Investors seeking yield are often tempted by the stocks of companies that convert a business model based on steady recurring revenues and/or high leverage into unusually high yields. SA readers are likely to be familiar with many of the companies that fit this model, especially in the REIT, MLP, Energy and Telecom sectors. In my experience, it pays to favor the bonds rather than the equity of companies with this model in order to reduce risk to principal and to enable a viable risk-adjusted investment that might not exist for a conservative investor without considering bonds. In many cases, the intermediate-term bonds of companies with this profile often pay almost as much as the dividend, but with the greater protection that bonds provide from being higher in the capital structure and hence likely to maintain their principal value unless a bankruptcy or restructuring unfolds. An investor using this strategy is giving up the appreciation potential that owning the equity would provide; however, that appreciation is often very limited or actually negative with these types of investment vehicles, and owning the bonds instead will often provide significantly greater overall risk-adjusted return. In most cases, I stay away from high-dividend equity plays in my own investing as I have found that the risk to principal generally outweighs the dividend return except in rare cases. I have, however, found these types of companies to be fertile ground for finding bonds with a good overall risk-reward profile.
I will show below how this can apply using different situations that highlight the pros and cons of this approach, but first, when considering any investment strategy, I recommend beginning by understanding the risks involved, so here is a list to start with some of the risks inherent in a bond-based approach:
- Bonds will generally have a limited upside in comparison to the equity, especially in the extended yield environment we currently find ourselves in (even given the recent sell-off in most interest-rate sensitive products). However, in practice, the equity of many high-dividend companies has very little chance of significant upside due to their heavy debt loads and generally mature business models.
- The use of Bonds in a portfolio should not be allowed to become a crutch which lowers one's investment standards by creating a poor risk/return profile. The Howard Marks mantra of "good companies with bad balance sheets" is an excellent way to think of which companies might be appropriate for your fixed income portfolio that may not be appropriate for your equity portfolio. Bad companies (e.g. bad management, bad business model) should be avoided by investors who do not have the scale or expertise to participate in distressed debt workouts. Companies with good balance sheets but bad business models are the worst scenario for a bond investor since their bonds are typically priced based on their credit rating; however, their rating is likely to be reduced as the balance sheet deteriorates driving down the price of the bonds and increasing default risk.
- If the bonds can be called, then the likely yield to call will need to be considered, although companies with inordinately high-dividend payouts are often less likely to retain sufficient cash to call their bonds as aggressively as companies with more conservative payouts.
- One should assume that almost all corporate bonds are fully priced as of this writing, by which I mean that the rush to find anything with yield has created an irrational degree of demand and reduced margin of safety if economic or company-specific conditions worsen, even given the sell-off over the past two months.
- Many high-dividend companies carry a very high debt load and as such could have a difficult time issuing more debt if (when) credit conditions tighten. Also, if their debt load and cash flow is such that they are forced to only roll bonds forward rather than paying them off, this may be much harder to accomplish in the future.
Let's examine two examples to see how these risks can be managed to create a lower-risk path for the income investor. I have chosen Windstream Corporation (WIN) and Linn Energy (LINE) as representative examples.
First, consider Windstream. WIN is predominantly a provider of landline-based telecommunications and video services in rural and mid-sized markets in the mid-western US. Additionally, WIN is investing to grow its status as a provider of cloud-oriented applications support services to complement its focus on the small and medium sized business market. WIN currently pays a dividend of approximately 12% and is frequently promoted for dividend investors. Other SA authors have covered WIN's financials in detail so I will not repeat that here, however, several factors are key to deciding whether there is a potential play via debt, equity, both, or neither. First, landline telecommunications, while essential for many situations, has seen steady market share erosion as wireless takes a greater and greater market share. Further, there is significant competition between traditional telecommunications providers and cable operators who now provide telecommunications services via cable infrastructure. In short, while the declines in landline market share will likely level out, the potential to achieve a state of significant net growth through newer offerings such as cloud-based services or anything else is highly challenging, to say the least. Given that profile, I don't believe the risk/reward profile of WIN justifies an equity investment, especially as demonstrated in the last year by a drop in the share price that more than offsets the dividend.
However, if you believe, as I do (for now!) that 1) WIN's core business gradually stems the erosion of their subscriber base and can continue to throw off cash to service the debt, 2) WIN will successfully integrate their recent acquisitions, and that 3) WIN will continue to have access to the debt markets to extend debt maturities when necessary, then a small allocation to their debt such as CUSIP 97381WAF1 which yields approximately 6.8% to maturity and is currently trading at around 102 offers a reasonable risk/reward scenario. Most importantly, it is difficult to see the advantage to the equity over the bonds in this situation. A slight dividend yield advantage for the equity is offset by a major potential for underperformance in total return. A bond investment has returned approximately 7% over the last year while the equity investor has at best broken even given the loss in equity value of over 10% at recent prices. If the business experiences unexpected stress, then the dividend will need to be cut, however, the bond investor will be somewhat protected. If WIN's business has an unlikely increase in performance, then the bonds will likely increase in value as well (until returning to par at maturity), albeit to a lesser extent than the equity. Additionally, an aggressive investor could partially hedge the bond exposure with a long put option position on the equity, which could have been profitable in itself in the past year.
Another situation that looks similar on the surface, but that offers instructive differences, is that of Linn Energy (LINE and LNCO). LINE basically is in the business of investing in mature Oil and Gas properties and applying advanced extraction technology to extend the life of these older resources. Additionally, LINE is often able to acquire properties with significant NPV from larger players who want to deploy capital in what they perceive to be more strategic or higher return projects. A good example of this was Linn's recent purchase of the conventional natural gas assets from BP (BP). Like WIN, LINE is highly leveraged and pays a higher than average dividend at approximately 10.5% as of this writing, however unlike WIN, LINE has both a demonstrated history of growth in equity total returns and a decent case can be made for growth to return if natural gas prices rise to their historical norms and oil prices gradually rise. Neither of these is guaranteed but is certainly possible. A caution, however, is that LINE is the subject of widely varying opinion regarding the sustainability of its dividend, its accounting, and the total life of its resources. I would encourage anyone considering an investment in LINE to read the articles by other SA authors as well as the cautionary case laid out by John Hempton on his Bronte Capital blog. If you want to consider the bonds of LINE after your due diligence, a good example is CUSIP 536022AF3 which is currently trading to yield 7.3% to maturity in 2021.
These companies and others like them serve to exemplify distinctly different characteristics of the high-dividend model and the role that the bonds of these companies can play in a well-structured portfolio. In many cases the bonds of high Dividend Stocks pay almost as much as the dividends themselves with what has often proven to be much lower risk. Over the years, I have frequently found sound bond investments by picking up the bonds of high-yielding equities which I have found to consistently outperform the equity alternative.
Additional disclosure: I am long WIN Bonds and short LINE puts