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The Yield-Seeker's Dilemma

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Published : March 30th, 2013
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If you're looking for yield, the advice often seems black and white – either stay away from bonds to avoid the inevitable rise in interest rates, or jump right in as the Fed isn't moving rates until mid-2015. But as with many things in life, there's a gray area in between. Yes, bonds will get crushed by higher interest rates, but it's possible that alternatives could be crushed even more.

The alternatives to bonds are few and unattractive. A certificate of deposit (CD) paying below the inflation rate just isn't going to cut it. What many investors find themselves choosing seems like the next best thing: dividend-paying stocks. However, is this a solution or simply jumping from the frying pan into the fire?

Well, it depends. By entering the equity markets, you're taking on much more risk than a bond. In the Miller's Money Forever portfolio, we hold both dividend stocks and short-term bond funds to balance the risk of each. Both asset classes have considerable risks. In the case of bonds, it's interest-rate risk, as higher interest rates mean lower bond prices. In the case of equities, it's market risk. Sure, your stocks may be immune to interest-rate risk, but that won't protect one from the market if it were to crash 30% tomorrow.

When it comes to evaluating risks, bonds do have one advantage over equities: measurable risk prior to a loss. Bond funds typically list a characteristic known as "duration." In the most simplified definition, duration is the change in value of a bond for a one-percent change in interest rates. So, if a ten-year, intermediate-maturity bond fund has a duration of 6, a one-percent increase on ten-year bond rates in the market would result in a 6% decline in the value of the fund.

By understanding duration, you can plan ahead for the possibility of rising rates. One can pick either shorter-maturity bond funds or higher-yielding funds which will have a lower duration. Being able to evaluate duration is a huge advantage in assessing your risks. For example, if interest rates rise by three percent in the previous example, you can estimate a loss of 18%. What's so advantageous about knowing that?

Consider the risk-estimation problem with the alternative – dividend-paying stocks. If there's a full-blown market crash tomorrow, how much will you lose? Even defensive stocks could lose 20%, 40%, or maybe 50% or more. If you've been dipping into riskier dividend stocks promising higher yields, you could see 70% losses... or more. The point is that your potential loss is open-ended and unknown.

So, here's the pickle for yield seekers out there. Higher rates are pretty much set to hit by mid-2015, so bonds will slowly get crushed by rising rates. But the same thing might happen to equities – who is to say the market will keep rising until mid-2015?

When someone suggests that you should exit bonds for equities in fear of rising rates, there's an unstated underlying assumption of a stable stock market for the next two years. As we pass the all-time highs on the DJIA and S&P 500, I'm getting a little nervous about that assumption. If you think that the market is slightly overvalued now, where do you see it by mid-2015?

In comparison to the potential losses on dividend equities, a bond fund losing 18% doesn't sound like such a travesty anymore – especially if you cut your losses even earlier at the first sign of higher rates. Now, this isn't to say that bonds are the way to go and you should forget about equities. Instead, the point is to realize that you're simply trading one risk for another by leaving bonds for dividend equities.

By avoiding bonds altogether and getting your entire yield from equities, you're taking on lots of market risk. By staying only in bonds, you're taking on a huge amount of interest-rate risk. In the Miller's Money Forever portfolio, we've chosen to derive our yield from a hybrid approach – a few low-duration and low-maturity bond funds, as well as plenty of defensive dividend-paying stocks.

No matter how the market turns, we'll be in pretty good shape. If interest rates rise in mid-2015, that would probably mean the market is in better shape and the Fed is comfortable enough to raise rates, i.e., the stock market is doing pretty well. So, while we might lose on the bonds, capital gains on our dividend-paying equities will likely more than make up the difference. The opposite is true to a lesser extent. If the market crashes, rates will be pushed down even more, giving our bond funds a small boost. These gains on the bonds wouldn't make up for the losses on the equities, but they would help to soften the blow.

Note that this discussion is most relevant for those seeking yield and principal protection. If you're searching for capital gains, you're just not going to find it in bonds at today's rates. While the two sides of the argument are often portrayed as black and white, there are good reasons for a yield seeker to hold bonds as well as dividend-paying equities. This asset allocation doesn't need to be an either-or decision.

Some cash in very short-term bond funds still makes sense; one just has to be extremely selective in choosing the bond funds. That's why we recently published two special reports called The Yield Book and The Cash Book. Part of our mission in these reports was to find the very few bond funds that are worth choosing, given the fact that rates are set to rise within a few years. These reports aren't about being a bond bull, but rather earning a little interest on cash otherwise collecting dust, while minimizing interest-rate risk.

The reports are individually $29, but subscribers to Miller's Money Forever (a $99 annual subscription) receive both reports for free. In Money Forever (learn more about it), we also include several dividend-paying stocks, with one yielding as high as 5.7% since our original purchase price.

Regardless of whether you sign up, the key takeaway here is that there is no perfect answer to yield in this environment. The solution is not all bonds or all equities. It's about understanding the risks in each asset class and adjusting your portfolio accordingly. Most of you already understand the general risks in the stock market – 2008 was a harsh master. However, your homework tonight is checking the duration of your bond funds to assess your risk level there. Then, take a step back and see whether your portfolio needs some readjustment, perhaps to very short-term bonds or a little bit more equities.

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Vedran Vuk graduated with a BBA in Economics from Loyola University of New Orleans. Currently, he is pursuing a M.S. in Finance at Johns Hopkins University. He also spent time on a PhD. Economics program. His publications include academic journal articles, book chapter contributions, newspaper columns, and online articles. Prior to Casey Research, he worked in think tanks, government affairs, and corporate governance. Utilizing his experiences with academics, Washington politics, and financial knowledge, Vedran’s analysis often seeks to find the mid-point between these different areas.
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