Income Investor Check-up: How Much Risk Are You Taking?
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The Fiscal Times
October 9, 2013

Between the antics of our legislators in Washington and the still-looming prospect of the Federal Reserve easing up its support of the bond market and, the safe haven of the Treasury bond market looks less appealing by the day. Stocks are volatile, and likely to remain so: the S&P 500 has posted an impressive gain so far this year, even though earnings growth has remained anemic, in many cases. At the same time, the hunger for some kind of security in the shape of an actual cash return – not just capital gains – has remained intact ever since the Great Recession.

Little wonder, then, that investors are still chasing yield. The chairman and chief executive of the Financial Industry Regulatory Authority (Finra), Wall Street’s industry-funded watchdog, warned recently in the Financial Times, that his group “is concerned that some are turning to complex or alternative investments and taking risks they either do not understand or cannot afford. These products present clear hazards for investors and require regulators to monitor market conditions and the sales practices of financial professionals.”

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For years, financial advisors and market pundits have touted the advantages of dividend-yielding stocks. Other high-yielding securities, from master limited partnerships (MLPs) to junk bonds have become widely held. Indeed, junk bonds these days hardly deserve their alternative moniker of “high yield” bonds (the term Wall Street prefers), since, quite frankly, the price gains have meant that yields these days are anything but high, in either relative or absolute terms. And the riskiest part of the market – securities rated BB or even CCC – have been the best performers, tempting more investors to venture further into them.

Stretching for yield starts innocently enough, and it’s a logical response to the near-zero rates you can earn nowadays on checking accounts or money market funds. The problem? The higher the yield, the higher the amount of risk you’re adding to your portfolio, and that rule of thumb doesn’t change just because the absolute yield levels have crashed.

To be clear, junk bonds issuers probably aren’t about to default on their obligations. The way to look at this particular corner of the “yield” market is to think of the bonds as just a kind of stock, one that pays a yield and that in the event of a bankruptcy, gives you a greater chance of getting at least a small portion of your investment back. And if the economy improves, junk bonds typically outperform the rest of the fixed income market, as they have done in the last two years.

Nonetheless, this is the right time in the cycle to take a hard look at your portfolio and begin to distinguish “good yield” from “risky yield.” Many junk bonds may well end up in the latter category, in part because they have outperformed (and thus may be trading near their relative highs) and in part because there’s a greater risk of companies hitting speed bumps later in an economic cycle, leading to downgrades or even defaults.

There are other parts of the high yield universe you may want to view with skepticism, too. As Ashish Shah, head of global credit at AllianceBernstein, noted in an August blog post, bank loans are another source of concern. “Bankers are happy to turn the demand for high-yielding investments to their own advantage,” he notes, mentioning specifically ultra-high yield bonds issued to finance private equity transactions, although those yields are “payment in kind,” rather than cash.

That’s important, because bond yield funds have been a particularly bright spot for the fixed income mutual fund community this year, and the inflow of assets into these funds had made it possible for issuers to sell $848 billion of leveraged loans in the first three quarters of the year, beating the record set in the whole year of 2007 by a whopping 23 percent, according to data from Thomson Reuters. Covenant-lite structures – a riskier form of bank loan – also has set a new record so far in 2013.

So, what does a “good yield” look like? For starters, it’s about more than just yield. In the bond arena, it is yield measured against risk; in stocks, it is the size of the yield (specifically, the dividend payment) relative to the cash available for dividend payments (known as the payout ratio) and the company’s track record in raising dividends.

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Ideally, you’re looking for a yield that is north of the average for the S&P 500 index (currently 2.1 percent), that beats the five-year average growth rate of dividends (about 16 percent), and one where the payout ratio is still relatively low. The latter is important, because it means the company has a cash cushion available either to reinvest in its business or to fund further dividend increases.

“I’d be happy with a yield of 3 percent or 4 percent, and growth of 5 percent to 10 percent annually in the dividend,” says Jay Wong, co-manager of the Payden Equity Income Fund (PYVLX).

Some potential missteps in stretching for yield are obvious, such as snapping up a high-yielding stock that only looks attractive because its stock price has fallen. This kind of trap can leave the investor with big losses and no yield at all if the dividend proves to be “unsafe,” as was the case with J.C. Penney (NYSE: JCP). Not all potential problem areas are that dramatic, of course. Wong points out that while banks look like alluring bets at first blush, it’s slightly artificial. “JPMorgan Chase’s three-year dividend growth rate looks astonishing – it’s 89 percent – but the five-year growth is actually -2 percent,” Wong says. “What’s happening is a dividend recovery after the financial crisis.”

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Wong currently owns only two banks in his income-oriented portfolio – JPMorgan Chase (NYSE: JPM) and Wells Fargo (NYSE: WFC) – but is finding alluring yields in a less traditional sector. Technology stocks, like Microsoft (NASDAQ: MSFT), with a yield of 2.7 percent and Intel (NASDAQ: INTC), yielding 4 percent, are now popping up on his radar screen as appealing. Intel, long a “Dog of the Dow,” “is going through growing pains, but while you wait for them to get their house in order, you can clip that rather attractive coupon,” Wong says. Kraft Foods (NASDAQ: KRFT) is another winner, or, for those with a greater tolerance for volatility, Wynn Resorts (NASDAQ: WYNN). The latter’s typical dividend is merely OK, but Wong notes the company’s pattern has been to pay out at least that much or more in the fourth quarter of every year – $7.50 last year and $5 per share in 2011.

Some investors are wary of hybrid securities like MLPs and real estate investment trusts (REITs), but Wong is a fan, as long as they’re in the right corner of the market. Health care REITs, for instance, strike him as a more savvy and less risky bet than plain vanilla mortgage REITs. He’s also a fan of any MLP that offers a yield based on collecting tolls for the throughput of oil, natural gas or other commodities, rather than an upstream partnership where the ability to pay lavish yields hinges on commodity prices. Examples include Plains All-American (NYSE: PAA) and Buckeye Partners (NYSE: BPL).           

It’s human nature to hunger for yield in uncertain times, but that doesn’t mean you should – or need to – stretch beyond your comfort zone.

Business journalist Suzanne McGee spent more than 13 years at The Wall Street Journal before turning to freelance writing. Author of the book Chasing Goldman Sachs, she has written for Barron’s, The Financial Times, and Institutional Investor.