For the last few years I have been running a small High Yield Portfolio (HYP) as an experiment. The performance of this portfolio has been underwhelming, to say the least. I’ve taken some time recently to dig into the performance in more detail to examine why the performance is so lacklustre.
The theory: take steady income, and gear up
The thinking behind my HYP was clear:
- Set up a HYP in a US dollar account. Let’s call it $100k to keep numbers simple.
- Gear the portfolio up. With USD interest rates at <2%, I was targeting a general level of gearing of about 2:1. I.e. I’d have about $200k of assets, and $100k of loan costing me around $2k per year.
- Pick securities, of any type, which had the following characteristics:
- Yield of above 4%. I have averaged yields of around 6%. This amounts to $12k of income (6% of $200k).
- A historically steady share price. Or, if I have to, a slowly rising price – e.g. AT&T.
- No obvious warning signs of impending doom.
- Reinvest income. I don’t have any particular science to this – sometimes I buy on dips, sometimes I add a new holding.
- Pay a modest amount for ‘volatility insurance’. My way of doing this was to hold a short position on the SPY tracker, amounting to about $20k. This reduces my loan by $20k but costs me about 2% too so it doesn’t really change my $2k per year total cost. My average in-price for that short position is 131, which tells you how old this portfolio is (hint: SPY is now at about 224!).
- In theory this would lead to a portfolio with $100k net asset value, average income of about $10k (i.e. 10%), and a manageable level of volatility. I think I might also expect some drop in capital value, if I’ve bought assets whose yield is because they are effectively selling off assets.
- This portfolio would not be tax-efficient because the gross income of $12k would all be taxable (and investment interest isn’t deductible in the UK) but even net of tax the level of return would be about 6%. This isn’t stellar but if it was reliable year after year I would be quite pleased with it. Ideally it would also deliver a modest level of capital gain too.
The practice: average returns of half my expectation
What’s actually happened is that this portfolio suffered a fair amount of scope bloat in the first couple of years. I added some UK holdings, and the portfolio grew to over 20 holdings. I realised this wasn’t teaching me much and started pruning it, culminating in a drastic rationalisation during 2015. For 2016 I’ve left the portfolio steady with six (unequally sized) holdings in it, shown (all, bar one – GEB – a GE bond yielding about 4%) in the graph below:
Over the last four years my returns are shown below:
On the face of it, hooray! I’m getting gross income of around 13%. Even after the interest (which is the cost of the 2x gearing), and the (USA withholding) taxes, my net income is above 9%. Every year.
But, alas, my compound return here is about 3.5%. Pre taxes. This is miserable. Why? Because I’ve lost about 6% of my asset value every year, on average – mostly due to a savage 21% drop in 2015.
What lessons can we draw here?
I’d welcome readers thoughts here. To mind it appears that:
- The gearing is working nicely on the underlying income.
- Looking back at my holdings in the early period, I got hit several times by big drops in hitherto steady asset prices. I think there’s a clear lesson here: above average yields signal above average risk – a greater than average chance that you’ll face a 10% drop in asset prices. Look what just happened to PSON (Pearson) this week – its >6% yield was a signal that the market expected bad news and sure enough a profit warning emerged which caused a 30% drop in the share price.
- My ‘volatility insurance’ isn’t doing much for me. And in truth I don’t think it’s the right protection for these sort of holdings. I’m going to change strategy and scrap the insurance but replace it with Stop Losses, set at about 10% below the holding price
Right now I view this portfolio as ‘on probation’. I ran it much more cleanly in 2016 and saw roughly the behaviour I’d have expected, with a 10% return. But in a year when S&P was up 10% this was still underperformance. If I can see 7% or more this year then I’ll see the average return climb above 4% and I’ll feel more confident I can explain what’s going on. If I take another pasting then I think it’ll be time to liquidate this portfolio and redistribute the funds elsewhere.
Any other suggestions here? How do your HYP portfolios perform, versus your trackers?
FIRE v London 
Really interesting experiment.
6 holdings seems very concentrated, might explain some of the volatility.
Might be interesting to do something like this with income generating investment trusts.
