Chasing Yield Is Never a Good Strategy

(MoneyWatch)  The Federal Reserve has been highly successful in achieving one of its goals -- increasing the "price" of avoiding risk. Fearful investors seek the safety of Treasury instruments. Of course, this means they forego the risk premiums available from non-Treasury debt and equity investments. Driving the rates on Treasury bills to virtually zero has also had the effect of pulling down the yield on short-term bank CDs (which are also a riskless investment as long as you stay within the FDIC limits).

When rates fall sharply, investors search for higher yields. There are two ways to increase yield:

• The first is to take incremental maturity risk, which would increase the volatility of the portfolio and subject you to increased risk of unexpected inflation.
• The second is to take incremental credit risk.

Both strategies are in conflict with the main role of fixed income assets in portfolios. That role should be to reduce the overall level of portfolio risk to an acceptable level, allowing you to hold the appropriate amount of equities given your own unique ability, willingness and need to take risk. Therefore, fixed income instruments should be limited to only those of the highest investment grade. Investors seem to have already forgotten the lesson that 2008 provided.

In 2008, the equity markets experienced by far their worst year since the Great Depression. Times like these are when you need your fixed income assets to provide stability to your portfolio. Yet "alternative" fixed income investments -- such as high-yield bonds, convertible bonds, emerging market bonds, preferred stocks and stocks with high dividend yields -- suffered large losses. Bond funds that stretched for yield paid the price as well. One fund, Helios Intermediate Bond Fund, lost almost 85 percent.

There are two lessons investors should learn from the experience of 2008. The first is to never confuse yield with return. The second is that credit risk is correlated to equity risk -- when the risks to equities shows up, credit risk also tends to rear its ugly head at the same time. Thus, credit risk and equity risk don't mix well together in a portfolio. You would do well to limit fixed income investments to only Treasuries, government agency debt, FDIC-insured CDs and the highest investment grade municipal bonds (AAA/AA). If you're going to take corporate credit risk, limit it to only investment grade and short term. Investors that did so avoided the severe losses many experienced in 2008.

If you have made the mistake of stretching for yield because safe investments offered such low returns, remember that while smart people make mistakes, they don't repeat them. If you need or want to take more risk in search of higher returns, the more efficient way is to either increase your allocation to either stocks in general, or to riskier small-cap, value and emerging market stocks, not to stretch for yield.