February 22, 2012

Beware of the Yield

What would you say to a fund yielding 9.0% with highly tax-efficient distributions?

Sound appealing? It’s available, but it also comes with risks we fear some investors are overlooking.

Everyone wants yield. We can see this in the number of new income-oriented products and the heavy promotion of existing ones. Flipping through a recent investment magazine there were 20 full-page ads, with no less than 10 of them devoted to advertising income related products. Higher yields are alluring in today’s low interest rate environment, but it’s time to take a closer look at the risk of chasing yield.

We like to learn from history and chasing yield is not a new phenomenon. Today’s proliferation of high-yielding income funds reminds us of the Income Trust craze. So what lessons can we take from Income Trusts? Five years ago, we saw businesses that made poor candidates as dividend-payors, transform themselves into income trusts for the tax advantage of the distributions and to attract more investors. Many of these businesses had cash flows which were either too variable or too small to support the size of distribution they promised. The result was they distributed more cash flow than they earned and had to either take on more debt or “sell the furniture” to keep up. When the Hon. Jim Flaherty killed the Income Trust structure on Halloween 2006, these high-paying investments had to revert to relying on the quality of their underlying business to generate returns for their investors. Unfortunately, many investors had been evaluating these income trusts on their yield alone and were disappointed to learn neither the yield nor valuation was sustainable without the income trust structure.

Investing based on yield alone can frequently end in disappointment. Higher yields do not indicate better investments, in fact, they can sometimes point to more dangerous ones. Higher yielding bonds, for example, can imply more credit risk, a greater chance you will not get all your money back. Alternatively, higher yields can be a result of unusual features embedded within the bonds’ terms. Experienced credit analysis is required to navigate these bonds profitably. High dividend paying stocks could suggest a cut in dividends is coming or that the Company is overpaying dividends at a cost to the growth of the business. As we will see, a business or fund can payout any level of headline yield they like … over the short-term. This is why it is essential to understand the underlying investment and the risks that lie beneath the headline yield.

Today, some of the monthly income funds offered by Canadian banks look very attractive offering yields as high as 9%. As my Father used to say, if it sounds too good to be true, dig deeper. The question then becomes, with yields on government bonds averaging 2.5%, good quality companies paying dividends of 2 to 4% and mutual fund fees costing on average 2 to 2.5%, how are these funds able to pay out 9%? Simple, yield is not the same as income.

There is a difference between the headline yield advertised and the investment income the fund earns from its’ investments. Headline yield can be made up from four sources; interest income, dividends, capital gains and return of capital.

 

 

The last component, return of capital or ROC, allows funds to commit to pay any level of yield they wish, regardless of their investment returns. This is because ROC, in plain English, is the fund manager giving you back your own money without any investment return (that’s the tax-free component). Oh, and by the way, you won’t know how your payouts are broken down until after the yearend when the annual Management Report of Fund Performance (MRFP) is published.

It isn’t necessarily bad for funds to target a headline yield, it offers investors the ability to budget. However, unattainably high headline yields could influence managers to make decisions to the long-term detriment of your investment. Starting to sound familiar?

For example, a fund manager may wish to avoid paying out capital from the fund (remember they are incented to grow the capital they manage, not give it back), so they may be motivated to reach for high yielding, risky investments to satisfy the high targeted payout of the fund. Another issue with promising a high headline yield is a manager may attempt to increase capital gains to offset the amount of ROC needed to meet the yield commitment. In this case, they could be incented to sell the winners in the portfolio prematurely in order to crystallize the gains. Neither strategy is good for the long-term sustainability of a fund.

So what do we recommend? Stick to a fund that you understand, charges a reasonable fee of 1.5% or less and limits the distribution to the income they’re earning. This may produce a lower yield than you would like, or need, but you can always supplement the income by selling some of your holdings to make up the difference (i.e. determining your own ROC). This way you are in control of how much of your own capital you take back and the manager won’t be incented to take undue risk. Lastly, avoid funds with complicated income strategies you don’t understand. Not understanding what you own is, in our view, the most significant risk to any investor.

Remember the Income Trust experience when evaluating today’s high yielding income funds and always Beware of the Yield.

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. All tax decisions should be made after discussing your individual positioning with a qualified tax accountant, as everyone’s tax situation is unique. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.