HYP investing as a yield trap

[PrefInvestor]

Hi IanTHughes.

Thanks for your clarification of HYP investing rules (or is that guidelines.....?) anyway thanks.

I dont think that I did make any special reference to CLLN other than it being an investment where (had I been invested there) I would have taken avoiding action at the first signs of trouble. I cant guarantee that doing that in all cases is beneficial, but all I can say is that I personally would definitely have done so. Personally I am EXTREMELY risk averse and if I see what I perceive as ANY possible major threat to one of my investments then I typically sell immediately. I never put too much into any one investment which minimises the cost in such cases. Other people I know hang on to their losers like grim death hoping for a recovery, which indeed sometimes does come. But this approach is not for me.

ATB

Pref

[IanTHughes]

I dont think that I did make any special reference to CLLN other than it being an investment where (had I been invested there) I would have taken avoiding action at the first signs of trouble. I cant guarantee that doing that in all cases is beneficial, but all I can say is that I personally would definitely have done so. Personally I am EXTREMELY risk averse and if I see what I perceive as ANY possible major threat to one of my investments then I typically sell immediately. I never put too much into any one investment which minimises the cost in such cases. Other people I know hang on to their losers like grim death hoping for a recovery, which indeed sometimes does come. But this approach is not for me.

I do not want to get into a long-winded sematic argument about the meaning of “EXTREMELY” but I can tell you that if I was “extremely risk-averse I doubt very much I would be investing in equities at all, with the possible exception of Index Funds. As it is, I look to mitigate the obvious risk of buying individual holdings by diversification.

You say that you will “sell immediately” on “any possible major threat” and although you have not specifically stated what you consider to be a “major threat” can I assume it to be a profit warning? A dividend cut?

Assuming the foregoing, if I had put that into effect with my HYP I would indeed have salvaged some capital from Carillion PLC (CLLN). I don’t know exactly how much because if I remember correctly the shares immediately fell quite sharply once that profit warning was issued in July 2017. But I would also have consolidated a loss on Aviva Plc (AV) back in 2013, now showing a CAGR of 6.75% and a recovered dividend. In fact – with the benefit of hindsight of course – what I should have done was buy more!

The same can be said of BHP Billiton (BHP), which I would never have purchased, now showing an CAGR of 12.97% and an increased dividend. I would never have topped up Royal Dutch Shell (RDSB) – CAGR 8.69% - nor would I have ever purchased BP PLC (BP) – CAGR 20.45% - both with maintained and now, for BP at least, increased income.

There are others I could point to where a rule such as you describe to prevent an initial investment or even sell out of an otherwise good HYP share would have significantly reduced my returns without, as far as I can see, any reduction in risk at the time.

One final thing to consider is that any complete sale based on a yield that is “too high” or as a result of a profit warning or even a dividend cut, will on many occasions be made at a low point price-wise. Is that protecting your capital?


Ian

[Alaric]

In point of fact, it was originally stated that the capital to be invested could be 25% of a maturing pension pot – 25% being the maximum cash withdrawal allowed at the time. In other words, the income so gained was to be in addition to a pension annuity that would be purchased with the remaining 75%.

In some cases, defined benefit schemes with major employers or the public sector, it wasn't a case of purchasing a pension annuity, but receiving one as financed by the scheme.

But taking this one step further, what was the strategy for dealing with the residual funds from the 25% HYP? At the end of the lifetime of the recipient, the pension annuity would cease, but the assets of the HYP would remain. If the share values and income had kept pace with inflation, there should be the portfolio value of the original HYP investment revalued with inflation. If the HYP holder wanted to spend some of this wealth during their lifetime, some assets would have to have been sold. That is after all the financial point of an annuity, that it can give a higher return than direct investment into suitable income producing securities by virtue of the reversion of the funds held for non-survivors.

[JamesMuenchen]

I am still searching for the HYP "tablets of stone" that describe exactly what IS and what ISNT HYP.

Stephen Bland/PYAD also wrote about HYP on stockopedia
https://www.stockopedia.com/content/hyp ... comment=29

In the above example he states that the two types of "lousy" HYP shares are those that go bust or those that suspend the divi. Because:

Capital, remember, is very much secondary or irrelevant.

The community has always been divided on the issue though, and it was mostly incessant arguments about capital preservation that led to the split of the original TMF community into two separate forums. At least that's how i remember it

[daveh]

In point of fact, it was originally stated that the capital to be invested could be 25% of a maturing pension pot – 25% being the maximum cash withdrawal allowed at the time. In other words, the income so gained was to be in addition to a pension annuity that would be purchased with the remaining 75%.

