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I often cringe when I read an author put a blanket statement on equities such as "Remember, the higher the yield, the higher the risk." While I think such a statement would be quite true if we were speaking about the fixed-income market, I think a broad-brush statement like that about stocks is, at minimum, misleading and perhaps totally incorrect. For purposes of this article we'll define high-yield stock investing as anything in excess of 5 percent.

Risk assessment

Before issuing blanket statements regarding risk, one must define what risk means. Risk to capital? Risk to income? Total return risk? When we scan the "5+%" equity universe, we see a multitude of security types including some C-corps, REITs, MLPs, BDCs, as well as pooled securities like fixed- and option-income CEFs and leveraged ETF vehicles. As I've frequently stated in past articles, risk is really in the eye of the beholder for the income investor, with a predication on capital and yield goal attainment.

So if I posited whether Procter & Gamble (NYSE:PG), Realty Income (NYSE:O), or Frontier Communications (NASDAQ:FTR) were the riskiest dividend stock to own, how would you answer? One might offer a knee-jerk response of the latter simply because it yields the most and does business in a volatile sector. Someone else might see a REIT like O as posing too much unpredictability in rising rate or slow flow of capital environments. Another might answer PG because of its low total return potential, higher valuation, slow revenue growth rate, and low current yield.

I could offer you my own opinion here as to which name is riskier, but frankly it's irrelevant if you don't share symmetric portfolio goals with me. If one needs to own securities now that yield in excess of 5% or will grow to something in excess of say 7% over the next five years to support retirement, then a Procter & Gamble, Coke (NYSE:KO), J&J (NYSE:JNJ), or other "3ish" yielding dividend growth stock just won't cut it. Thus, someone could see low yield as risky even if from a variety of other analytic perspectives negligible risk is deemed.

A Question Of Instant Or Delayed Gratification

While you'll never hear me utter the line of "higher yield = higher risk," there is a more obvious symmetric rule amongst the yield universe. And that is the higher the yield, the less reliable the income stream. If we examine a cross section of double digit yielding securities, we find names such as mREIT American Capital Agency (NASDAQ:AGNC), option income CEFs from Eaton Vance like ETV and EXG, as well as business development companies like Prospect Capital (NASDAQ:PSEC). These names are not going to form the core of a dividend growth portfolio due to low or negative recent payout growth. But because they all possess double digit yields, they could form the core of a high-yield investor's holdings.

While you receive instant dividend gratification from these issues that could take decades to establish if you buy a 3% dividend yielder with a 7% dividend growth rate, your yield will prove more erratic than dividend growth, especially during rocky macroeconomic/interest rate climates. Thus, if time is on your side, it may prove more prudent to focus on dividend growth and establish a portfolio of stocks with predictable and safer-source cash flows. However, for those behind the 8-ball or needing instant gratification, dividend growth stocks may prove not to be the most prudent strategic option.

Managing Your High Yield Risk

Simply put, the best way to manage the risk of a high-yield portfolio is through diversification. A little over a year ago, I had interaction with a bullish mREIT author who suggested that retired investors would do fine by having 25% of an income portfolio in the space. Fast forwarding to today, with widespread income and capital declines of 25-50%, that was not the best of advice. Whatever your opinion on the mREIT model is, it did not hold up well during recent interest rate gyration.

We've also seen two large blowups in the MLP space over the past year. Linn Energy (LINE,LNCO) and Boardwalk Partners (NYSE:BWP) investors have both seen paper capital destruction, while the latter has also decreased its dividend to investors.

If we compare that performance to other similar high-yielders like BDCs and option-income CEFs, we see a stark contrast. While capital performance from BDCs was not eye-popping over the past year, most investors saw no yield fluctuation. Same could be said for option-income CEFs, which benefited somewhat from the strong equity market last year, while also paying strong tax deferred distributions equating to in many cases a 20% total return proposition.

There are also opportunities for home runs in the high-yield space. One of my favorite names over the past year has been NorthStar Realty Finance (NYSE:NRF), which I pointed out on many occasions during 2013. I began buying this stock when it was yielding around 10% at the end of 2012, sensing the market was missing the boat. The stock has more than doubled since with accompanying robust dividend growth to boot.

