As soon as the rate on the 10-year broke below 2% in 2012, the whoosh of money fleeing fixed income for higher yields has been deafening. Investors yanked $86 billion out of U.S. bond mutual funds and ETFs last year, the most since 1994. The problem is that in the ever higher search for yield, many investors have forgotten the reason why bonds should be in a diversified portfolio in the first place. Ignoring fundamentals and only screening for yield could set you up for one of these three dividend disasters.
Yield but Less Safety in Stocks
I am not saying that dividend stocks cannot be a partial substitute for bonds. Companies like Coca Cola (NYSE:KO) and Johnson & Johnson (NYSE:JNJ) pay a reasonable yield at relatively low volatility. It is when investors look only for yield that they get into trouble.
While a company can pay for dividends with cash flows from investments and financing, it is cash flow from operations that makes for true sustainability. Cash flows from operations and free cash flows are the first things I check when looking at any stock, dividend or otherwise. If a company is not generating cash from its business then my stake as an owner will ultimately be worthless.
Share price is something that gets overlooked a lot when investors look to high-yield payers. A 12% annual yield is great but it means nothing if the shares decline and wipeout any total return. Worse yet, is the moderate yield that has increased just by virtue of a drop in the share price. Business factors that cause a precipitous drop in shares are usually the same ones that preclude a cut in the dividend amount.
TransAlta Corporation (NYSE:TAC), Canada's largest publicly-traded power utility, offers an 8.6% yield but has seen its shares fall by almost 20% over the last year. To be fair, all utilities have come up against the rising rate environment and most have underperformed. For U.S. dollar-based investors, the weakening Canadian dollar has not helped returns either.
The company has missed earnings estimates in the last eight quarters and has started to sell assets to raise cash. Shares in its renewable-energy division were sold in August for $200 million. TransAlta cut its dividend every quarter last year and will most likely need to cut this year as well. Cash flow from operations has fallen in the last two fiscal years and free cash flow turned negative in 2012.
CYS Investments (NYSE:CYS) is a mortgage REIT, investing in agency-backed mortgages bought with short-term loans on its assets. The shares pay a 17.4% yield but have declined by more than 40% in the past twelve months. The rate environment is also partially to blame here but the drop in shares of CYS Investments is far above that seen in industry peers.
Cash flow from operations has been negative at the company for the last four consecutive years and passed $7 billion in 2012. Book value fell off of a cliff last year and will probably be under pressure for at least another year until long-term rates stabilize. The underlying business model for mREITs is still sound but rising rates are squeezing out weaker players like CYS Investments. Investors looking at the space may want to consider peers like Capstead Mortgage (NYSE:CMO) or hybrid mREITs like Two Harbors Investment (NYSE:TWO) instead.
Solar Capital (NASDAQ:SLRC) is a $1 billion investment company that makes non-control investments in middle-market companies. The 8.2% drop in the shares over the last year has completely wiped out the 7.1% dividend yield, and investors' total return will be even worse after paying taxes on the distributions. As larger players look for fee income to cover higher regulatory burdens, Solar Capital could continue to get squeezed out of the best middle-market deals.
Shares of Solar Capital were downgraded by two firms last year to the equivalent of a hold recommendation. The Board of Directors authorized a $100 million share buyback program in December but may have difficulty actually buying back shares with declining cash flow. Cash flow from operations has fallen over the last two years and was negative in 2012. While the per share amount stayed relatively consistent at $2.40 per share, the company cut the total amount of dividends paid in each of the last three fiscal years. The per share amount was cut to $0.40 per quarter this year.
The median dividend equity fund has a 5-year annualized volatility of 15, meaning that prices generally vary by about 15% a year, while the annualized volatility for the median intermediate bond fund is just three. Dividend stocks can provide a good current yield and help to mitigate lower yields in your bond portfolio, just don't forget that there is more to stocks than just high yields. Expand your screening selection to avoid dividend disasters.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.