The Quest for Yield: Tread Carefully

Income-seeking can find plenty of securities with generous yields, despite the Federal Reserve and other central banks’ war on savers.

But in this uncertain economic environment and in the latter stages of a bull market, due diligence and selectivity are critical.

Moth-like investors who blindly gravitate toward sweet yields can face sour consequences when the bottom falls out on higher-risk names.

US gross domestic product (GDP) continues to grow at a lackluster pace, increasing the economy’s vulnerability to potential shocks. Second-quarter earnings revealed deteriorating fundamentals in a number of industries and some companies in our Utility Report Card.

Although utilities and other essential-service companies generate resilient cash flow during periods of economic weakness, these stocks can still take a hit when the broader market sells off. Recall that the Dow Jones Utilities Average gave up 30 percent of its value in 2008, when the financial crisis and onset of the Great Recession pummeled equities of all stripes.

Dividend-paying stocks can also take a temporary hit when the Federal Reserve makes noise about raising interest rates. Conventional wisdom holds that an uptick in interest rates reduces the value of future dividends, a flawed argument that overlooks the potential for the companies to grow their payouts.

Interest rates and utility stocks exhibit scant correlation over the long run. And when the Fed hiked interest rates by 425 basis points between June 2004 and June 2006, the Dow Jones Utilities Average generated a total return of 61.1 percent—almost four times the gain posted by the S&P 500.

The recent rally in utility and telecom stocks has propelled these sectors to valuations that historically have proved unsustainable, compressing yields and reducing the number of Portfolio holdings that trade below our buy targets.

In this environment, income-seeking investors may be tempted to go out on a limb to lock in a big yield. But sweet yields can bring sour consequences if you aren’t careful. We highlight three areas where investors can find value in today’s market.