default risk, they carry considerable inflation risk.  As attractive as a 4% or more yield on U.S. Treasury bills or notes sounds, they currently have no to low real return when inflation is factored in.

For example, if you buy a $25,000, 20-year bond with a 4% coupon, you’ll receive $25,000 back in 20 years and $1,000/yr. in interest.  The reality is that you don’t know what $25,000 will be worth in 20 years because the future rate of inflation is unknown.  If inflation rises over the 20 years, then the purchasing power of the bond will have declined and your original $25,000 simply won’t buy the same goods and services.  In effect, you are losing ground gradually to inflation.

High-yielding investments may not be great long-term investments.

Bonds may have high interest payments, but they offer no opportunity for growth in their value on redemption.

Stocks of companies that pay high dividends to their shareholders may do so because they have few interesting investment opportunities and little growth. Attractive dividend levels today may not be sustained over time as the company’s prospects dim.

Focusing on income may lead to paying unnecessary taxes.

The tax rate on interest income is substantially higher than the tax rate on capital gains for most investors. Stocks that generate capital gains can provide far more efficient cash flow than income from bonds.

With the total return approach, fundamental principles of finance (asset allocation and diversification) are applied to design a portfolio that properly balances risks and expected returns from a broad array of asset classes to match your lifetime financial goals. After-tax cash flows from interest, dividends, capital gains, and sales of securities can be applied to meet current cash needs, while any excess can be reinvested for future portfolio growth.

It is easy to confuse “I need my portfolio to support my spending needs” (a goal), “I am conservative” (a risk tolerance), and “I need income producing investments” (an implementation approach). In developing your investment approach, an orderly sequence is important. Define your goals first, then develop a plan that balances these goals with risks.

A total return approach to portfolio design will improve the likelihood that your portfolio will be able to support your withdrawal needs over time.

Valerie Connolly, CFA

Valerie joined HTG in 2011 as a senior advisor. Drawing on 30 years of experience in financial services, she greatly enjoys collaborating with clients to shape their financial aspirations. Valerie takes a lead role in developing client investment plans, researching investment vehicles and developing firm-wide investment policy.

Valerie received a BA from Wellesley College and an MBA from University of Chicago. She is a CFA® charterholder and a member of the CFA Institute and CFA Society Stamford.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
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