The Logic Behind Chasing Yield

September 27, 2016

There is a stark contrast between the two charts. Measured by standard deviation, short-term bonds are much less volatile than longer-maturity offerings. Dividend stocks show similar volatility to the stock market. Real estate, because of its concentration and contribution to the financial crisis, is the most volatile. International stocks have moderately higher volatility than domestic stocks.

Income volatility displays significantly different characteristics. First, the three bond ETFs reverse their risk. Long-duration Treasurys show reduced risk because interest rate cuts have less effect. On the other hand, the short-duration market reacts more swiftly to changing rates, making the income flow less stable.

Dividend-paying stocks carry the lowest degree of income volatility. Investors planning to live on investment income experience the lowest volatility in annual income by investing in higher-yielding stocks. Real estate, while more volatile than a diversified portfolio of stocks, still sees a significant drop as well. The S&P remains more volatile, and international stocks, which are more likely to pay dividends, see a significant drop.

Conclusion

Income volatility analysis guides investors toward more consistent yields. It challenges the conventional thinking that standard deviation, or other performance-based metrics, represent how income-oriented investors view risk.

Yet my top market concern remains declines in income-producing securities. An interest rate hike would likely boost volatility for investors who have been chasing yield and enjoying the heady performance from pursuing income securities. The Wall Street Journal recently reported evidence of income’s prominence: “The five-year rolling correlation between S&P 500 companies’ dividend yield and the index’s performance has been above 0.95 for the eight quarters through June, according to S&P Global Market Intelligence.”

Using income volatility to analyze risk requires the investor to commit to focus on income even when markets drop sharply (and yields rise). Will that commitment hold if these investments lag the broader market? Based on past behavior, probably not.

Income investors should also contemplate how the popularity of yield may cause companies to increase yield more than they should, causing those higher yields to come with extra risk. Past income volatility may not reflect future results.

(Note on Risk Metrics: For simplicity, I chose standard deviation rather than beta as the risk measure. While beta may be a better measure of evaluating the risk of bonds, I wanted to highlight the underlying risk of income securities when held in a nondiversified portfolio. The income numbers were evaluated annually, rather than monthly, because this is how people budget, and some holdings only pay income quarterly or semiannually.)

At the time of this writing, CLS Investments invests in SHY, IEF, TLT, SPY AND EFA for its clients. CLS Investments is a third-party investment manager and ETF strategist. It began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds. Contact CLS' Chief Strategist Scott Kubie at 402-896-7406 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.

 

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