When A 10-Year Treasury Yield Just Isn’t Enough

By Oct 29, 2012, 9:34 AM Author's Blog  

In a world of abnormally low interest rates, the search for yield has become a priority for many investors. The good news is that there are several opportunities for boosting your investment income relative to the usual suspects. The bad news is that higher yield tends to come with higher risk. That’s nothing new, of course, which is to say that risk management is still essential for designing portfolios, regardless of your objective.

How to proceed? As usual, it’s a good idea to start with a benchmark and then consider the alternatives. A 10-year Treasury Note currently yields 1.78%, as of October 26. Its inflation-indexed counterpart has a negative yield of 69 basis points, so let’s eliminate this option right away.

Where else can we look for higher yields? The possibilities among ETFs are an obvious starting point. Here’s a list of ETFs representing various slices of the major asset classes and their trailing 12-month yield through October 26, according to Morningstar.com. In all cases below, the yields exceed the 10-year Note’s payout:

When A 10 Year Treasury Yield Just Isnt Enough

If you bought all 11 ETFs above and weighted them equally, the trailing yield on the portfolio would be 3.90%, or more than twice as high as the current yield on the 10-year Treasury. The market’s capacity for providing yield-enhancing possibilities, in short, is alive and kicking. What’s the catch? Risk, of course.

Juicing yield over a “safe” Treasury is a risky proposition. Quite a lot of the risk is minimized by holding 11 different ETFs that focus on different asset classes. Let’s assume that the 3.90% trailing yield is a reasonable forecast for what this 11-ETF portfolio will deliver for the foreseeable future. In that case, your work is done. But what if 3.90% still falls short of what you need?

It’s time to consider another possibility: taking on more risk to engineer a higher expected yield. One option is to reweight the 11 ETFs above so that the portfolio yield rises. Pushing the strategy further, you might simply hold the five highest-yielding ETFs in the table above in equal portions. In that case, the trailing yield jumps to roughly 5.3%, or nearly three times the 10-year Treasury’s yield. But what you’ve picked up in terms of higher yield comes with higher risk by concentrating the portfolio in a smaller set of asset classes—asset classes that are likely to suffer a fair amount of price volatility.

The question, then, is deciding if boosting the yield to 5.3% from 3.9% is worth the extra risk of holding a smaller number of asset classes? There’s no right or wrong answer because these types of decisions should be customized for each investor, based on risk tolerance, investment objective, time horizon, etc.

Meantime, I don’t want to leave the impression that the table above is the last word on the possibilities for earning higher yields. There are many other ETF and mutual fund choices, along with a world of possibility via individual securities.

The larger point is that the basic framework outlined above—consider the benchmark and a broad list of relevant alternatives–is a reasonable roadmap for designing a portfolio that will provide the highest yield given your risk tolerance and financial situation. Obvious? Perhaps, although there are too many recommendations out there these days that suggest otherwise. For instance, I’ve seen a number of articles advising readers to load up on the high-yielding investment du jour in the search for yield, be it an ETF or a handful of individual securities. That’s fine if you’ve considered a broad set of alternatives first.

Unfortunately, too many investors rush into a handful of investments without considering the strategic perspective. A better approach, and one that works well for portfolio design and management generally, is to start with an expansive set of potential choices and then customize the mix to suit your particular needs. For most folks, that means ETFs and mutual funds.

Keep in mind that building a higher-yielding portfolio isn’t all that difficult. The real challenge is building one that’s appropriate in risk-adjusted terms.

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