Seeking Yield? Avoid These 5 Mistakes

Just two short years ago, yields on 10-year Treasury bonds were below 2%. They’ve more than doubled since then, as the Federal Reserve hiked interest rates 11 times in an effort to stamp out inflation. Those rate increases were partly to blame for stocks’ and bonds’ losses in 2022: Higher yields depress the prices of already-existing bonds with lower yields, and higher interest rates also threaten to slow the economy, which in turn hurts stock prices. Notwithstanding those bobbles, however, higher interest rates are largely a positive for investors. Higher yields lift the long-term return prospects for bonds and other short-term assets, meaning that investors can earn higher returns without having to venture into riskier asset types like stocks. That, in turn, makes other aspects of financial planning easier. For example, with higher yields on safe securities, our starting safe withdrawal percentage from new retirees bumped up to 4.0% in 2023, from 3.8% in 2022 and 3.3% in 2021, when yields were at their nadir. But higher yields also bring potential pitfalls, including the following five mistakes.

Mistake 1: Being Complacent With Cash Holdings

If you practice a policy of benign neglect with your portfolio, that’s usually all for the best. But when it comes to wringing a higher yield from your cash holdings, complacency isn’t your friend. If you’re in a low-yielding (read: high-cost) cash account, your investment provider won’t automatically swap you into a higher-yielding option. Shopping around for higher yields didn’t seem worth it when interest rates were so persistently low; it was hard to get excited about picking up an extra 50 basis points in interest. But times have changed, and depending on where you hold your cash, the yield differential between higher-earning and lower-earning cash accounts has gotten more meaningful. Brokerage “sweep” accounts are a notoriously low-yielding type of cash account, where you’re paying for the convenience of having the cash sit alongside your investment account. Some such accounts are still paying less than 0.50% per year, for example, even as many high-yield savings accounts and money market funds have payouts that are literally 10 times higher.

Mistake 2: Overallocating to the ‘Bird in the Hand’

For investors who are attracted to the higher safe yields that cash offers today, one risk is overdoing that allocation. As yields trended up in 2022 and 2023 and stocks and bonds experienced significant volatility, some of the hottest investments around were certificates of deposit, money market funds, and I Bonds, the latter of which offer an inflation adjustment on top of the fixed rate of interest they pay. Everyone likes a “bird in the hand” versus the uncertain prospects that can accompany investing in stocks. But it’s also important to recognize that those higher yields may be ephemeral; what looks like a sure thing today may not be in a few months or years. If interest rates head back down, your high-yield savings account yield could plummet, or you could be forced to reinvest the proceeds from a CD that just matured at a much less attractive rate. Bond-fund yields will also rise and fall based on the prevailing interest-rate environment, though at least your bond price benefits when rates go down. Unless you’ve locked in today’s higher yields by purchasing individual bonds with long maturities, you’ll be vulnerable to whatever interest rates are on offer at any point in time.

Mistake 3: Ignoring the Role of Inflation

Another way that today’s “safe” yields can be illusory is that they don’t reflect the corrosive effects of inflation on whatever payout you’re able to earn. Unless you’re buying I Bonds or Treasury Inflation-Protected Securities, which offer an adjustment on your investment to preserve purchasing power on your income when prices are rising, whatever yield you see is going to be gobbled up at least in part by inflation. The 5% yield on a 10-year Treasury bond, for example, could easily be half that amount once even an average rate of inflation is taken into account. The broader point is that over very long periods of time, cash investments usually keep pace with inflation—but barely. Bonds do a bit better, but real returns aren’t impressive and are apt to be eroded further still once you factor in ordinary income tax on income distributions. Of those three major asset classes, only stocks have delivered a robust return over inflation over long periods.

Mistake 4: Stretching for Yield

“More money has been lost chasing yield than at the point of a gun.” OK, that saying is a bit overdramatic, but investors can get themselves into trouble prioritizing yield over total return and risk controls. Because recessionary worries have abated, lower-quality, economically sensitive bonds have performed very well recently, and they also held up better than higher-quality bonds in 2022′s rising-interest-rate environment. And low-quality bond yields are higher than high-quality bond yields, to begin with. However, such bonds are much less useful in an equity-market shock or recession. It’s also worth noting that the yield differential between high- and low-quality bonds is quite low relative to historic norms, which means that high-yield investors don’t have much of a margin of safety in an economic downturn. For those reasons, you’re better off using low-quality bonds as an aggressive kicker for your bond portfolio rather than relying on them as ballast. Alternatively, if you’re going to make room for such bonds in your portfolio—whether high-yield bonds, bank loans, or emerging-markets bonds—consider doing so with your equity allocation rather than deploying your bond allocation in that direction.

Mistake 5: Ignoring Asset Location

Another key area where investors can trip up with respect to income-producing securities is not paying due attention to asset location—taking care to house certain assets in specific account types in an effort to reduce the drag of taxes. Like inflation, taxes can take a significant bite out of your yielders’ returns, in that income from cash and fixed-income investments is taxed at your ordinary income tax rate, as high as 37%. (Dividend income is treated more favorably from a tax standpoint, usually at a 10% or 15% rate.) Taxes weren’t a major consideration when yields were so low. But now that they’re higher, housing those income producers inside of a tax-sheltered is a best practice. Alternatively, if you’re holding cash and/or bonds in your taxable account—and many investors do so for liquidity reasons—investigate whether you might not be better off holding municipal securities instead of taxable ones. Income from municipal securities generally skirts federal income tax, and if the issuer is your state or local municipality, you may be able to avoid state and local income taxes, too.