This Month’s Newsletter

Given the current rate environment, how has the search for yield changed?

Join our Monthly Newsletter October 2019

Junius V. Beaver, III

Co-CIO, Principal

Remember the good old days back in the 90’s? The market was roaring, AOL was the Internet and the Super Bowl ads were spectacular! We came to love that annoying beeping and screeching sound we heard as we logged onto the internet. “Friends” and “Seinfeld” were all the rage, and that song from the “Titanic” kept lingering in our heads! There was something else wonderful in the 90’s – you could buy a high-quality bond with a coupon of 7 or 8%. When the market finally crashed in April of 2000 and the S&P 500 dropped by 50% and the Nasdaq dropped by 79%, your diversified portfolio worked like a charm. Bonds provided a buffer and continued to throw off plenty of income for accumulators and retirees alike. Let’s fast forward twenty years and see how things look now. There is a positive – the boy bands are gone!!

As you can see in the chart above, things have changed dramatically. The quest for yield is now a job and not a gift as it was back then. The ten-year treasury is now yielding 1.5% vs. 6.5%. High quality corporate bonds are yielding 3.5% vs. 8%, and high yield bonds are paying 5% vs. 10%. This is great if you are buying a home, but if you are looking for retirement income, or a buffer in the event this market cycle ever comes to an end, it’s not great. So, where does an investor look now for a reasonable yield with a solid degree of safety? The short answer is it’s hard. You can still invest in any high yield (junk) bond and get higher yields. The catch is the amount of risk you are taking. Significant!

Over the last twenty years the average default rate across all categories of corporate bonds has been 1.8%. On paper it doesn’t seem that bad. The issue becomes a little scarier when you pull back the curtain. The defaults on AAA-A paper is 0%- 0.2%. over that period. If you move to B-rated paper, defaults rise to a little over 4%. Finally, CCC-C had a default rate of nearly 5%! The serious issue is when recessions do occur.

Over the last twenty years we have had two significant recessions. During those times we have seen high yield bond defaults spike to nearly 15%. We believe most people don’t realize the risk they are taking in order to get historically low rates of return for these investments. Put differently, would you loan someone $100 for a year to get $5 dollars back if there was greater than 10% chance you weren’t going to get paid at all? I wouldn’t. Yet retirees have been plowing money into these bonds for the last ten years with little to no understanding of the amount of risk they are taking! The moral of this story is twofold. Make sure the bond segment of your portfolio is well diversified. If you are heavily invested in high yield bonds, you need to ask yourself a question. Am I getting paid enough ($5 per $100), given where we are in the cycle (almost 11 years) for a 1 in 6 chance of not getting paid if a recession occurs?

Finally, let’s take a look at REITs and high dividend yielding stocks. In the late 1990’s REIT’s were yielding ~8.5% vs. 3.4% today. Today’s yield is certainly not bad given the current interest rate environment, plus you have the potential for growth going forward. As with everything, there is no free lunch. There is risk to REITs much the same way as equities. REITs have a very high correlation to the equity markets (about 80%) which means if the markets have a pullback, they will be affected in much the same way. High dividend yielding stocks are also a solid option. While the large capitalization value high dividend yielding index provides a yield of 2.5% (1% more than the ten year treasury), it does provide the opportunity for growth as well. The flipside is it can also go down in poor markets. Another benefit to large cap value stocks is they tend to go down less than the overall markets in a decline.

At Lanier, we try to think outside of the box for solutions to benefit our clients. There are ways to still generate income with solid rates of return. This is true in the public and private markets. The difference today is the amount of research and due diligence required in order to feel comfortable with what you are investing in for the long term.

Junius V. (Trip) Beaver III, is a co-founder of Lanier Asset Management and serves as its Co-Chief Investment Officer. Trip has been a financial advisor delivering high-value investment solutions to affluent individuals since 1994. In addition to his work at Lanier, Trip donates his time and investment expertise to charitable organizations such as the Library Foundation and the Metro United Way.