Should You Invest for Safety, Yield or Profit?

By
A A A

SAN DIEGO (ETFguide.com)  Who doesn't want to have their cake and eat it too? When it comes to investing, we all would like to have our money in a safe place that pays plenty of dividends (or interest) and goes up in value.

However, juicy yields and dividends have been hard to come by recently. The benchmark 10-year Treasury Note (Chicago Options: ^TNX ) yields 2.52% and remains within striking distance of its all-time low.

Like animals searching for water holes in the desert, investors are on a constant mission to find the best yields. If one yield source has dried out, they move on to the next. Unfortunately, shallow watering holes are safe but dry out fast, while abundant watering holes tend to host crocodiles and other dangers.

Metaphorically speaking, where can investors find the most secure and abundant watering hole, or income and safety?

The Highest Yields

High yield bonds such as the SPDR Barclays Capital High Yield Bond ETF ( NYSEArca: JNK ) and iShares iBoxx High Yield Corporate Bond ETF (NYSEArca: HYG) have filled investors thirst for income with yields around 9%.

The term 'high yield corporate bond fund' understates the potential risk associated with such tempting returns. The ticker JNK - which stands for junk - more appropriately, describes the credit worthiness of the underlying issuers.

Junk is not treated as junk as long as it's perceived to be 'safe.' Perception, however, is a fickle thing and can change in an instant. The chart below shows that JNK and HYG perform like stocks but are labeled bonds.

There is no free lunch, and if an investment offers the same upside potential as stocks, don't be surprised if it delivers the same downside risk. The downside risk of the S&P (SNP: ^GSPC) and Dow Jones (DJI: ^DJI) in 2008/2009 was nearly matched by junk bonds.

 

Corporate bonds like the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD), with a yield of 4.53% have found favor in the eyes of yield-hungry investors as well. As the chart above shows, even LQD is subject to significant swings.

Treasury Bonds

Despite a skyrocketing balance sheet, debt issued by the U.S. Treasury is still considered safe. This doesn't mean though that you can't lose money.

In fact, long-term Treasuries (20 years and more) are very susceptible to interest rate changes. Due to the inverse correlation between price and yield, an increase in yield can cause a serious decline in your capital.

From August 25 to September 16, the iShares Barclays 20+ Year Treasury Bond ETF (NYSEArca: TLT) dropped as much as 8.49 points or 7.76%. TLT has an annual dividend yield of 3.7%. In other words, the capital losses accrued within a matter of two weeks wiped out over two years worth of yield. How is that for safety?

On the exact day TLT topped, the ETF Profit Strategy Newsletter published the following research, which applied the same technical analysis the newsletter generally applies to stocks:

'Today's spike pushed /ZB (the futures ticker for the 30-Year Bond) to 136'31. From there prices retreated and formed a red candle high on the daily chart that closed at 135'08. Today's high coincided exactly with the weekly r2. In addition, ZB's overbought condition can be seen by the fact that ZB has closed above the upper accelerations band for nine consecutive trading days. From its December 2008 high at 123.15, the iShares Barclays 20+ Year Treasury Bond ETF ( TLT ) fell as low as 87.3. At today's high of 109.34, TLT retraced precisely 61.8% of the points lost during the previous decline. Technical analysis along with fundamentals suggests that T-Bonds are getting ready to roll over.'

Since its September 16 low, bond prices have recovered somewhat and may even attempt to rally to new highs, but the long-term outlook for the 30-year and 10-year Treasuries is not pretty.  Short-term ETFs like the iShares Barclays 1-3 Year Treasury (NYSEArca: SHY) won't satisfy yield junkies, but will keep you sleeping better at night.

Dividends

Is it better to focus on dividends or capital gains? Ideally, you would like to get both, but in a worst-case scenario you could end up with neither. Since dividend rich stocks are not synonymous with safety, discernment and common sense are an absolute pre-requisite.

Ask yourself, would you rack up your credit card debt  just to earn points? If that doesn't make sense, why would you want to risk your principal just to earn dividends?

In 2008, the ETF Profit Strategy Newsletter warned: 'The highest dividends are paid by the worst performing sectors. If history is a guide, dividend ETFs will not be able to protect investors as the stock market slides further.'

Throughout 2008 and early 2009, dividend rich stocks and ETFs continued to disappoint investors. As prices of the iShares DJ Select Dividend ETF (NYSEArca: DVY), SPDR S&P Dividend (NYSEArca: SDY), Vanguard High Dividend Yield (NYSEArca: VYM), and Financial Select Sectors SPDRs ( NYSEArca: XLF ) tumbled more than 50%, dividend yields for those ETFs moved close to 10%.

Was the 50% drop worth the yield increase? No, especially since dividends didn't really increase, the percentage yield simply doubled as a result of stocks losing half their value.

There was, however, a time when it made sense to bargain shop and cash in on juicy yields and capital appreciation potential.

On March 2nd, 2009, the ETF Profit Strategy Newsletter sent out the following buy alert: 'Dividend ETFs with a higher allocation to financials are likely to rise higher than the broad market. Some of the dividend yields are quite juicy and can help to offset 'timing mistakes'. There are two things to keep in mind: 1) dividend yields will go down over the next few months 2) the ETFs with the highest yields are likely to be the most volatile.'

Investors who loaded up, at a time when yields were high and prices were low, got to have their cake and eat it too.' At the time, the Select Sector Financial SPDR had a near 10% yield and a $6 price tag. Today it has a 0.92% yield and a $14 price tag.

Just Not a 'Dividend-Environment'

A look at history shows that periods of extremely low yields are generally followed by periods of low prices. Dividend yields for the Dow Jones reached an all-time low in 1999. This was followed by the 2000 tech (NYSEArca: XLK) bust from which neither stocks nor the economy have yet recovered.

Today, dividend yields are still close to their 1999 lows. History suggests that investors hunting for yields in risky places, such as junk bonds, run a fair risk of getting burned.

Dividend yields provide a quick, easy and unadulterated look at valuations. Low yields equal overvaluation. Unlike P/E ratios, dividend yields can't be 'spiked' (the 'E' of P/E can easily be manipulated via accounting tricks).

While dividend yields are not a short-term timing tool, they point towards troubling times ahead. A detailed analysis of dividend yields and other valuation metrics, along with their long-term implications, is available via the ETF Profit Strategy Newsletter and its semi-weekly updates on the market's whereabouts. 



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: TLT

ETFguide

ETFguide

More from ETFguide:

Related Videos

Can You Trust CarFax?
Can You Trust CarFax?               

Stocks

Referenced

Most Active by Volume

164,810,018
  • $16.16 ▲ 4.12%
50,233,746
  • $55.89 ▲ 4.66%
38,892,062
  • $37 ▲ 5.35%
36,824,964
  • $35.15 ▲ 1.88%
34,222,883
  • $9.74 ▲ 6.22%
32,620,827
  • $100.58 ▲ 0.01%
29,001,008
  • $30.10 ▼ 0.76%
25,347,187
  • $8.25 ▲ 1.48%
As of 8/21/2014, 04:03 PM

Find a Credit Card

Select a credit card product by:
Select an offer:
Search
Data Provided by BankRate.com