Last Updated on December 2, 2024
Overview – The Allure of High Investment Yields
One of the misbeliefs some investors have when starting out is that a high yield is always a desirable characteristic when evaluating investment merit.
With respect to stocks (more specifically, common stock), no doubt one of the many criteria investors pay attention to is if it pays a dividend, and if so, for how long and if the dividend has been slashed or increased in recent years. Bonds aren’t known for being a major source of capital gains, so the major consideration virtually all bond investors focus on is the interest being offered.
A reasonable investment yield is, generally speaking, a desirable trait for a prospective investment to have. A stock that has been paying dividends for several years while also steadily increasing it is a clear sign of financial strength, and a bond issuer that offers a strong yield without ever missing a payment, while also repaying the initial amount once the bond has expired, clearly shows their financial affairs are in order.
However, problems start to arise when investment yield becomes the sole factor when making investment decisions, while other quantitative and qualitative factors are given less importance, or worse, neglected entirely.
Calculating Investment Yield
Before continuing our discussion on the dangers of pursuing a high investment yield no matter what, let’s take a step back and understand what yield is, and how to calculate it.
For our purposes, we will limit our discussion of yields to the domain of bonds and common stock (common and preferred stock have different dividend considerations. For more on those, check it out here).
The equations for yield, adjusted for both types of investment instruments, are:
Looking specifically at common stocks, the amount paid in dividends relative to a business’ earnings (dividend coverage) can be reported in two ways, the first being the dividend payout ratio:
Although this figure is commonly reported and proudly highlighted in reports, the problem with using the dividend payout ratio is that the amount of dividends being paid is being compared to net income.
Recall from The Annual Report and Financial Statements that net income does not mean all earnings are in cash – an enterprise could have millions of dollars in receivables and only a few thousand dollars in cash, but net income would still be in the millions because of the receivables.
Businesses usually pay their dividends in cash, more specifically excess cash, therefore a more accurate measure of whether a company can sufficiently pay dividends with the cash they have on hand is to compare the dividends paid to free cash flow:
This modified payout ratio is arguably a more accurate measure of dividend coverage because free cash flow is the leftover cash companies have on hand, which can then be used to pay debts or to be distributed as dividends.
A company could theoretically post record profits but not be able to cover dividends if they have insufficient cash on hand. If there is no free cash flow, then companies are either forced to dip into their retained earnings, borrow money, or halt/reduce the dividend.
Yield and Investment Merit: Bonds
We’ve previously gone over what exactly bonds are, but to recap, they are essentially just portions of a debt that are broken into smaller pieces and are then sold. When a bond is sold, the bond issuer uses the funds to help pay the debt they owe, but they are now responsible for making sure they compensate the buyer by paying them routine interest payments, as well as the full amount of the bond at a specified date.
Bonds aren’t exactly known for major increases or drops in their price, so they usually aren’t purchased as a way to make money via capital gains. What they are known for, however, are their interest payments, which almost always get distributed to bondholders on time and in full.
Not only that, but if a company or institution were to go bankrupt, then the bondholders are the first in line to get compensated, further increasing the security they offer to investors.
It’s generally understood that the quality of a bond is inversely proportional to its yield. Put another way, the higher the possibility that a bond will default, the higher the yield that will be offered – this is done as a way to entice investors to buy them despite the heightened risk.
Investors who are hell-bent on getting the highest investment yield possible from bonds will most likely focus almost exclusively on these high-risk offerings, taking comfort in the fact that bondholders are the first in line to get compensated. However, this wishful thinking has some major holes in it.
First, it’s important to dispel the notion that bonds are “inherently safe” investments. Some investors believe that bonds are foolproof simply because they receive a promise that they’ll get their capital back in addition to whatever interest payments they receive. It certainly doesn’t help that bondholders rank ahead of stockholders in terms of who gets compensated first, adding to this false sense of security.
Just because bondholders are promised that they’ll receive their initial capital outlay back along with their interest payments doesn’t mean it’s guaranteed that they will. It doesn’t matter if you’re the first in line to get compensated if there isn’t any money on hand to compensate you in the first place.
Now, this doesn’t mean bond investors are forced to settle for mediocre yields. High-quality bonds that also offer strong yields certainly exist, though you may need to look to other countries/markets to find them. Rather, the point being made here is that a bond’s investment merit isn’t determined by how robust its yield is, but rather by its ability to pay the yield that they promise.
Investors are free to purchase junk bonds that offer yields upwards of 20% or more, but that impressive yield won’t mean very much if the bond issuer fails to make those interest payments and can’t repay the initial capital outlay because it defaulted.
