How an Investment's Yield Can Break

What breaks a particular investment’s yield is part of the three-question stress test I will share during the AAII Income Investing Seminar. An interruption to the income stream or a significant decrease in the stream’s inflation-adjusted value are both ways a yield can “break.”

The stress test itself is a framework for evaluating the riskiness of income-generating investments. These risks cluster into a few categories across asset types. They include deterioration in the issuer’s ability to pay, interest rate moves, structural features like call provisions and inflation-eroding fixed payments.

This week, I share ways that the yields of stocks, bonds and other assets can break as a preview of the seminar.

• Stocks: Anything that hinders a company’s ability to sustain a dividend breaks the yield. A key ratio for stocks is the payout ratio, which is the dividend divided by earnings. Ratios above 100% mean that the company is paying out more than it earns, which generally can’t continue indefinitely. A decrease in operating cash flow that is not attributable to timing issues is a big warning sign. Yields well above those of sector peers often signal that the market is pricing in extra risk.
• Bonds: A significant risk of default will break any bond’s yield. Credit rating downgrades usually precede default; downgrades to B or CCC/Caa ratings are very worrisome. (Avoid any bond with even worse ratings.) Inflation also breaks a bond’s yield because interest payments are fixed on the date of issuance. Even average inflation of 3% reduces the real (inflation-adjusted) value of a coupon by more than half over a 30-year period. The same metrics used to measure a corporation’s ability to pay dividends can be applied to analyze its ability to fulfill its debt obligations. The specific source of revenue for a revenue bond should be monitored as well, since decreases in that revenue could be problematic. Callable bonds can be redeemed early by the issuer, and convertible bonds can be converted to stock—both ending the income stream.
• Real Estate Investment Trusts (REITs): A key metric for REITs is funds from operations (FFO). FFO equals net income plus depreciation and amortization, adjusted for gains or losses on real estate sales. Decreases in FFO lead to smaller dividends payments. Slowing economic conditions or rising interest rates can put downward pressure on FFO.
• Master Limited Partnerships (MLPs): Part of an MLP’s distribution can be return of capital, which reduces your cost basis. The lower your cost basis, the larger the potential capital gains taxes owed when units are sold in a taxable account. The yield appeal of an MLP will also diminish if unrelated business tax income (UBTI) is realized in an individual retirement account (IRA).
• Preferred Stocks: Preferred stock dividends are paid out of earnings and can be cut or suspended for the same reasons that common stock dividends can. Monitor a company’s payout ratio and cash flow. Cumulative preferreds accrue missed dividends that must be paid before common dividends resume; noncumulative preferreds do not. Credit ratings are a useful sustainability check.
• Annuities: The income paid by these products may not be as attractive after fees and surrender charges are factored in. Income from fixed annuities is subject to the same inflation risk as bonds.

I will go into more detail about each of these types of investments—as well as exchange-traded funds (ETFs) and mutual funds—in the Income Investing Seminar, which starts on June 4. Learn more about the seminar.