What “I Want the One with the Higher Yield” Really Means

high yield often means higher risk

What “I want more yield” often means

Unless you live under a rock, you know that interest rates are low.  Historically low.

With low interest rates, your checking and savings accounts likely aren’t earning much.  Banks are paying next to nothing on your savings.  Even moving money into CD’s will only earn a saver a few basis points (less than 1%) over the course of a few years.

That’s the bad news.

The good news is borrowing money is really cheap.  Most notably, mortgage rates are really low.    Rates are in the 3-4% range for 15 year and 30 years mortgages.

So what is someone to do?

In this low rate environment, I often am the recipient of the following questions; How can I get more yield?  Where can I get more yield?  What else is out there that is giving me more yield?

Before we dig into the details of “how to get more yield” and understanding what “getting more yield means,” it’s important to understand how fixed income (bonds) work.

When you purchase a bond there are three key components, the face value, the interest rate, and the term.  If we assume a bond has a face value of $10,000, a 5% interest rate, and a 5 year term, an expected timeline of payments looks like this:

  • Immediately –                                 You pay $10,000 to buy the bond
  • End of years 1 through 5 –            You receive $500 dollars of interest (5% of $10,000)
  • End of year 5 –                                You get your $10,000 back

It looks very similar to a CD you get at a bank.

How Do I Get More Yield?

In short, there are two ways to possibly “get more” when it comes to yield and investing, specifically in terms of bond yield.

  1. Decrease the quality of your bonds
  2. Increase the length of your bonds

Decrease the quality of your bonds

Have you ever loaned a friend $20 bucks because they ran out of cash?  Or picked up a tab at dinner because your friend only had a credit card?

If you are like me, you know immediately whether that friend is going to run to the closest ATM and pay you back, or if you just “loaned” money to a buddy that’s officially gone forever.

Investing in fixed income is very similar.

When you invest in fixed income, you are loaning money to governments and corporations in the expectation they are going to pay you back at the end of the term.  If the risk is low they are not going to pay you back (known as default), you get a low interest rate.

For example, you can think of loaning money to the US Government as your friend who runs to the ATM and pays you back immediately.  There is very little risk the US Government is not going to pay you back.  Because of the low risk of default (the term for not getting paid back), the interest rate the US government is going to pay you on your money is low.

If the risk is high you are not going to be paid back, the yield you should expect is higher.  In today’s world the Greek government would be considered high risk.

Increase the length of your bonds

Another way to possibly increase the yield on your fixed income is to lengthen the term of your bond.  For example, a 1 year bond typically pays less than a 5 year bond, a 5 year bond less than a 10 year, a 10 year less than a 20 year, and so on.

The longer you are willing to “lock up” your money, the more the bond issuer should be willing to pay.

It’s important to consider by locking your money up for a long time, you are assuming additional risk in terms of liquidity risk and inflation risk.

What do you need to know?

Bottom line – If you invest in something with more yield than another….it’s more risky.  It’s not necessarily a better deal.  It’s not something special your friend was able to get just for you.  It’s not magic.

More yield = More risk (all else being equal)

Remember, more risk does not mean you will not be paid back.  More risk does not mean your bond will default.  It’s very possible everything may work out as planned.

But as an investor, it’s critical to know that if you are buying one investment that has more yield than another, you are usually taking on more risk.

All investment entails inherent risk. There can be no guarantee that any particular yield or return will be achieved from any investment.

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