Bonds issued by governments of advanced economies and large corporations may not offer the highest yields, but they certainly offer the highest security because the chances of them not being able to satisfy the promise they made to bondholders is essentially nil.
Chasing after a bond sporting a high investment yield will never end well if an investor doesn’t first take the time to verify if the yield being offered can be honoured in the first place. A bond that sports a high yield but is unable to meet that promise is as good as worthless.
Yield and Investment Merit: Common Stocks
Many investors choose to add stocks (more specifically, common stock) to their portfolios because some of them pay dividends. Therefore one criterion many investors pay attention to when assessing a common stock is its yield.
Unlike bonds, which have a fixed yield once you purchase them, common stocks do not. The dividend being offered can be raised by the Board of Directors at their discretion. In fact, some companies choose to routinely increase the dividend they offer on their common stock in order to entice investors while simultaneously serving as a way to display their financial strength (no sensible company would increase their dividend if they couldn’t afford to do so).
There’s nothing wrong with making yield a major criterion when screening potential common stocks. In fact, it’s not unheard of for a high-quality stock that also offers a strong yield (though “strong” is subjective).
However, just like bonds, there are some investors who make it their mission to go after common stocks that offer the highest yields possible, while paying very little, if any, attention to other factors.
Just like any other investment, a stock that offers a high yield is certainly enticing, but a high yield is only as impressive as a company’s ability to pay it. A 15% yield sounds great until you learn that the company offering it consistently struggles to raise the cash needed to pay it.
When looking at a stock that offers a dividend, the logical next step any intelligent investor would take would be to determine if that yield can be sustained. Just like bonds, a high yield doesn’t mean much if it can’t be honoured. Fortunately, this question can be answered without too much hassle by taking the time to go through the financial statements.
Has the company consistently reported a profit over the past few years? What percentage of their earnings are in the form of receivables? Do they generate adequate free cash flow, and if so, can they do it consistently? These are just some things investors may want to ask themselves when pursuing a common stock that offers a dividend.
Yield is just one of the many factors that influence a common stock’s investment merit. Hyper fixating on this one factor while choosing to ignore many other, equally important factors may potentially lead to a very bad investment decision.
A common stock offering a double-digit yield may look great until you realize that they’re barely able to sustain it, and inevitably slash the dividend or suspend giving them entirely in the near future, leaving you high and dry in the process – a problem that could’ve been avoided if you weren’t blinded by greed.
Asking Yourself How Much Risk You’re Willing to Shoulder
Investors who decide to chase after high yields probably aren’t asking themselves a very simple yet important question: how much risk are they willing to take on for the sake of getting those higher yields?
In investing, you can’t hope to gain something in exchange for nothing. Anytime you commit any money for investment purposes you also take on the risk that you may not get it back: risk vs. return is the foundation of investing. Now, there are ways to keep risk at bay such as risk management and inherently safer design, but generally speaking, if you want greater returns then you must also be willing to take on the increased risk that comes with it.
There are investors who have a very high tolerance for risk, but nobody’s tolerance is infinite – that’s because nobody has the resources needed to take on an infinite amount of risk. Therefore, at some point investors who chase after high investment yields need to look back and make sure they aren’t inadvertently creating a house of cards.
Nothing is stopping an investor from owning a portfolio comprised entirely of junk bonds and speculative common stocks, but if those junk bonds were to default en masse or if those speculative stocks decided to suspend their dividend, then they will be left high and dry.
Are you really willing to take on prodigious amounts of risk, even if it means everything around you could collapse in the blink of an eye?
Again, there’s nothing inherently wrong with wanting to go after investments that offer a high yield, but if the yield is your top priority then you better make sure you have a world-class risk management system in place or have several contingencies in mind just in case things fall apart.
Wrapping Up
Many investors are always on the hunt for higher yields on their investments, but some of them make it their sole mission to focus on getting the highest yields possible. While there’s nothing wrong with wanting an investment that offers a higher yield, problems start to arise when yield becomes the only focus.
A bond that offers a high yield is certainly enticing, but if the bond issuer is unable to pay the interest and return the initial capital outlay, then that high yield is essentially moot.
Many stock investors salivate when they see a common stock that offers a high yield, but if the company always struggles to raise the cash needed to live up to this promise then the dividend they offer may need to be dramatically slashed or suspended entirely.
Ultimately, investors must seriously ask themselves how much risk they’re willing to take on for the sake of chasing after higher yields and if that risk is worth it or not.