In some cases, defined benefit schemes with major employers or the public sector, it wasn't a case of purchasing a pension annuity, but receiving one as financed by the scheme.

But taking this one step further, what was the strategy for dealing with the residual funds from the 25% HYP? At the end of the lifetime of the recipient, the pension annuity would cease, but the assets of the HYP would remain. If the share values and income had kept pace with inflation, there should be the portfolio value of the original HYP investment revalued with inflation. If the HYP holder wanted to spend some of this wealth during their lifetime, some assets would have to have been sold. That is after all the financial point of an annuity, that it can give a higher return than direct investment into suitable income producing securities by virtue of the reversion of the funds held for non-survivors.

I don't think it was mentioned per se other than the comment that unlike an annuity there would be a substantial sum left at the end to pass on however you wished.

I'm in almost that situation except I built up my HYP so I could retire/ have an income if I lost my job before I can take my DB pension. My plan is to live off the income from my HYP and eventually my pension, but not to eat into the capital. As I am single any inheritance will go to my godson and his sister and charity (provided I get round to writing a will!)

[IanTHughes]

But taking this one step further, what was the strategy for dealing with the residual funds from the 25% HYP? At the end of the lifetime of the recipient, the pension annuity would cease, but the assets of the HYP would remain. If the share values and income had kept pace with inflation, there should be the portfolio value of the original HYP investment revalued with inflation. If the HYP holder wanted to spend some of this wealth during their lifetime, some assets would have to have been sold.

I am not sure of the reason for your question but one of the secondary benefits of HYP Vs an annuity is that upon the death of the holder of an HYP, the capital can be passed down to whosoever is/are beneficiaries of the last will and testament. An annuity, once purchased, means the surrendering of that capital to the annuity provider. Furthermore, if so desired, capital in an HYP is available at any time, not so with an annuity.

That is after all the financial point of an annuity, that it can give a higher return than direct investment into suitable income producing securities by virtue of the reversion of the funds held for non-survivors.

Today is my birthday and I am now 61, so I have been looking at annuity rates recently. I have discovered that to purchase an annuity giving an income, increasing by inflation as measured by RPI, would provide a starting yield of just over 2.5%. My HYP is currently yielding over 6%, although of course at higher risk.

So your assertion that an annuity can “give a higher return than direct investment into suitable income producing securities” is patently untrue in my view.


Ian

[Alaric]

So your assertion that an annuity can “give a higher return than direct investment into suitable income producing securities” is patently untrue in my view.

I would recommend that you compare like with like. An annuity is guaranteed and regulated in a way that a HYP isn't, so the underlying investments are constrained.

The correct comparison is between a portfolio invested exclusively in fixed and index securities of which most are government bonds and an annuity.

In real terms, the yield on indexed government securities is now negative, so 2.5% with an annuity is much higher.

If it was possible to underpin an annuity with HYP type assets, it would be able to give a higher return that a pure HYP.

[IanTHughes]

So your assertion that an annuity can “give a higher return than direct investment into suitable income producing securities” is patently untrue in my view.

I would recommend that you compare like with like. An annuity is guaranteed and regulated in a way that a HYP isn't, so the underlying investments are constrained.

The correct comparison is between a portfolio invested exclusively in fixed and index securities of which most are government bonds and an annuity.

I was comparing one method of providing a retirement income (annuity) with another (HYP). This topic is about HYP so if you wanted to compare an annuity to another style of investing, I can only say that you should have made that clear. You did not so how was I to know?


Ian

[TUK020]

Today is my birthday and I am now 61, so I have been looking at annuity rates recently. I have discovered that to purchase an annuity giving an income, increasing by inflation as measured by RPI, would provide a starting yield of just over 2.5%. My HYP is currently yielding over 6%, although of course at higher risk.

So your assertion that an annuity can “give a higher return than direct investment into suitable income producing securities” is patently untrue in my view.


Ian

Happy Birthday!

[Alaric]

I am not sure of the reason for your question but one of the secondary benefits of HYP Vs an annuity is that upon the death of the holder of an HYP, the capital can be passed down to whosoever is/are beneficiaries of the last will and testament.

The reason for my question is this. There are shares with high dividend yields, not because the Company is trading profitably enough, but because the Directors are essentially paying out the assets of the Company by way of dividends. Eventually the Company will run out of money, but it might take longer than the lifetime of the pension HYPer. So should an attempt be made to distinguish between the Companies that will retain their worth and Companies that won't? If it's only the Estate that will see the difference, it may not matter, but why then the reluctance to boost returns by the occasional sale?