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Thanks for sharing. Very interesting.
Could you take the same conceptual approach with short/medium term bonds that you hold to maturity? Then the interim MTM is irrelevant (assuming they don’t actually blow up). I think you can buy individual bonds on IB platform (easier to find on the desktop TWS – I have trouble finding them on the mobile app).
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Very interesting idea.
The GEB holding is a long dated (I think) GE bond and has been working very nicely. Very stable pricing and ok coupon. I will have a look for some more. The challenge will be finding yield to maturity of over 4% in the current rate environment; for higher yield bonds I value diversification (i.e. JNK). Any suggestions very welcome!
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Looks like a fun experiment.
> The gearing is working nicely on the underlying income.
It is certainly self funding at the current interest rate level. Is it setup as margin lending, or have you borrowed separately and just happen to park the funds in this portfolio?
> Looking back at my holdings in the early period, I got hit several times by big drops in hitherto steady asset prices. I think there’s a clear lesson here
Indeed! Fun though it is, trying to time the market will earn you a kick in the bollocks more often than not! 😉
> above average yields signal above average risk – a greater than average chance that you’ll face a 10% drop in asset prices
That follows. When you think about it dividends are the results of past performance + reserves, while stock prices are forward looking. So a high yield tends to indicate low growth prospects or a poor outlook… or that the company is part of one of the many cartels/oligopolies that dominate the Australian market!
> Any other suggestions here?
The stock picking is a fun hobby, but from a pure returns point of view you could look at a tracker following something like MSCI USA High Dividend Yield Index or even the FTSE All-World High Dividend Yield Index. It would spread your risk over a larger basket of holdings, perhaps perform a bit more consistently.
Also talk to somebody wise in the dark arts of international tax law, there would probably be structures in the US (or elsewhere) you could invest through that would reduce how much the local tax man picks your pocket.
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Thanks slow dad. Generally I am sceptical of the high div ETFs for this purpose and they don’t have lower price volatility than theⁿ market (assertion). @Monevator tells us they have high trading costs. They also correlate closely with the market.
My JNK and PFF holdings have diversification, good yield and low price volatility, tho little upside, so they have been staples. But still it hasn’t been working…
Do I take it you follow the Oz market too?! Good to find the fellow travellers!
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I’ve been known to keep an eye on the Australian markets.
When I go off on a rant about the high fees and piss poor performance of super fund operators it lets me do so from a suitably informed point of view!
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Thanks slow dad. Generally I am sceptical of the high div ETFs for this purpose and they don’t have lower price volatility than theⁿ market (assertion). @Monevator tells us they have high trading costs. They also correlate closely with the market.
My JNK and PFF holdings have diversification, good yield and low price volatility, tho little upside, so they have been staples. But still it hasn’t been working…
I haven’t got enough commitment to this to justify tax optimisation. If it started to look like it worked then I’d be more up for that.
Do I take it you follow the Oz market too?! Good to find the fellow travellers!
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Hi FvL,
Interesting to see how you are running the HYP – and also what a pasting it took in terms of capital value.
Personally I am not a fan of leveraging up, although as Slow Dad comments above, it seems to have worked well for you in this instance.
If you are averaging yields of above 6% that to me would indicate a high level of risk that something is going to get cut.
I am assuming you do full research before in terms of the company itself, and if you would be happy to take that hit?
A number of the shares I have in my (open) portfolio have taken a couple of years to get back above water from the price I paid for them, but I also try and see have two sections: Dividend Growth and Capital Growth. So far I am doing better on the latter.
Did you spread your purchases out when you started or did you employ all the money at the same time?
With the reinvested dividends, can you benefit from cheaper charges (and avoid trying to time the market) by simply using the dividend reinvestment option? I guess it would depend where the money is coming from to pay the tax charges….
I think the portfolio of only 6 holdings is way too narrow for this sort of thing – at least with 20 or so then you have some comfort when dividends do get cut (I have experienced the cut on some of my holdings and yet year on year my dividend income has continued to grow).
