Interest and dividends paid from investments are important parts of the investment's total returns. These yields come in many forms, sizes and taxable statuses. Yields can be a large contributor to total return from a bond, or contribute a much smaller percentage to total return in a stock, mutual fund or ETF.
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Overview of Yields
Some of the most common yields come from government and corporate bonds, and their prices often competitively reflect the yields they offer. In the case of municipal bonds, the prices are typically a reflection of after-tax yield. Stocks can also pay out a portion of profits in dividends or yields, but often pay less than bonds in general. While the general risk-reward relationships apply to those who look for high yields, the level of risk associated with yield and their spreads are not as clearly defined as they are in other investment markets.
Regardless of the economic cycle or the source of the yields, a large portion of the investment industry and the investing public is devoted to seeking out the highest yields possible. Finding and keeping the best yields over multiple market cycles is a challenging and dynamic process that keeps investors on a vigilant search. (For more, see Dividend Yield For The Downturn.)
Investing has inherent risks, which are by no means exempted from those investing in yield-bearing instruments. One of the most common ways to capture yields is to purchase U.S. government bonds. While these are considered risk-free by most investors, their investment yields have had a history of volatility that would suggest otherwise. While government bonds tend to pay yields lower than corporate bonds, swings in their prices, especially in longer maturity bonds, are not out of the question. Corporate bonds typically pay higher yields than government bonds but have a much broader selection of yields and risks. Corporate bonds can range in yields that are often linked to their relevant risk status or credit rating. While the relationship of yields of corporate bonds can at times appear to have a linear relationship, the same emotions and subsequent volatilities often apply to corporate bonds as well as their stocks.
Knowing the inherent risks and potential swings in prices and yields, here are a few of the multiple strategies investors use to capture the highest yields:
- Using dividend stocks instead of corporate bonds, especially when their stocks yield higher than their bonds
- Hanging over the edge of the investment grade cliff
- Complementing with tax-exempt bonds when in higher tax brackets
- Convertible stocks and bonds
- Spreading market risk across many holdings
Putting the Strategies into Practice
Dividend-paying stocks can be used to capture yields and can be most effectively used when their stocks are yielding close to, or more than, their bonds. A stock's yield (annual dividend/current price) is particular to each company's current payout structure, in relation to its price. Some companies and industries have a history of paying higher yields to their investors for various reasons, including attracting those investors seeking yields. Some industries like utilities, energy and manufacturing have historically paid more than their peers, as they typically do not need to reinvest their earnings as much as companies in growth sectors like technology and pharmaceuticals.
Capturing dividend income from a stock does create additional risks. In the event of a bankruptcy, common shareholders can lose their entire investments, where bond holders may have the rights to remaining assets. On the flip side, if your strategy is to focus on the dividends of a stock with a price that has fallen significantly, your upside growth potential in market value is higher than it would be with a bond.
It is important to take a close look at the company's dividend policy both historically and into the future. If the company has a long history of raising its dividend, that is a good sign of its commitment to shareholders. It is also important to look for future problems on the horizon that may jeopardize that dividend, whether it is a macro or microeconomic event. It is also important to remember that stock dividends are subjected to double taxation, where the issuing company pays dividends after tax and you as an investor pay income taxes on the income. (To learn more, see Dividend Facts You May Not Know.)
While this is not necessarily a textbook strategy, investors seeking higher yield will often dedicate a portion of their income to bonds that may be near or hanging over the edge of the investment grade cliff. This strategy works quite well near the bottom of an economic cycle, but requires good timing and vigilant research efforts.
Ups and Downs
It is not uncommon for a company to have a long track record of a relatively high investment grade from Standard & Poor's, Moody's or Fitch, and then experience dramatic downgrades from either systematic or un-systematic forces. Since bonds' yields move inversely to their price, as the price of bonds fall, their yields rise. Unfortunately, those holding the bonds take the initial hit prior to the actual downgrade, as perceptions usually drive the price before the actual downgrade.
For those who can buy those bonds as they near their bottom or are on the cusp of upgrades, yields can be gathered with no upward limit, as can the upswing in the bond's price. The obvious risks here are getting the timing right, and avoiding a company on its way to bankruptcy. While there are no guarantees, finding a company that issues bonds on a regular basis, that trades actively and is temporarily out of favor due to economic woes are good sources at which to look.
Another prudent strategy is to combine taxable and tax-exempt bonds as a portion of an overall diversified strategy. There have been numerous times over the last three decades that tax-exempt bonds were yielding more than taxable bonds because of credit risk, whether actual or perceived. While these bonds can be covered by the general health of the underlying entity (state, city) or linked to a specific project (toll roads, stadiums) or even carry insurance, they may be temporarily out of favor. The beauty of buying these bonds when their yields are close to or exceed taxable bonds is that after-tax, their benefits are even better for those in higher tax brackets.
Buying with the Top Down
One segment of the market that is often overlooked is the convertible stock and bond market. Many investors may avoid these investments because they are not always presented as options, and many novice investors are confused as to how they work. The concept behind convertibles is based on two components: the yields you can capture from the underlying stocks and bonds, and the potential to convert the issues in the future to equity positions. Convertibles can move like the general market with high correlations, especially during large upward or downward swings, but historically behave based on their convertibility values. Convertibles can be a good source of income and upward conversion value, and can add value as part of a diversified portfolio. (Learn more in Why Companies Issue Convertible Bonds.)
Spread Yourself Thick
One of the best ways to combine all of these strategies is to spread the risk across many holdings. For institutional investors and those with very large portfolios, purchasing many individual holdings is reasonable. For the smaller investor, however, the same results can be achieved by utilizing some of the many actively- or passively-managed pooled assets on the market. There are hundreds of mutual funds and ETFs that can be used to invest in high dividend paying stocks, below or borderline investment grade bonds, tax-exempt bonds and convertible issues. Since there are so many options, a little due diligence is in order to make sure the fund is managed to its charter and that its fees are reasonable. (To learn more, see Mutual Fund Or ETF: Which Is Right For You?)
Investing for yields has often been called the "widows and orphans" strategy, with visions of little old ladies clipping coupons at their banks. While many investors' strategies are constructed solely to provide income, long-term investors who spend a little time can significantly increase their total return by capturing higher yields and benefit from potential upsides of investments. While most dividend and interest income is taxable, if the actual yield is high enough to outweigh the tax costs, or the upside potential for growth or conversion is foreseeable, these strategies are worth a look. Unlike the buy-and-hold ladder-type strategies utilizing low-risk bonds, these strategies require an active interest and effort, but the long-term benefits are worth the work. (For more, check out Do "Widow And Orphan" Stocks Still Exist?)