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OPINION

The pitfalls of income investing

The pitfalls of income investing
June 9, 2015
The pitfalls of income investing

One of these risks is simply cyclical risk - the danger of recession. In 2007 some of the highest-yielding stocks were mortgage lenders such as Bradford & Bingley and Northern Rock. These did not survive long enough to pay a decent income. This is part of a pattern: in the last two recessions - 1991 and 2008-09 - the FTSE high-yield index underperformed its low-yield counterpart.

This is no accident. High-yield stocks, by definition, offer more cash flows in the near future than lower-yielding ones do. If there are worries about companies' near-term profitability because of a recession, high yielders will therefore often suffer more than low yielders.

Cyclical risk, however, doesn't affect only high-yield shares. It's also a danger for another high-yielding asset: buy-to-let property. A recession would see house prices fall and an increased risk of voids - being unable to find a tenant, at least at rents you expect.

However, not all high-yield stocks are cyclical. Others have a high yield because investors don't expect much growth from them, and so require high dividends now to compensate for relatively low dividends in future. This, however, exposes us to another risk - the danger of negative momentum.

Imagine investors become more pessimistic about a company's growth, so its price falls and yield rises. But its price might not fall sufficiently to fully embody such pessimism - either because some investors cling to their prior beliefs and so underreact to bad news, or because some institutional investors are unable to short-sell the stock. If this is the case, the stock will be overpriced even though it has fallen. If so, a high yield would lead to further price falls.

Of course, you don't have to imagine this at all. It's what happened to Tesco and J Sainsbury last summer. These had decent yields - but that didn't stop their prices falling further.

There's a third risk that afflicts higher-yielding bonds: tail risk. Lower quality bonds offer a high income - and apparently low correlations with equities - to compensate for the small risk of a default. If this materialises you could easily lose half your investment, and only get the remainder after a long wait.

Which brings me to a fourth risk - liquidity risk, the danger that you'll not be able to sell an asset quickly unless you take a big loss. This is obviously a danger for buy-to-letting: the property market tends to become even more illiquid in downturns. But it's also an indirect problem for holders of investment trusts which invest in asset-backed securities or some bonds. Because such assets can become illiquid in bad times, these funds could move to a big discount to net asset value.

A fifth danger is policy risk. This could be especially acute for buy-to-let investors. Dan Davies at Frontline Analysts points out that the government's benefits cap implies big cuts in housing benefit, which in turn means landlords face the danger of either rent arrears or lower rents. Even if your tenants aren't on housing benefit, this could have knock-on effects simply because it could reduce rents generally. Stephen Gibbons and Alan Manning at the LSE have estimated that over half of housing benefit is in fact a landlords' subsidy.

Income investors thus face many dangers, on top of the ordinary ever-present risk that shares generally will fall. Worse still, these risks are correlated. If we were to see a recession, many high-yielding stocks would do badly; property prices would fall; increased default risk would cut the prices of higher-yielding bonds; and previously liquid assets such as property or low-quality bonds would become less easy to sell. An apparently well-diversified portfolio of shares, bonds and property would therefore not look so safe after all.

You might think these risks are worth taking. Cliff Asness at AQR Capital Management says the tendency for higher-yielding stocks to outperform on average is a "well-established empirical fact". And some high yielders - such as utilities and tobacco stocks - are actually relative safe and so benefit from the tendency for defensive shares to do better than they should.

Even so, there's a problem here. The big risk for income investors - recession - is hard to predict; economists have consistently failed to foresee downturns.

In this context, there's one indicator income investors must watch - the gilt yield curve. This has in the past warned us of the risk of recession; it became inverted (with 10-year yields falling below two-year ones) before the last three downturns. Right now, the upward-sloping yield curve suggests there's little immediate danger here. But this could change if Bank rate rises and we don't get much of a sell-off in gilts.

Perhaps, then, the risks for income investors will pay off for a while longer. But let's be clear that there are indeed risks. Those Yorkshiremen are right: you don't get owt for nowt.