Income strategies are everywhere these days. If you follow investments, you have probably heard a few people in the industry talk about the “need for regular income”. They often suggest that you should add “bonds with higher income” or “companies that pay a high dividend” to your portfolio.

The funds management industry in New Zealand has also encroached on this rhetoric: 9 out of 11 prominent fund managers in New Zealand have an “income fund”. In the institutional space “absolute return bond funds” are increasingly popular – the industry’s income equivalent for wholesale investors.

A cynic might say that this is because it is an easy story to sell. But as great as the words “income” and “absolute return” sound it is crucial that you understand what you are actually buying, and how much risk you are taking. Like cheese in a trap you may be able to observe the expected income, but the risk may not be as easy to see. “Understanding the ingredients will give you a healthy experience in markets”, as we put it in one of our investment beliefs.

At Makao Investments we believe there are three common traps that you should look out for before you jump into an income strategy:

1. Higher income means higher risk
2. Higher dividend paying stocks are not necessarily safer
3. High income is not the only way to avoid high transaction costs

Let’s look at the three in a bit more detail:

Higher income means higher risk

One of the most simple but important concepts in investments is that risk is the flipside of return. This relationship is strong and extremely well documented. There’s no such thing as a free lunch, if you want more return, you usually end up taking more risk.

This is relatively easy to analyse in fixed income markets. You just have to look at the yield to maturity¹ of a bond and it will tell you how risky the market considers the bond to be at the moment. The higher the yield, the more risk you will typically take. The price of the bond could drop dramatically, and, in a worst case, you may not get your money back.

Let’s see how this works in practice. The following charts show four global fixed income indices that represent numerous bonds around the world. In the first chart, we look at the yield of these indices at the end of last year. The second chart shows the performance of those indices in the first quarter of 2020.²

The charts show that the higher the yield of the index, the bigger the drop in price during the selloff in the last quarter. There is nothing wrong with that as such, higher risk may very well end up generating higher returns over the long-term. But if you just saw the 5.7% cheese, you may have been caught – at least temporarily – in the -25% performance trap.

It is slightly more complicated with individual bonds. Companies have firm specific risks that are largely diversified away in an index. However, a scatterplot of several bonds of large corporations in New Zealand shows a similar relationship over the quarter.

All else equal, higher income spells higher risk. Make sure you understand the risk before you invest in an income fund or a bond with a high yield.

Higher dividend paying stocks are not necessarily safer

A decent dividend yield may be a sign of a stable company, but it is not a guarantee of lower risk. It is important to take a step back and acknowledge that dividend policies are set by the management of the company, not by the market. A company’s board has effectively two ways to allocate earnings. Retain the earnings to grow the company further or return the money to investors through dividends or share buybacks. Before you jump into a high dividend company you need to understand the drivers behind the company’s decision:

• Is the company expecting earnings to steadily grow? (a good sign)
• Is the business running out of profitable projects to invest in? (a less positive sign)
• Has the company used a lot of debt financing to sustain the dividend? (a bad sign)

Whatever the cause, we should avoid superficial judgement. Once more, we can turn to the recent selloff for some useful illustration. Both listed infrastructure and listed property were widely portrayed as the “safer” equity investments with a high dividend yield. We have even heard some industry participants describe infrastructure stocks as “a mix between stocks and bonds” to underline how safe this sector is supposed to be.

Unfortunately, that did not turn out to be the case over the last few months. While the equity market (MSCI World) dropped significantly, these sectors underperformed the broader market by 10% or more:

It is worth noting that global listed property is a repeat offender, having already sold off more heavily than the overall market in the global financial crisis in 2008/09.

When you lift the hood and look through the headline dividend numbers, one thing you may find is more leverage, meaning these companies use more debt to finance their activities than you would find in other sectors. To quote our asset allocation report to a client in early February:

“While property is arguably a more stable investment, listed property companies tend to use higher amounts of debt (…) in the event of an economic crisis, this can lead to difficulties with refinancing that investors in unlevered property would not experience.”

We are not categorically advising against these sectors of the equity market, but we caution people from assuming that stocks with high dividends are always less risky.

This is where insightful advice and an appropriate model for asset allocation can make a real difference.

High income is not the only way to avoid high transaction costs

Another common marketing ploy is that you need to hold stocks and bonds with high income to avoid excessive transaction costs. This might have been the case in the early days of financial markets, but the investment industry has solved this problem a long time ago. Most funds have low transactions costs (less than 0.5%), mainly because your investments are pooled with a series of other investors.

The economies of scale achieved from pooling assets results in less brokerage commissions relative to the value of the underlying securities. So not only do you typically get significantly more diversification through a pooled fund, you are also often lowering your transaction costs.

It would be foolish to think that you do not have to trade if you hold individual securities. When bonds mature, the proceeds need to be reinvested, and the mix between shares and bonds will need to be rebalanced over the long-term. In fact, periodic redemptions from your investment portfolio may help to realign your asset allocation back to target weights.

Do not forget that higher income typically means higher risk. Taking more risk just to save transaction costs is a flawed way to set up your investment strategy, in our view. The primary consideration should be to find the right balance between risk and return.

So, the next time you are asked if you want some “income” in your investment portfolio, we suggest you make sure that you do not step into one of the three traps we discussed in this post.

¹ The yield to maturity is a measure of the annual return you can expect to make until the bond matures (i.e., until the time when the principal amount is paid back to investors). It is not the same as the coupon, or the “income” that you can expect from the bond. The coupon is the cash flow you will get paid periodically. It might have been indicative of the risk when the bond was originally issued – but the best measure of return and risk once a bond starts trading is the yield.

² Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Past performance is not necessarily a good indicator of future returns.