Jubak's Journal
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Today's high yield, tomorrow's headache
Some investments with high yields promise current income but endanger your principal. It's best to watch total return instead. Here's how.
By Jim Jubak
Who can afford to keep their money safe these days? Certainly not anyone who needs income from their investments to pay the bills.
With core inflation running at 1.6% annually, the average 12-month certificate of deposit paying just 1.1% is actually shrinking day by day. No wonder that anything offering a higher yield is suddenly so popular. And the higher the yield, the better, no matter what the risk.
In the year's first half, companies with the weakest credit ratings, those rated CCC and below that are the most likely to go bust, have sold investors $5 billion in bonds, up from just $463 million in the first six months of 2002.
But investors hungry for income need to ask themselves about the total return from such a move: Whats the likelihood that reaching for higher yield will take a bite out of principal?
You dont have to look at exotic investments to see how the trade-off between yield and risk works. Just take a gander at the total return from 10-year Treasury notes in the last month. Ten-year Treasury notes are yielding about 3.7%, which is likely to sound pretty rich to an investor collecting 1% in a CD.
Paying the price
But the price of Treasury notes has tumbled by more than 4% in the last month, so that higher yield comes with a price.
An investor with $10,000 in bonds may have collected one semiannual interest payment of about $180 at the end of June. But the value of those bonds has fallen by about $400 in that time, making the total return in the last month a negative $220.
Thats a big deal because many income investors, especially those in retirement, live off a combination of interest and drawdowns on principal.
Thinking about total return instead of just current income changes both what an investor buys and how an investor buys it. Investors focused on total-return income consider what might happen to interest rates and inflation during the period that theyll hold an investment.
For example, no investor looking just at current yield would think of buying the 10-year inflation-protected Treasury maturing in January 2012 over the plain vanilla 10-year Treasury note due in February 2012. The plain vanilla Treasury yields 3.47% now. The inflation protected Treasury, or TIP, yields just 1.83%.
But the total-return investor knows that if inflation heats up -- and drives interest rates up, say, to just 4.5% on a 10-year note -- then the value of an initial $10,000 in the plain-vanilla Treasury notes would fall to $9,230, a decline of $770.
The investor in inflation-protected notes would fare much better. The Treasury guarantees to pay the full face value of the note on maturity plus an adjustment to account for inflation. And the notes regular interest payments are also automatically increased to compensate for inflation.
How you buy affects what you buy
Total-return income investors also know that how they buy is as important as what they buy.
For instance, an investor who expects interest rates to rise -- and bond prices to fall -- over the next two years would opt for buying a two-year Treasury note outright rather than through a mutual fund. By doing that, the investor is guaranteed to get back the original face value of the note at maturity, no matter what happens to the notes price before it matures. Bond funds, which are always buying and selling, dont offer that kind of guarantee of a return of the original investment amount at maturity.
Its sure a lot of work to think about the direction of the economy, interest rates and inflation before investing for income. For the last decade, as interest rates have moved in only one direction -- down -- income investors havent had to worry about these issues. But now, with interest rates at historic lows and the strong possibility that interest rates and inflation will move up over the next 10 years, income investors cant afford to shirk their total return homework.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET.
At the time of publication, Jim Jubak didnt own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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