[IanTHughes]

The reason for my question is this. There are shares with high dividend yields, not because the Company is trading profitably enough, but because the Directors are essentially paying out the assets of the Company by way of dividends.

In point of fact dividends can only legally be paid out of profits or retained profits. Although I do appreciate that it is possible that the company could be paying out dividends when the cash could be better used to pay down debt for example.

Eventually the Company will run out of money, but it might take longer than the lifetime of the pension HYPer. So should an attempt be made to distinguish between the Companies that will retain their worth and Companies that won't?

One should always attempt to ascertain that the dividend being paid is sustainable going forward, as best one can anyway. With regards to a single share, if a company is paying what is considered a sustainable dividend, the capital value will be fine. But, because of the possible risks that an individual company may suspend or cancel dividend payments, or even go bust, appropriate diversification is essential.

If one is successful and the overall Portfolio Income continues, even increases, well into the future, then the capital value will be secure, over the long term. Of course, there will be ups and downs along the way, sometimes quite severe. HYP does not suggest one should ignore capital value, rather it simply aims for an increasing income which will, over time, result in a similar increase in capital.

I thought everyone understood that.


Ian

[Itsallaguess]

Personally I am EXTREMELY risk averse and if I see what I perceive as ANY possible major threat to one of my investments then I typically sell immediately.

Hi Pref,

It sounds like the HYP strategy isn't for you.

It's nothing to worry about - it doesn't suit me either, but it's where I started from in terms of income investment, so I think I can offer some helpful advise on an avenue of income-investment that might better suit your investment-personality.

I think it's very, very important for us as individuals to fully appreciate our investment-personality before we begin to commit large amounts of capital to an investment strategy that will hopefully persist for many years.

A while ago I wrote a post describing my journey away from the pure HYP strategy, on through the 'one-way HYP revolving door', and into higher-yield collective investments, such as investment-trusts.

You can read it here - https://www.lemonfool.co.uk/viewtopic.php?f=31&t=15438

I was never fully comfortable with the pure HYP strategy, and didn't enjoy what seemed to be a regular attrition rate in terms of failed dividends and reduced capital in my single-company HYP components over the years, but since moving largely away from that type of portfolio, and into a mixed set of collective high-yield investments, my ability to enjoy my investing has risen immensely. It gets on with doing what it does, and I don't worry about it at all. What's not to like...

Yes, there's a slight hit to income via slightly lower yields, but I will happily accept that there's a small price to pay to move away from a position of simply not being comfortable with the income-investment strategy that I used to be fully committed to, and the one I continue to add capital to now.

I hope you find the above thread useful.

Cheers,

Itsallaguess

[PrefInvestor]

Hi IanTHughes, Yes Happy Birthday !!.

Just to clarify all my comments are purely aimed at increasing my knowledge and understanding of what is clearly a successful strategy. If I have come across as even vaguely critical then I apologise as this was not my intention. I am relatively new to investing in equities having for many years held my portfolio mainly in preference shares. Until last March that is when the pref market crashed due to a redemption threat and since then I have been finding my way investing in mainly high yield things (stocks, ITs, Investment Trusts and just recently a few Preference Shares still). I have always had some exposure to equities (typically about 20% of my pre March portfolio) but the holding size was always quite small – quite deliberately.

Regarding the points you raised in your earlier post:-
1. I am no great lover of single stocks, they are far too volatile for my liking. And US single stocks in particular are horrendous. My portfolio ATM contains only 6 single stocks BP, RDSB, AV, LGEN, GSK & HSBA. These I hope I can trust to be not TOO volatile, maintain their dividend and not go out of business !. Everything else is in ITs, ETFs plus a few of my old favourite Preference Shares that I bought back into at the end of last year.

When I first started out investing my pref money in March initially I had a lot more single stocks (I had about 50 holdings at one point), but I have since moved away from that strategy and now have around 30 holdings.

2. Regarding significant events that I have used to assess a stocks viability. Typically I have conducted a review on any profit warning, trading update or results or if the stock value fell below 10% of the capital invested (all dividends included). I would consider market position, earnings, debt, likelihood of a dividend cut, likelihood of going into liquidation. My review would typically decide on one of three courses of action - sell, average down or just continue to hold. Those criteria took me out of the likes of Kier & Intu earlier in the year which saved me some pain. I also got out of VOD on this basis. However it is clear from what you and other have written that holding on to quality stocks when they are in decline can still be the best strategy. That said I have always been conscious of avoiding getting stuck significantly underwater with any stock, leaving you stuck just waiting hoping for a recovery. I have addressed this issue with my current portfolio by vastly reducing the number of single stocks.

ATB

Pref

[PrefInvestor]

Hi Itsallaguess,

Yes I read the post at the link that you provided and indeed it did sound a lot more like my scene than HYP. I will read on.

Many Thanks

Pref

[IanTHughes]

Hi IanTHughes, Yes Happy Birthday !!.

Why thank you. Although I was rather fishing for that

My portfolio ATM contains only 6 single stocks BP, RDSB, AV, LGEN, GSK & HSBA.

Well, HYP requires the holding of only single stocks and by purchasing only high yield, stocks that at the time of purchase anyway, are somewhat out of favour.

Typically I have conducted a review on any profit warning, trading update or results or if the stock value fell below 10% of the capital invested (all dividends included).

"Value falling below 10% of the capital invested (all dividends included)" is a truly significant fall. Do you actually mean that or do you mean "Value falling BY 10% of the capital invested (all dividends included)", which in my view is a rather insignificant fall?

I have always been conscious of avoiding getting stuck significantly underwater with any stock, leaving you stuck just waiting hoping for a recovery. I have addressed this issue with my current portfolio by vastly reducing the number of single stocks.

HYP is not a suitable investing strategy for you and I would go further and say that you should stay out of Equities all together. You just cannot accept the risk of capital loss that is inherent in any equity investment.


Ian

[PrefInvestor]

Hi Again ianTHughes, Yes I meant “by” I have a very low tolerance for losses. Enjoy the rest of your birthday.

Pref

[IanTHughes]

Hi Again ianTHughes, Yes I meant “by” I have a very low tolerance for losses.

Well in that case, as I said, HYP is most definitely not for you, far too much risk. Anyway, I wish you all the best in your investing and do let us know what strategy you end up with.

Enjoy the rest of your birthday.

The salmon and caviar is now on the table and the roast beef is just about ready. More importantly, the bottle of Claret has been gently breathing.

Cheers


Ian

[Arborbridge]

If that's REA, please don't touch it. I had an IT with 5% in this company and they are destroying Orangutan habit to cultivate palm oil - I found it very distressing to have inadvertently been dragged into possibly killing off an endangered species.

I hope you will give some weight to this enthical side.

O/T here I think. Every company we invest in has an unethical side if one looks hard enough.

It's certainly not OT for the board. People have often discussed why they abstain from a particular investment and that's all I'm doing. It's up to the individual to make a judgement, but it's perfectly acceptable to point out the issues and to do so without censorship from those who happen to disagree.

I just felt the information was worth giving - ignore it if you like but gagging me is not warranted.

[Arborbridge]

So your assertion that an annuity can “give a higher return than direct investment into suitable income producing securities” is patently untrue in my view.

I would recommend that you compare like with like. An annuity is guaranteed and regulated in a way that a HYP isn't, so the underlying investments are constrained.

You are absolutely right, and we should remind ourselves from time to time that HYP is a risk strategy. The rationalisation "HYP=Annuity" is achieved by smoke and mirrors. It is done by alleging that the market will never crash into the ultimate black hole and that dividends will carry on being paid out at an acceptable level for the remainder of our lives.

Each of us must make the calculation on whether we think the risk is worth taking. In my view, if the economic system were so in peril that the market and payout collapsed to the point where it endangered my standard of living, I believe there would be severe social consequences far worse than my pension worries. Frankly, I can't see it happening.

Thus, I'm sanguine with HYP=annuity, but remind myself that it is a risk I've agreed to ignore for the purpose.

Arb.

[TUK020]

An HYP can and probably will have periodic falls in dividend income.
Long term records published by TJH showed a 40% drop in income following the Great Financial Crash.

Therefore you either need to:
a) accept that an HYP will result in variable payout
b) accept that if you have a fixed payout, there is a finite chance that you will run out of money
c) run a cash buffer to mitigate sequence of returns risk.

The appropriate comparison to an annuity is not an HYP in isolation, but an HYP + cash buffer.

If you start with your payout = dividend income, plus 2 years worth of payout buffer.
Then only increase payout in line with dividend income if you have already increased the buffer, this should give you a rising payout most of the time, but also tide you through any market downturns.

For comparison to annuity purposes, you cannot assume 100% of capital invested in HYP, as you will need to reserve 8-10% for the cash buffer.