The dangers of chasing dividends

[nun]

I have some friends that are big fans of closed end bond funds, particularly Pimco Corporate Opportunity. They love the big dividends. I point out the risk involved and that buying above NAV is to be avoided, but I think they are blinded by the dividends. With interest rates so low I fear that many people are running to high yield bonds without adjusting their AA for risk.

 

[brewer12345]

I own plenty of CEFs, but I am buying stuff at deep discounts and trying to stick with underlying assets I am happy with. Yield is a consideration, but it takes a backseat (trunk?) to value. Buying at crazy premiums to NAV is a great way to get killed.

The junk market offers no value at all, that I can see.

 

[RockyMtn]

Strictly chasing yield is something that should be avoided. As with overall asset allocation a similar allocation approach within bonds, bond funds, bond etfs, etc is a smarter approach IMO.

 

[ziggy29]

When "safe" yields are at their worst is precisely the time when chasing yield is most dangerous. That's when yield tends to be priced with the highest premium, and "buy high" isn't generally a good way to build wealth over time.

 

[nun]

When "safe" yields are at their worst is precisely the time when chasing yield is most dangerous. That's when yield tends to be priced with the highest premium, and "buy high" isn't generally a good way to build wealth over time.

The real danger comes with someone who needs retirement income and looks around at bond index funds, high quality corporate bond and dividend funds, Treasuries etc or CDs and realises the yields won't cover their expenses, so they go over to the "junk" dark side. Pimco Corporate Opportunity average is BBB....so not complete junk and ok for someone with a job, but I wouldn't rely on it for ER income.

 

[teejayevans]

re: junk bond funds
As long as the funds are diversified, unless you are expected total collapse, I don't think they are that risky?
TJ

 

[ziggy29]

re: junk bond funds
As long as the funds are diversified, unless you are expected total collapse, I don't think they are that risky?

You need to consider not only the default rate, but the interest rate risk. If rates rise, junk prices will fall faster because the yield chasers can head for the exits as decent yields can be found in "safer" places.

As for collapse, it doesn't need total collapse to be risky here. If a decent (not bottom of the barrel) quality "junk" fund is yielding 6% (all-time lows, by the way, with Vanguard's primary offering yielding a pitiful 5.69% as I type this), you only need a 2-2.5% default rate above intermediate term investment grade corporates to lose all the yield you chased, and only about a 3% *total* default rate to lose out compared to a 10-year Treasury.

(In other words, if a 3% default rate on a fund yielding 6% leaves you with a 3% total return absent of NAV fluctuation, it's no better than a 10-year Treasury now yielding 3.04% - again, absent NAV fluctuation. And I suspect junk's value would fall faster than a Treasury in a rising rate environment. And it's hard -- but not impossible -- to envision an environment where junk's default rate is less than 3%, but very easy to envision an environment where the default rate goes much, MUCH higher. That makes the risk/reward proposition very dicey.)

 

[brewer12345]

Actually, Junk isn't generally that rate sensitive because it tends to be of shorter maturities (nobody issues 30 year junk and even 10 years is a stretch). The risk (absent defaults) is a widening of junk spreads, which can inflict a fairly painful mark to market. If defaults spike, you may also get stung, although it depends on what recoveries turn out to be.

Simply, the spreads offered on junk do not compensate for the risks, IMO. But the junk market implodes every few to several years, so I will wait.

 

[jimnjana]

Strictly chasing yield is something that should be avoided.

I agree, but I think there is an exception when chasing Yield is better than the alternative. I think the exception is when you are spending down principal from a retirement account. In our situation, DW has a 30K TSP balance that we will tap in less than 3 years. Basically we maximize our cashflow by moving the money from the TSP into a fund that pays a monthly distribution that includes return of capital. We will pay a higher managment fee, but will realize a higher monthly withdrawal, for a much longer period of time. If we left the money in the TSP there is a 100% probability that we will spend down the entire 30K in less than 15yrs, with the alternative, there are risks that the distribution could be reduced or stopped, but at least I can mitigate some of the risk.

 

[ziggy29]

Actually, Junk isn't generally that rate sensitive because it tends to be of shorter maturities (nobody issues 30 year junk and even 10 years is a stretch). The risk (absent defaults) is a widening of junk spreads, which can inflict a fairly painful mark to market. If defaults spike, you may also get stung, although it depends on what recoveries turn out to be.

Yeah, but junk also acts a lot more like stocks than investment-grade bonds do. So if stocks are hammered by a rate hike, junk can be hit harder than one would expect by shorter maturity alone. It is this aspect of junk that makes the spreads fluctuate so wildly. And junk spreads at or near historical lows mean you need close to historically low default rates to justify their pricing, and does anyone really see that happening, especially seeing as the "stimulus package" that was cheap oil is gone?

 

[brewer12345]

does anyone really see that happening, especially seeing as the "stimulus package" that was cheap oil is gone?

The majority of people in the junk market seem to think that is exactly the case.

I would say that this is the sort of thing that investing in only indexes makes it hard to really have a handle on. If you buy individual bonds and are doing your appropriate due diligence, you have scoured the balance sheet, understand the capital structure, understand how the issuer generates cash to pay bondholders, etc. If you only buy index funds all you know is the yield and the price.