This quarter’s newsletter outlines our views on “chasing yield” (i.e., investing in securities primarily based on their income yield) and the risks inherent in this strategy.  We highlight some notable instances in the past decade when reaching for yield has hurt investors, as well as some common misconceptions about high-yielding investments.

High dividend-paying stocks are not a safe or sensible substitute for bonds. Despite the constant stream of investment offerings luring investors into high-yielding securities, we advise against replacing bonds with high dividend stocks in your portfolio.

• Dividend-paying stocks are equity investments and they carry very different and more pronounced risks than their bond counterparts.  In 2008, for example, the S&P 500 High Yield Dividend Aristocrats Index (i.e. a select basket of dividend-paying stocks) lost 26.6% while the Barclay’s Aggregate Bond Index gained 5.1%.
• The downside risk of high dividend-paying stocks is significantly greater than bonds, regardless of the income stream each provides.  A bad year for stocks can be much worse than a bad year for high-quality short/intermediate term bonds.
• Because financial markets are relatively efficient, an investment’s expected return should be proportional to its level of risk.  If safe money (the 10-year U.S. Treasury Note, for example) is paying roughly 1.60% per year, any security yielding double or triple this amount will surely be subject to greater risk.
• While abnormally high dividend yields may be appealing to investors at first glance, they should also raise some suspicion.  Investors who buy a stock purely on the basis of the dividend may experience losses if the dividend is reduced and the stock price drops in response.  Dividends are not necessarily cut immediately when a company is in financial distress.  As such, some stocks may appear to have misleadingly high dividend yields.  With the announcement of a dividend cut, the yield drops back to a more typical level along with an accompanying drop in share price.
• Corporate bonds are inherently safer than common stocks because they are senior in a company’s capital structure.  In the event of a company’s liquidation or bankruptcy, bondholders are paid before common stockholders.  If there are no funds remaining after bondholders are paid, stockholders will not get paid anything.  This risk is one of the reasons why stockholders demand a higher return than bondholders.
• A dividend focus may lead investors to overweight particular asset classes and industry sectors, as well as avoid stocks that may not pay dividends but may have more promising long-term growth prospects.

Preferred stocks, which are stocks that tend to act more like bonds, are also a false safe-haven for investors chasing higher yield.  Preferred stocks carry their own specific risks that are often overlooked.  These include long maturities, industry concentration, and oftentimes relatively poor credit quality.

Reaching for yield often leads to unexpected losses.  The recent rise and fall of Master Limited Partnerships (MLP) is a prime example of how focusing purely on yield can lead to poor investment results.  An MLP is a hybrid entity that trades on a public stock exchange and generally operates within the energy sector.  MLPs do not pay corporate taxes and are required to distribute nearly all of their income to investors, which typically leads to a relatively high yield.  Investors often buy MLPs for their high yields (which may be double or triple that of the S&P 500 Index) without fully understanding the investment.

Higher yield is only one side of the story, as MLPs are quite volatile and are certainly not a safe haven.  As illustrated by a chart of the Alerian MLP Index, investors who were seduced by rich-yielding MLPs in 2014 experienced a precipitous drop when oil prices fell.  Many may have seen their investment cut in half by February of this year.