As more investors dig for income, more investors are getting themselves into trouble. Hidden risks from high yielding funds that use leverage and interest rate risk from popular TIPS abound.
If you’re searching for more cash flow from your investments, how can you avoid the pitfalls? Let’s analyze four income tips that top my list:
1) High dividends are great, but can change on the dime
The three highest yielding stocks currently within the S&P 500 are Pitney Bowes (NYSE:PBI) – 10.02%, Frontier Communications (NASDAQ:FTR) – 10.44%, and Windstream (NASDAQ:WIN) – 10.36%. Each of these companies is involved in business equipment, technology, and telecommunications.
Although the dividend yields for these companies is higher than the S&P 500′s (NYSE:SPY) average yield of around 2%, the yield dynamic is in constant flux. Dividends are not guaranteed and can be cut or even eliminated at any moment.
A few years ago, high dividends within the S&P were dominated by banking and financial stocks (NYSE:XLF). At that time, yields weren’t high because of positive business prospects for the financial sector.
Rather, share prices had fallen a staggering 73% from 2007-08 thereby increasing the juiciness of financial sector dividend yields. Today, S&P financials yield around 1.70%, which is less than the broader S&P 500. My how things change!
Here’s the lesson: Dividend yields are constantly changing and today’s hotshots (or high yielders) can easily become tomorrow’s turkeys (low yielders).
2) Leverage increases volatility
The idea behind leverage is to magnify the performance or yield of an investment. But when used the wrong way, leverage can magnify losses.
Many income investors flock to closed end funds (CEFs), like the Gabelli Dividend & Income Fund (NYSE:GDV), without a full understanding of what’s driving those yields. GDV has a distribution rate of 6.19%, but how does it get that type of juicy yield? Is it because Mario Gabelli is an investment genius? Not really. GDV borrows money and has a leverage ratio of 24.27%. Three words: Juice, juice, juice!
Here’s the problem: Funds that use leverage to obtain higher dividend payouts tend to have greater volatility in yield, market price and net asset value (NAV) than non-leveraged funds. Also, it’s nearly impossible to hedge your risk in a leveraged actively managed fund like GDV, because there’s no predicting what the fund manager will do next.
As a result of these shortcomings, shareholders in high yielding leveraged CEFs subject themselves to larger drops in NAV compared to similar non-levered funds, due to their sensitivity to changes in interest rates. Any narrowing of spreads between short- and long-term rates may damage potential profit margins for the fund and potentially lower the dividend paid by the fund.
3) TIPS aren’t a hedge for rising rates
Treasury inflation protected securities (TIPS) were introduced in the late 1990s and promise investors their principal value will keep up with the Consumer Price Index.
TIPS ETFs are quite popular and investors have pumped around $1 billion over the past year into the iShares Barclays TIPS (NYSE:TIP), despite a current yield of just 1.72%.
Unfortunately, many income investors have flocked to treasury inflation protected securities (TIPS) with the misunderstanding they are safe from spikes in interest rates.
If nominal Treasury yields (NYSE:IEF) increase because of higher inflation, TIPS are protected. But if nominal yields rise because of an increase in interest rates, the price of TIPS can fall.
Put another way, if your TIPS have an average duration of six years and real interest rates rise by 1%, your implied loss would be 6%. A 2% increase in real rates would translate into a 12% loss.
4) Add alternative income strategies
The definition of insanity (one of them) is doing the same thing over and over and expecting a different result. The fact is income focused investors are not able to get the same type of income generation they did before.
Today, the S&P’s dividend yield is greater than the 10-year Treasury yield, which is only the second time since 1947 that’s occurred. These distortions have been caused in part by the Federal Reserve Bank along with the aftermath of the U.S. financial crisis.
Here’s the message: Investors better come up with a better game plan for generating adequate income. You don’t necessarily need to take more risk, but rather, you need to look in the right places.