In this Market Ethos, we explore a different lens for looking at yield solutions for a portfolio. Given most yield-providing allocations are also expected to provide some portfolio defence, we have shared a risk-adjusted yield framework to help consider different yield strategies for a portfolio.
In a simpler time, portfolios were constructed by combining equities and bonds. The equities provided much of the capital appreciation or growth for the portfolio, while the bonds provided some income and acted as a ballast or portfolio stabilizer during those troubled times when the equity growth driver fell. As the markets evolved and the available investment strategies expanded, things became less simple.
We all lived through this evolution. In the 1990s, equities really enjoyed increased popularity as a driver of capital appreciation. Before this, individual equity ownership was much lower. In the 2000s, value and dividends became dominant factors. In the 2010s, with yields continually moving lower, investors turned to a multitude of different yield-producing strategies to compensate. Moving down the credit spectrum, getting more exotic in instruments or geographies, option/derivative income generators and, of course, dividend-focused equity strategies.
This demand for increased diversification of yield sources for portfolios has only increased during the past few years, given the heightened correlation between equities and bonds – a higher correlation means the defensive or stabilizing portfolio contribution from bonds has diminished. The silver lining is that higher yields now make bonds a larger contributor to portfolio yield and potentially portfolio performance. As with everything, there always seems to be a trade-off.
The same trade-offs often apply to different sources of yields. For instance, today, the broader Canadian bond universe (based on ETF) has a yield of about 3.4%. Meanwhile, shares of BCE Inc. have a dividend yield of 12%. Can you compare these two sources of yield? Let’s ignore the difference in tax for a moment. Obviously, a single company carries more risk than the overall bond market. Remember, the non-equity portion of the portfolio was designed to provide some income and some stability – a dual role. So, let’s look at the yield on a risk-adjusted or, more specifically, a downside risk-adjusted basis.
Yield-to-risk ratio – The Sortino ratio is a common metric that measures returns relative to downside deviation, a measure of downside risk below a certain level. Often, this level is set at zero, so it is only penalized for negative monthly returns. The more common standard deviation penalizes for both up- and downside volatility, but who doesn’t like upside volatility? The yield-to-risk ratio is similar to that of Sortino, which measures the current yield of an investment relative to its historical downside risk. As a result, it provides a downside risk-adjusted yield ratio. The higher the yield, the higher the score. The higher the risk, the lower the score.
Given that the role in a portfolio of most yield-providing strategies is both income and portfolio stability, this provides a combined lens for this dual objective. The chart below shows a number of different bond strategies based on available ETFs, with their respective yield-to-risk ratio and current yield.
While emerging market bonds and Canadian preferred shares have some of the highest yields, they do not stack up well on a risk-adjusted basis. For investors in these asset classes, that may bring back some painful memories. Plain old bonds, both Canada and the U.S., both stock up pretty well on a risk-adjusted yield basis.
Another factor to consider when using multiple sources of yield in a portfolio is how they are correlated. Given traditional bonds may have muted defence in a more correlated world; ideally, we would want a lower correlation to bonds. Prefs may not stack up well from a yield-to-risk ratio, but they do provide a performance that is very different from that of the bond market. As does high yield.
However, yield is now being sourced from many areas outside the bond universe. The following provides the same metrics for a number of dividend-focused ETFs and other income-oriented strategies. The benefit of going outside the normal bond arena is that strategies can be found that provide yield and different styles of defence.
Clearly, there are attractive yields available in the equity dividend space; however, the defensive characteristics are lacking. They may often be called ‘bond proxies,’ but that is a loose proxy. On the positive, the proliferation of differentiated yield-generating strategies has created many other options to better diversify a portfolio’s yield sources.
Two important notes: tax & growth – It is somewhat unfair to compare yields on a pre-tax basis, and some allowances should be considered for after-tax yields. Of course, tax-sheltered accounts don’t care. And then there is growth. The equities likely have a growth component and the ability to grow dividends. Those are very positive characteristics that must be considered separately.
Final Thoughts
Today, a portfolio’s yield is generated from many different sources and types of investments, well beyond bonds. Having a well-diversified yield has become even more important in a higher-correlated world, as relying on one or two sources may prove risky. The good news is there are many sources of yield in the market, thanks to higher rates and the industry’s ability to innovate. Adding these different sources, consideration should be given to a risk-adjusted yield framework, given that this is often part of the portfolio that should score well on defence.
It may not be a simpler time, but it sure is more interesting.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
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Sources: Charts are sourced to Bloomberg L. P.
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