Seeking income? Chasing yields can be tricky territory

Rochester Business Journal
April 24, 2015
Mark Armbruster
On Investing

Income-producing investments, bonds producing a lot of interest income and stocks paying large dividends have been on a tear over the last few years.

With yields on bonds falling to all-time lows, investors seeking income from their portfolios have been turning to master limited partnerships, real estate investment trusts, junk bonds and stocks with large dividend yields.

I have heard many investors reason that with the 10-year Treasury bond yielding less than 2 percent, there is no reason to own bonds. After all, you can get more income by holding a portfolio of blue chip stocks. For example, Procter & Gamble’s stock yields over 3 percent currently. By using stocks instead of bonds, you not only get more income, but you also earn any upside appreciation from the stocks.

This sounds like a terrific idea, except for the fact that you also expose yourself to the downside risk of the stock market. Even though they may provide more income than high-quality bonds, the return characteristics of MLPs, REITs, junk bonds and higher yielding stocks are very different from safer government and high-quality corporate bonds. Historically, they have all experienced much greater volatility and downside risk, especially during bear markets.

It may not take much of a bear market for high-income investments to face significant losses, however. Given the popularity of these investments recently, their valuations have risen to record high levels that I believe are unsustainable.

REITs have been top performers in the stock market the past several quarters, driving their valuations to lofty levels. In fact, by two valuation measures, the Price to Funds from Operations ratio and the income yield, publicly-traded REITs are trading at all-time highs. These valuation levels seem inconsistent with underlying fundamentals that appear less than robust.

Office vacancy rates are still above historic norms, and they are just slightly better than the rate reached after the recession in 2010…