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Do You Know Where the
“Yield Power” Is?In the world of high-yield securities, investors on a quest for the biggest yields are often lured into securities that either
they don’t understand or are simply tempted beyond their personal discipline to investigate how that yield is being supported.If you can’t identify where the “Yield Power” is that makes the king-size payouts possible, then they should avoid purchasing
them.So how do you know which ones to avoid?
There are some big red flags to be aware of that can trap an investor and ruin their long-term portfolio. They are known as
the Seven Sins of High-Yield Investing.Let’s take a closer look…
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Sin #1: Buying Open-Ended Mutual Funds
This statement may come as a shock to most investors, but if there is a choice to buy a certain index or sector closed-end fund
instead of an open-end fund, opt for the closed-end fund.First of all, with the Dow showing triple-digit point swings on an intra-day basis, you never know when you may want to exit
the fund if the market makes a dramatic move up or down. With an open-end mutual fund, you can only sell at the end of the day.We’ve lived through a few sessions this past year where the Dow opens higher by 200 points in the morning only to plunge by
400 points by the close.Maybe having the ability to exit one’s funds during the day makes way more sense than having to wait
until the market is closed before being able to punch out of a meltdown.
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Sin #2: Paying Big Premiums Over Net Asset Value
Most closed-end funds trade at a premium or discount to their Net Asset Value (NAV) for various reasons and can offer excellent
investment opportunities. Locking in a high-yield payout in a discounted fund can make for some exciting total returns.Yet some investors buy into a popular closed-end fund that is trading at an enormous premium to its NAV. Why would anyone pay
up to 25% for shares of a hot closed-end fund when they could buy that same basket of stocks or bonds from their broker at real
market value? It’s a bit insane.It happens all the time in the closed-end high-yield bond funds, or as they are commonly called, junk bond funds or covered-call
closed-end funds.Good closed-end funds that historically trade at a premium to NAV should be purchased when that premium falls
under 10%. So be sure to avoid buying into a closed-end fund trading at a huge premium to its NAV.
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Sin #3: Receiving a Return of Capital
This is one of those areas that should be treated like poison. When a big, fat, juicy dividend yield is composed in whole or
in part by what is termed a “return of capital,” you want to steer clear.When a mutual
fund or entity pays out a scheduled dividend payment that hasn’t been earned by profits or interest income, you can bet that
a portion of that dividend will be in the form of a return of capital, which simply means you as an investor are receiving some
of your money back as part of the dividend.Two negative things happen here:
- First, by getting some of your principle back, it lowers your cost basis from a tax standpoint.
- Second, if a dividend is being supported by a return of capital, then you know the underlying entity is in trouble.
Funds, partnerships,
trusts and other hybrid structures know that cutting a dividend payout is like a death blow to a security that was purchased for
its yield. And as a result, managers of those assets are loath to cut dividends and will use return of capital to maintain payout
levels until things get better.Needless to say, that last line is all about wishful thinking on the part of the manager but should be a waving red flag to
the shareholder. Assuming things don’t improve quickly, that asset will only depreciate with each effort to hold a dividend payout
that is not supported by real fundamentals. Not a fun scenario.
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Sin #4: Buying Into Managed Distributions
Some closed-end funds pay out what is known as “managed distributions” as a template for their dividend policy.
What happens
here is that the fund, in its attempt to draw investor attention, states that it will pay out a managed distribution that is a
percentage of the NAV at the end of each quarter. The idea being stability of income.Hardly! Most closed-end funds that employ
a managed distribution payout policy use 8% as the percentage of NAV they peg the fund to at the end of the quarter.So let’s say a healthcare fund trading at $10 that depends on paying its 8% stated yield from capital gains, interest and covered
call writing doesn’t earn enough to cover the 2% quarterly dividend payment. Let’s say they only earned about 1% of the 2% needed
to pay out to shareholders but by proxy have to pay out the full 2%. At this point, the fund manager has no choice but to pay
back the other 1% as a return of capital, again hoping to make up for the income shortfall in the quarters ahead. In this case,
we almost always will see shares of such a fund fall once it becomes known that the makeup of that managed distribution is not
fully earned.The result of this is that when the price of the fund shares declines, so does the managed distribution of the 8% payout because
it’s a function of the price of the NAV and not a fixed dividend like most income funds.
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Sin #5: Owning Securities with High Payout Ratios
All common stocks, income trusts, master limited partnerships, REITS and other pass-through entities have what is called a payout
ratio. It’s a number that essentially says how much of the dividend is paid out from each dollar of net income.A company like AT&T has a payout ratio of 74%, meaning that the company retains 26 cents of every dollar after dividends
are paid out to put back into the business. This is a decent ratio, but something around 50% to 60% is more ideal.When screening for high yield, many entities like the Canadian Income Trusts push the envelope of the payout ratio equation
in an attempt to maintain their lofty dividend yields. When the price of crude oil and natural gas plummeted from their 2008 summer
highs, the payout ratios of many of these energy-related income trusts rose from the mid-50% range to over 110% of income received.Many believers of long-term higher energy prices stayed with the trusts during this period of what was determined to be a short-lived
sell off in oil and gas prices, but the sell off has persisted well into 2009. So, to counter the negative affects on their balance
sheets, most of these income trusts had to slash their dividend payouts and dig into cash to meet fixed stated monthly payouts.
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Sin #6: Getting Paid in Special Dividends
A common method for paying dividends from funds that invest outside the U.S. is to pay “special dividends” composed of short-
and long-term capital gains. The dividend policies of such funds are predicated on the ability of the fund manger to pay out whatever
gains can be garnered over the course of a year depending on short or long-term holding periods.Closed-end funds based on China, India and other emerging markets had explosive returns from 2003–2007, chalking up 50%+
returns. But a large portion of those returns where paid out in the form of huge capital gains-based dividends and are reflected
in most screening software portals that suggest these funds are still paying out these gorilla-sized dividend yields.They’re not, and the data can be hugely misleading when investors are hunting for big yields through various screening tools.
Needless to say, in a bear market like the past eighteen months, these once-hot funds won’t pay out a dime because they aren’t
making any money, making the dividend yields zero.Bottom line is that these types of funds shouldn’t be considered income vehicles in the first place.
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Sin #7: Buying Domestic Energy Trusts
Most high-yield income investors want an energy component within their portfolio as a long-term cornerstone against inflation.
That makes perfect sense, but only if that income vehicle can stand the test of time. It does this by replenishing reserves at
a rate higher than those energy assets to the market place at whatever the prevailing prices are.This is the main drawback of owning domestic energy trusts. They have fixed reserves, meaning that once the life of the resources
in the trust is depleted, the trust shuts down and goes out of business.You can only imagine what happens to the share price of such trusts in the long run. Sure, they get a pop when crude jumps to
$100 per barrel, but eventually they run out of oil and gas to sell to the market.Learn more about Bryan Perry’s Cash Machine — Wall Street’s ultimate source for
safe high-yield investing here.And for more savvy investing tips, check out:
