The classic truism by Raymond DeVoe Jr. is particularly appropriate today: “More money has been lost reaching for yield than at the point of a gun.”
Searching for investments with higher yields has often led to bubbles and has often lost money for investors. For example:
- The sub-prime mortgage-backed securities that collapsed in 2008 were marketed as money market funds with a higher yield.
- The income trust bubble that was popped in2006 by new tax rules was all about a perceived higher yield.
- Collapse of the “junk bond” market in 1989.
The issue with reaching for yield is that investors often think of it as a free ride. They do not realize that there is always a higher risk associated with higher yields.
The recent Federal Budget revealed that the “bond bubble” (as some have called it) happening today is causing issues. One of the tax “loopholes” the finance minister, Jim Flaherty, felt it necessary to block was the “income conversion” of bond funds. The interesting part is that it is not the wealthy that are being primarily targeted. It is ordinary Canadians that own bond, balanced or income mutual funds or ETFs outside their RRSP.
Mutual funds have been doing “income conversion” for many years. They use a technique using forward contracts to make the fixed income in a bond fund taxed as capital gains, instead of as interest. This effectively improves returns on bonds by reducing the tax. Last week’s Federal Budget eliminated the benefits of this technique.
Why pick on ordinary Canadians trying to make a small yield? The issue is that Investors have continued to have an insatiable thirst for investments with a bit more yield, which has led investment companies to use this technique in more and more products. Too much tax is being lost now, so the announcement in the Federal Budget is not surprising.
In this case, investors will not experience a big loss, but there may be higher taxes on these investments going forward.
What is the lesson from this? When you buy investments, it is always important to consider the total return (not just the yield). Make sure you understand the risk when you search for higher yields, such as the highest yield money market or income fund, the highest possible dividend yield – or the lowest-taxed bond, income or balanced fund.