Thus, while there are potential pitfalls in high-yield, I would contend that the savvy investor who avoids concentration, diversifying amongst securities and security types, and executing a value or contrarian strategy, may not necessarily be exposing themselves to the far-flung disaster that high-yield bears tend to accentuate.

High-Yield Vs. Dividend Growth Allocation

I wrote the following in a comment thread to one of my recent articles:

If I had my druthers at retirement, assuming I had enough capital, I'd sit in boring companies all day, quietly collect dividends, and play golf every day, rather than strategize about my portfolio.

From my perspective, dividend growth is a fabulous strategy for investors who don't want to think too much about their portfolios and have the capital to turn somewhat of a blind eye to market volatility. Dividend growth investors tend to only get hot under the collar when their portfolio constituents have dividend increases come under pressure. So certainly, if I had the capital and did not need to necessarily focus on growth or preservation of said capital I'd much rather have the bulk of my portfolio invested in time tested "branded" companies like P&G, Coke, or a Colgate (NYSE:CL) that have shown an ability and affinity for growing shareholder payouts.

However, as was mentioned above, that may not be the holy grail for all investors with limited capital or little time to grow income. Further, one risks secular decline in dividend growth rates from portfolio companies. I would point to anemic increases this past week from both Wal-Mart (NYSE:WMT) and Kimberly Clark (NYSE:KMB) of only 2.12% and 3.70%, respectively.

If one needs an 8-10% yield in the near or immediate future, alternatives to "sleepy" dividend payers might have to be considered. But given the price and income volatility that may accompany the higher-yielding names, I don't think these are typically companies that you want to establish a "set it and forget it" attitude towards. While I certainly advocate a level of capital risk control to all parts of a portfolio, your higher-yielders should be watched a bit closer than "garden variety" dividend fare in my view.

How much one should be allocated toward higher yield names is again predicated on one's personal situation. For the "average" income investor, I continue to stress the wisdom behind diversification. You are taking on much more risk to both your income stream and capital with 20 - five percent positions then you are with 50 - two percent positions. So whether you tilt a portfolio toward dividend growth or high-yield plays, there is no sense in my mind to concentrate positions.

If you are intent on owning say a 10% position in mREITs, you should spread the love equally amongst at least five names, each accounting for no more than 2% of total portfolio value in my opinion. Alternatively, you could do what I've done over the past month, which is to buy an ETF like REM as an easy-in, easy-out play on the space. Or if you are ultra-aggressive or need super high income, you could consider MORL, a leveraged mREIT ETF.

So optimal income portfolio allocation may be viewed variably by investors with different amounts of capital to work with and varying capital and income end goals, at different life stages, and with differing conceptions of portfolio risk.

Strategy Session

In my view, the ideal income portfolio for the somewhat strategically agnostic, risk aware investor is one diversified amongst many different equity strategies, stocks, and sectors, as well as peppered with higher income plays and even bonds that may prove non-correlated (REITs, MLPs, BDCs, and mREITs) to broader market movement and traditional dividend growth stock capital performance. I would also advocate a variable, perpetual cash position to take advantage of yield opportunities that arise through individual stock sell offs or market pullbacks.

Despite the multi-year hearkening of a higher interest rate environment, long rates have actually pulled back this year, lighting a flame under the REIT/mREIT sectors and bonds, while the broader market has volleyed back and forth to a flat line. I suggested investors bump up exposure to REITs late last year and that move has paid off near-term, although I'd probably advise putting the brakes on that idea, given some of the swift advances we've seen.

To maximize the income stream, I also feel more actively inclined investors should consider swaps out of lower yielding, fully valued equities into higher yielding plays rather than viewing any position as a "forever stock." As an example of such I have taken some profits in aforementioned NorthStar Realty and rotated into RAIT Financial (NYSE:RAS), which creates a 225 basis point yield advantage, with better risk-adjusted total return in my view.

Conclusion

I do not feel the answer to this article's title is a simple yes or no answer for most investors. While higher-yielders may present elevated volatility, instant gratification may be necessary or supersede a "slow and steady" strategy in many cases. And though dividend growth is perceived as low-risk, it is certainly not no-risk. In the end I suppose the answer comes down to the rather unimaginative, fence sitting conclusion of "it depends on who you are."

Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.

Source: Are High-Yield Equities Riskier Than Dividend Growth Stocks?