In low interest rate environments, investors search for higher yields than the scant interest they can receive from savings accounts, money market funds, or CDs. Stock and bond investments that pay out streams of income lead some investors to chase this yield rather than focus on total returns. However, it’s important to understand that focusing on income or yield can mean taking on different risks.
A distinction critical to making smart decisions is the difference between yield and total return. In common usage, income yield is just the cash distributed to an investor. Total return includes capital gains or losses as well. An investor focused on yield may have a negative total return despite a positive yield. Capital gains and losses can figure prominently in the overall return to the investor in the long run. Examining only the current yield of an asset may not be indicative of total return and may lead an investor to concentrate their portfolio in high yield, low total return assets.
The Shortcomings of a Yield-Only Approach
Investors who ignore total return in favor of income yield risk losing value while they earn yield. Let’s take Mr. Yieldlove, who has always relied on yield for making investment decisions, as a hypothetical example. He screens for bonds that have a coupon yield of greater than 10%.
One of the highest-yielding bonds is an issuance from a company that we’ll call About-To-Default Inc. The bond pays a very attractive semi-annual coupon of $50 and has two years remaining until maturity. If Mr. Yieldlove purchases the bond for $1,000 and holds it for one year, he would receive a $100 coupon, giving him a coupon yield of 10%. But his total return is dependent on the price of the bond at the time he sells, assuming the bond does not default. And the prices of the bond will be closely related to the market’s estimate of its likelihood of default. Suppose the chance of default has increased, and the price of the bond has fallen to $900 by the time he sells it, Mr. Yieldlove’s coupon of $100 would be negated by the price decrease, giving him a total return of 0% ([$100 + (-$100)]/$1,000).
All else equal, typically lower credit bonds have higher spreads. Spread is the extra compensation that an investor receives for investing in bonds that are less safe than U.S. treasuries.
- AGG: The highly rated U.S. Aggregate Bond ETF tracks the performance of U.S. government bonds, investment grade corporate bonds, mortgage pass-through securities and asset-backed securities. It has the lowest credit spread.
- LQD: U.S. Investment-grade Corporate Debt ETF has the second lowest spread and default rate.
- HYG: U.S. High-Yield Corporate Debt ETF has the second highest spread due to the high risk of default associated with its component bonds.
- QTLC: U.S. Corporate B – Ca Capped Index has the highest spread because it’s exposed to the performance of the taxable B1-Ca rate range of the fixed-rate U.S. dollar denominated corporate bond market.
Lower Credit Ratings Come With Higher Credit Spreads
Historical yields are not future yields.
Like all things that are bought and sold, the forces of demand and supply affect the price of a security. Whether the security is a stock or a bond, market value affects the calculation of yield. Stock dividend yields and bond current yields are calculated as the payout (dividend or coupon) as a percentage of market value. This means that assets that have a lower relative price, often because they are riskier, have a higher apparent yield.
Suppose a stock pays a $1 annual dividend and has a value of $10 per share; the stock has a 10% ($1/$10) dividend yield. If the share price drops to $5 on fears of a default, the dividend yield rises to 20% ($1/$5).
Likewise, a bond’s current yield is measured relative to the bond’s current price. A bond that pays an annual coupon of $100 and sells for $1,000 has a current yield of 10%. If the bond price falls to $800, the current yield rises to 12.5%.
In other words, assuming a constant payout (stock dividend or bond coupon), a rising dividend yield or current yield indicates a falling stock or bond value. While investors may see the rising yield and be happy, they should be careful to note where it comes from. If yields rise because asset values fall, those rising yields may mean lower total returns and should be viewed very cautiously.
While investors may see the rising yield and be happy, they should be careful to note where it comes from.
Companies that pay out dividends tend to be large companies with limited growth prospects. Dividend streams are by no means guaranteed however. As an example, General Motors (GM) paid a $0.50 dividend each quarter from 1997 to 2005. In the mid-2000s, it had a dividend yield of more than 10%. Beginning in 2006, GM cut its dividend by 50%, suspended it altogether in 2008, and declared bankruptcy in 2009. GM is now back in business, with an annual dividend of $1.20 and a dividend yield of about 3%. Similar dividend suspensions and (less often) bankruptcies have occurred with companies across other industries.
One of the biggest downsides to chasing dividends is concentration risk. The top-yielding securities are concentrated in sectors like financial services and utilities, which tend to grow less in rising markets.
While a dividend initiation doesn’t necessarily indicate that a company has stopped growing, dividend initiations can signify that a company is entering a more mature stage of growth. Companies create value through investing in projects that are higher than the firm’s hurdle rate; Companies that choose to reinvest its profits tend to view its own internal projects positively.
Yield accelerates taxes.
Taxes can further erode the attractiveness of income yield for an investor. At a minimum, income yield accelerates the taxation of gains, sometimes at higher rates than capital gains.
Most dividends that are paid out by U.S. publicly listed corporations can be “qualified dividends,” as long as the investor holds the security for a set amount of time. Qualified dividends are taxed at the same rate as long-term capital gains (15% for those in the 25% to 35% tax brackets; 20% for those who surpass the 35% tax bracket), a rate that is lower than the tax rate on personal income.
By contrast, non-qualified dividends are taxed at the same rate as personal income, a rate higher than that of long-term capital gains. Dividends are qualified or nonqualified based on how long the investor has held the stock (more than 60 days to be “qualified”).
Of course, these distinctions matter only if the stocks are held in taxable accounts. In a tax-advantaged account, such as a traditional or Roth IRA, the dividends are not taxed when earned but may be taxed on distribution from a traditional IRA. Thus there is no tax rationale for preferring qualifying dividends in a tax-advantaged account.
Dividends, even qualified ones taxed at the lower capital gains rate, are still taxed each year. In contrast, a capital gain is not taxed until realized, i.e., when shares are sold. A dividend (in a taxable account) accelerates that gain and forces you to realize a return now and incur the tax consequences. A long-term investor will likely take those dividends and plow them back into the same companies those dividends came from. For investors using that yield for spending, any dividend yield in excess of what they spend is likewise subject to a deadweight tax. As a result, overweighting dividends increases tax drag on your returns. All else being equal, and depending on your circumstances, delaying taxes and letting untaxed returns compound will likely be the more tax-efficient strategy.
Dividends Accelerate Taxes
Note: This is a hypothetical example with a fixed 5% return which when distributed as income is taxed at ordinary rates, or long-term capital gains rates if QDI. The ‘capital gains only’ assumes the returns is internal to the company as cash, and represents the capital gain upon realization at the given time horizon inside a taxable account.
Dividends are fine—just don’t over–weight them.
A company has several options when it comes to deploying extra cash: invest in internal projects, repurchase its own shares, acquire other companies, and paying out dividends. Companies that issue dividends have decided that out of all of options it has, dividend issuance is the best option. Investors should not eschew dividend paying companies as dividends can provide current income and certainty about a company’s financial well-being.
However, ignoring total return and focusing solely on yield subjects you to concentration risk and is not immune to losses of principal. Long-term investors should seek diversification—of asset class, geography, industry, maturity, and duration—as well as yield, while considering the most efficient strategy for creating wealth, generating income, and minimizing taxes. Diversification is a cornerstone of Betterment’s investing strategy and is one of the most important tenets of successful long-term investing.
More from Betterment:
- How We Use Your Dividends to Keep Your Tax Bill Low
- The 10 Most Overlooked Tax Deductions and Credits
- Investment Selection: Building Portfolios Fund by Fund
The information on the Betterment Resource Center is for educational purposes only. It is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.