Looking Beyond Yield
As retirement approaches, many investors focus more heavily on the income their portfolio produces. Interest and dividends feel tangible as they are received in cash and can help fund regular spending.
That naturally leads to a simple question: what do my investments yield?
Yield is useful, but it is only one part of the picture. A high yield does not necessarily mean an investment is earning more, is safer or will produce a better result. In some cases, it can be a warning sign.
What Is Yield?
Yield measures the cash an investment pays relative to its current market value.
For example, if an investment worth $100 pays $5 a year in interest or dividends, its yield is 5% (yield = annual income divided by current market price).
The calculation is simple, but the result can be misleading. If the investment’s price falls from $100 to $50 and the annual payment remains $5, the yield rises from 5% to 10%. The investment is not paying more. Its yield has increased because its price has fallen. A higher yield can sometimes reflect greater risk rather than better value.
Quoted yields may also be calculated in different ways. Some use the most recent payment, while others use total distributions over the past year or estimate future payments. Before relying on a quoted yield, it is important to understand how it was calculated and what is funding the payment.
Income or a Return of Your Own Capital?
A distribution can come from interest, dividends, appreciation or a return of the investor’s own capital. Each payment may look the same in an investment account, but economically they are different.
When a distribution is funded by interest, dividends or investment gains, the portfolio has generated the payment. When it is funded by a return of capital, part of the investor’s original investment is simply being paid back.
A return of capital is not always a problem. A fund may use it deliberately to provide more consistent monthly cash flow, particularly when its underlying investments are appreciating. However, it should not be mistaken for income.
If an investment earns a total return of 4% but distributes 7%, the additional 3% is coming from investor’s original capital. If it consistently pays out more than it earns, an investment’s value will decline unless investment growth makes up the difference.
The payment may feel like income, but part of it may simply be a withdrawal.
A High Yield Can Be a Warning Sign
High yields are attractive, especially to investors who rely on their portfolios for cash flow. But unusually high yields often come with greater risk.
Assume a company pays an annual dividend of $4 per share. At a share price of $80, the dividend yield is 5% (i.e. $4 divided by $80). If the share price falls to $40, the yield rises to 10%, even though the dividend has not changed. The market may be signalling that the dividend is no longer sustainable. If the company cuts it to $2, an investor who expected a 10% yield will receive only 5% on the original $40 investment. The share price may fall further as well.
This is often called a “yield trap”: the yield looks attractive because the market is pricing in underlying business or financial risk. The same principle applies to higher-yielding bonds. A higher interest rate is generally compensation for greater credit risk, volatility or potential loss.
Investors should ask why a yield is high rather than assume that a higher number is automatically better.
Income Does Not Offset a Large Capital Loss
Similarly, a high yield may provide useful cash flow, but it will not necessarily compensate for a significant decline in the investment’s value.
Consider an investment purchased for $100 that pays a 7% annual yield. The investor receives $7 during the year. If the investment falls from $100 to $75, the capital loss is $25. After including the $7 of income, the total loss is still $18, or 18%. The yield may have looked attractive, but it did not come close to offsetting the decline in value.
An investor can receive substantial distributions over several years and still earn a poor overall return if the investment steadily loses value. The question is not how much income did an investment pay, but rather what was its total return after including both the income received and the change in value?
After Tax Return Matters More Than Yield Alone
Tax can make a significant difference to the amount an investor ultimately has available to spend. Interest income is generally taxed at an investor’s full marginal tax rate. Canadian dividends receive more favourable treatment than interest, while capital gains are generally taxed more lightly and tax is usually deferred until an investment is sold.
The precise result depends on the investor’s circumstances, the type of account and the nature of the income. The broader point, however, is that investors spend after-tax returns, not pre-tax yields.
A portfolio generating a 6% yield may leave an investor with less spendable income than a lower-yielding portfolio that produces a stronger and more tax-efficient total return. Focusing too heavily on yield can also lead investors to concentrate in a small number of sectors, accept more risk and generate more taxable income than they need.
In many cases, a better approach is to build a diversified portfolio focused on earning a total return that funds spending through a combination of interest, dividends and periodic sales of appreciating investments.
A dollar received as a dividend and a dollar raised by selling part of an appreciated investment can both be used to fund spending. What matters is the after-tax amount received and whether the overall withdrawal strategy is sustainable.
Put the Plan Before the Product
Income-producing investments can play an important role in a portfolio. Reliable interest and dividends can reduce the need to sell assets during difficult markets.
The issue is the order in which the decisions are made. The financial plan should first determine how much cash flow a client requires, when it will be needed and how that need may change. The portfolio can then be designed to support those requirements.
Problems arise when the search for the highest yield begins to drive the investment strategy. At that point, the portfolio may take on risks that have little to do with a client’s actual needs.
The Bridgeport Perspective
At Bridgeport, we start our process with determining the level of cash flow our client needs to support their lifestyle.
We then assess each investment based on the role it plays in achieving that objective. Yield is one consideration, but it must be weighed alongside the durability of the income, growth potential, tax treatment, liquidity and the resilience of the portfolio as a whole.
The appropriate balance differs for every client. That is why we view retirement income as an important component of the planning process rather than simply a search for income-producing products.
This article provides general information only and does not constitute individualized investment, tax or legal advice. The appropriate strategy will depend on your circumstances. Historical market events are not predictive of future results.