In terms of the trackers, I have started diversifying and using both Investment Trusts and Trackers. I’m using the VHYL in my current portfolio, whilst it only tracks the market it means I dont worry about what happens and take the dividends. When I start adding VWRL next tax year I will be able to get a real feel for the two, and then I will no doubt plump for the better (I honestly don’t know which)
As Slow Dad also said above – worth checking advice on tax options with the US as you may be able to find a vehicle to help on that side of things.
There is something to be said for just fire and forget into trackers, but I personally have too much fun “playing the market” (i.e. gambling as I have no special edge) – but I do try and limit it!
Cheers, and good luck for 2017!
FiL
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Hi
I’ve started a similar approach without the leverage but using mixture of high yield bond funds and the maximising boost funds like the schroder incomer maximser.
Preferably those with monthly divs as well like the UBS Global Enhanced Equity Income Fund C Inc.
Most TER on these is expensive but covered by a mixture of high divs
It may work out…
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The trick you really want to pull off his to have you interest tax deductible, and your dividends tax free. (US dividends free of withholding). You can do this, if you take a sort of portfolio approach. Have US stocks in your SIPP (no withholding tax) have your leverage in a UK ltd company that holds the UK Holdings, look at the whole thing holistically. The other option is holding things like the DVYL etn in your SIPP, it holds just those sort of stocks and embeds fairly cheap leverage.
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Yes I’m wondering about moving some of my margin loan onto a buy to let mortgage which is somewhat tax deductible. How do I stop paying USA withholding taxes on my (selftrade) sipp? Thanks for the suggestions!
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UK Pensions are recognized by by the IRS as tax free under the US/UK tax treaty, so ask selftrade. and therefore if the pension fills in the W8-BEN form correctly, then W/H tax is zero. I’ve done this with interactive brokers (via @sipp http://www.atsipp.co.uk), and Hargreaves Lansdowne. HL have an issue that all cash is in GBP in their sipp, so all dividends get converted to GBP (1.5% spread), then when you buy USD stocks, it’s that spread again. Obviously with IB you can leave it all in USD and charges for FX’ing are anyway reasonable.
Unfortunately the IB SIPP trading account doesn’t allow margin.
Or you can by something in the SIPP that achieves the same thing: e.g. http://etracs.ubs.com/product/detail/index/ussymbol/DVYL
Whilst you have to take credit risk to UBS, this will buy you all those high dividend stocks, give you financing that’s cheaper (or equivalent to IB’s rates), monthly leverage re-sets, and is actually _less_ because you can only lose 100%.
I also think the BTL mortgage makes sense, this is what I do, you obviously have less ‘margin call’ risk. I think UK property is a bad bet here, but there’s certainly no point having an un-levered property and then a margin loan. Be prepared to shop long and hard for a rate that’s anywhere near as competitive as IB margin loans, best floating rate mortgage is circa +1% above IB rates. You have to decide if the (limited) tax deduct-ability and reduced term risk make it worth-while.
This is only an example, obviously this is not financial advice.
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An offset mortgage might be the best of both worlds, allowing you to shift between cheaper IB margin rates and higher but stable mortgage rates as and when needed. (Likewise, obviously not financial advice)
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My learnings from this would be:
1. If you want capital growth, target stocks you believe will grow in value. It’s more tax-efficient than getting your returns from dividend retention
2. Gearing is great if you expect a portfolio to rise in value. You selected stocks you expected to hold steady. Given they were well into the warning zone on yield there was an above-average chance of price falls, which leverage would magnify
3. Volatility insurance is worth buying if you might need to liquidate a portfolio during a bear market. If you can afford to wait until the market recovers, it’s an unnecessary expense
4. I’m guessing the decision to do this in USD served you well in Sterling terms, but it could have gone the other way
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[…] 6% or more, which is getting into ‘high yield’ securities only – something that I know from experience tend to deliver pretty poor total returns. Of course capital gains may yet deliver an overall gain, […]
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[…] me visibility on a couple of particular investment styles. I’ve written before about how my High Yield Portfolio has sucked; these days it is a very small sub portfolio, and thank goodness – because its […]
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Appreciate you blogginng this
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