High Yields with REITs and Junk Bond Funds

Dec.21.08 | About: SPDR Barclays (JNK)

Rodney Dangerfield was probably best known for asking about why "he can't get no respect?" Today, that question applies to high yield securities. I have written a lot about MLPs. Here I'll talk about REITs and junk bond funds with extraordinarily high yields (pretty much record yields). Their prices collapsed in September 2008, causing the yields to double, sending them well into double digits.

REITs

REITs have a useful index, the Dow Jones REIT Index. In September, the index was at 270 after having gotten through a very difficult year with only minimal damage. Then it fell off a cliff. The index dropped to under 100 in just two months. Dividend yields more than doubled with this decline. As of Thursday (the time of writing), it has rebounded modestly from the low to 140 but still remains down sharply from September levels. Dividend yields on big name, quality REITs are around 8%. Middle ones have rates in double digits while more marginal REITs have astronomical yields.

Their businesses haven't changed. They're fairly stable. Most REITs own properties and buildings, hard assets which hold their values, at a minimum, over time. In real estate, over ten years there are typically two good years, two bad years and the rest are middle kind of years. This and next year will clearly represent the two bad years. That period won't last, as has been the case in the past. But the problem is getting through the rough period.

In ordinary times (like last year), yields on major REITs ranged from roughly 4-10%. Now yields range from 8% to 20+%, depending on the quality associated with the dividend. One key measure is comparing their yields to the yield on the 10 year Treasury bond (currently below 2.1%). Generally the premium for REIT yields is very little to a few hundred basis points, depending on the REIT. Today that premium is 1000 to 2000+ basis points.

For individual accounts, REITs can be helpful at tax time. At many REITs, a portion of the dividends are not taxable and another portion may be taxed at capital gains rates. Percentages vary from year to year, but the effect is to reduce taxes paid on the dividends.

The extraordinary spreads can't last as has been the case in the past. Hopefully dividends will continue with little or even no damage. A few might even increase modestly. Lower valuations of the dividends in the future will raise stock prices and dividends provide additional gains.

High yield (junk) bond funds

High yield (junk) bond funds had a similar price performance in 2008. The Lehman High Yield Bond ETF (NYSEARCA:JNK) for much of 2008 was trading around the mid-40s. By September it had slipped to 43. In mid-September, when the subprime loan problem came to light, junk bonds funds also fell off a cliff. Prices for the ETF plunged to the 27s (today it's at 28) sending its yield soaring to almost 16%. Individual junk bond funds have plunged even more dramatically, dividend yields skyrocketed above 20%.

Let me give an example from one of my junk bond funds. At mid-year, it increased (I repeat INCREASED) the dividend about 15%. The market responded by selling off 15% the first week after the higher dividend was announced. In the last couple of months it dropped in half, while still paying the higher dividend, so that the number of shares purchased with monthly reinvested dividends has more than doubled.

The premium over the Treasury bond rate can only be described as astronomical. During ordinary times, again such as last year, the premium has been around 400 basis points. Today that premium has shot up to over 2000 basis points on many junk bond funds. Where there are high yields, there is a comparable amount of risk. But finding the good ones will be profitable by locking up high yields for the future.

Junk bonds have gone through two rough periods: the 1990 period and the start of this decade. Both were very bloody times when junk bond funds got hammered for holding problem debts. But they carried on. So far there have been no dividend cuts I am aware of. Of course, the future will involve walking through a minefield. Even allowing for dividend cuts, investing in these securities can be profitable. For example, here is a mythical junk bond fund:

  • Today's price $9.00
  • Today's dividend $2.00

A 22% yield is common today. Let's assume their dividend decreases to $1.50 next year. Eventually more normal evaluations will return bringing a yield of 10% on the dividend. That implies a stock price around $15.00, up sharply from $9.00 today. Plus next year would produce dividends of around $1.75, depending when the dividend is cut. Going forward, the $1.50 dividend will be paid on a stock which originally cost $9, still a very nice yield! When the 2.1% yield on the Treasury goes up to more traditional levels, those bond prices will fall. Higher rates on Treasuries may follow after financing massive amounts of government spending next year. The Treasury bond which is supposed to be "risk free" really has its share of risk!

Outlook

Both security classes, along with MLPs, have record high yields because of high levels of risk associated with the dividends. Nervous Nellies will not interested in them. However, for brave investors with long term horizons, these conditions provide a way of locking up high yields (even after allowing for dividend reductions) for the long term. The venturesome might want to check out these securities.

Disclosure: no positions