Diversification Lets You Increase Portfolio Yield without More Risk

Money market funds are low-risk but pay little. Junk bonds and long-term bonds yield more but they’re risky. So how can you ramp up yield without taking on too much risk?

With strategic diversification, you can safely boost your portfolio’s yield. It’s the only strategy that can both decrease risk and increase yield. True diversification is about building a portfolio of uncorrelated investments that aren’t all affected by the same economic factors.

Some risks aren’t worth taking. Long-term rates are very low. If they rise significantly, you can lose a lot of money in a long-term bond fund. In the current environment, the higher yield is typically not worth the increase in risk.

Where can you get more yield without too much risk? Consider REITs and floating-rate funds.

REITS BOOST YIELD AND DIVERSIFICATION

Due to real estate’s low correlation with other investments, REIT funds can provide a hedge against a lengthy period of poor performance in the stock and bond markets. The investment’s low correlation to other assets may provide an opportunity to reduce risk and increase portfolio yield.

A diversified REIT fund produces reliable income from properties such as shopping malls, apartment buildings, office buildings and hotels. Since these properties are generally located across the U.S., and sometimes in other countries, geographic risk is minimized.

But don’t go overboard. While REIT funds offer good yields, like all other equities, they’re volatile. So limit your REIT investments to 7.5 percent of your equity allocation. Even that modest allocation offers yield and diversification.

I recommend actively managed and index REIT funds that invest in the U.S and abroad. Avoid private and obscure REITS to keep risk down.

FLOATING-RATE FUNDS OFFER BULWARK AGAINST RISING RATES

Floating rate or bank-loan funds buy loans made by banks to companies with below-investment-grade credit ratings. Their higher yields and floating rate make them attractive.

Because the underlying loans’ yields can rise along with broader market rates, share prices may hold steady when rates rise, thus protecting you from interest-rate risk.

Unlike other high-yield bonds, floating-rate loans have safeguards built in, including collateral requirements, performance-based covenants and a senior position within a company’s capital structure. Senior debt is more likely than other debt to be repaid in case of bankruptcy. Many loans have floor provisions so that interest payments cannot go lower than a set minimum should market rates decline.

These funds are attractive when rising interest rates are a greater concern than the creditworthiness of the underlying investments.

A skilled fund manager controls risk by choosing more-secure loans. Look for a conservatively managed floating-rate fund instead of trying to find the highest yield.

You can safely invest up to 15 percent of your fixed-income portfolio in a floating-rate fund.

STASH HIGH-YIELDERS IN RETIREMENT ACCOUNTS

Investments that produce large amounts of ordinary income, such as floating-rate funds and REITS, should usually be held in tax-deferred accounts like IRAs and 401(k)s. The tax bite on your portfolio is reduced, allowing for greater long-term growth and higher total returns.

Some investments do not benefit from being held in a tax-deferred account — for example, international investments that withhold foreign taxes on dividends.

It’s better to hold these in a taxable brokerage account so that you can recover some of the foreign taxes paid via the foreign tax credit on your tax return.

KEEP YOUR CORE BOND INVESTMENTS SHORT-TERM

With interest rates still near record lows, the only direction to go is up. You don’t want to be caught holding long-term bonds when the music stops. A 1 percent increase in interest rates should trigger about a 10 percent loss on a 10-year bond.

High-quality short-term bond funds are far less volatile. They should form the core of your fixed-income portfolio. They provide competitive yields — better than money market funds — for a minimal increase in risk.

Don’t focus too much on the risks of each potential investment in isolation. Instead, consider how a new investment will interact with the rest of your portfolio. Would adding it increase or decrease your overall risk, or have no impact? Take a holistic view when working to boost your yield while minimizing risk.

Thomas Walsh, Certified Financial Planner and portfolio manager with Palisades Hudson Financial Group, practices in the firm’s Atlanta office. Palisades Hudson Financial Group is a fee-only financial planning firm and investment manager based Fort Lauderdale, Florida, with more than $1.2 billion under management. It offers financial planning, wealth management, and tax services. Its Entertainment and Sports Team serves entertainers and professional athletes. Branch offices are in Stamford, Connecticut; Atlanta, Georgia; Portland, Oregon; and Austin, Texas.