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Income-generating investments - whether it be corporate bonds, preferred stock, convertible bonds or dividend stocks - have become more popular than ever. There are three main reasons for this trend.

  • Yield seeking. Due to demographic trends, more investors are thinking about and planning for their post-retirement income. This causes many investors to search for – and frequently stretch for – income yield.
  • Risk aversion. The enormous volatility of stocks since 2008 has caused a shift in investor perceptions regarding the relative risk of owning stocks versus bonds. Bonds preferred shares, convertibles and dividend stocks are considered safe; non-dividend paying stocks are considered risky. The flight to safety has driven many investors away from a focus with capital appreciation potential and toward investments that produce current income.
  • Performance chasing. All of the above has been reinforced in the manner of a “virtuous cycle” by the strong performance of bonds, convertibles and dividend stocks versus non-dividend paying stocks. Indeed, income oriented investments such as those listed above have strongly outperformed non-dividend equities in recent times. Indeed this outperformance holds true for most periods during the past three decades and the last decade in particular. There is a tendency for investors to be lured into investments based on their past performance, particularly recent performance.

The rush for yield has lured investors into arenas that they are not familiar with. Former equity investors are dabbling in various fixed income instruments. In addition, fixed income investors are stretch for yield by purchasing stocks with high dividends/distributions.

Yield seeking behavior introduces very substantial risks that derive from lack of knowledge on the part of investors that are hungry for yield.

Income Traps

There are several traps that tend to lure investors seeking higher yields to inappropriate investments.

In an article entitled “Bond Yield Traps,” I highlighted some of the traps that fixed income investors are falling into. I will review briefly.

Yield versus default risk trap. There is no free lunch. In order to attain higher yield, investors must implicitly accept higher risk of default. All other variables remaining equal, higher yield implies a higher probability of default. When you buy a bond with a higher yield than another bond, that yield advantage or spread can be deceptive. At the end of the day, a certain percentage of companies default – and the he higher the yield, the higher the expected default rate. Thus, once the default rate is factored into projected total return, the expected total return of a higher yielding bond will not be much higher than that of lower yielding but safer fixed income instruments.

Yield versus duration trap. Many investors knowingly or unknowingly stretch for yield by increasing the duration of their bond-holdings. The problem, again, is that there is no free lunch. Increased duration necessarily implies increased risk – via inflation and/or interest rates. While a 1% increase in the general interest rate level rates will (all other variables remaining equal) affect the value of a bond with a duration of one year by roughly 1%, a 1% increase in interest rates will affect the value of a bond with a duration of 10 years by almost 10%. Many investors are not even aware that a rise in interest rates can cause capital losses in their portfolio. However, bond investors are exposed to significant capital losses. And the higher the duration of the portfolio, the more subject it is to capital losses. With interest rates currently at historically low levels, the risk of capital losses in bond portfolios has perhaps never been higher.

The current yield trap. Many investors judge the value of a bond by its current yield – i.e. the annual income paid by the bond divided by the bond price. Unfortunately, current yield can be a very misleading indicator of value. I explain this in-depth in an article entitled, “Bonds And The Current Yield Trap.” Briefly, current yield is a misleading indicator of value when the value of the bond is priced above $100 – a relatively frequent occurrence in times such as now when interest rates are extremely low (^TNX ^TYX).

Dividend investors face variations of these risks. Specifically, here are a few.

High yield versus dividend risk trap. There is no free lunch. All other variables remaining equal, a stock with a higher dividend yield has a higher probability of cutting its dividend than a stock with a lower dividend yield. The risk of dividend cuts can derive from two sources.

Business risk. Maintaining the payout ratio constant, stocks with riskier businesses will tend to have higher dividend yields than stocks with less risky businesses.

Payout ratio. Maintaining business risk constant, stocks with higher payout ratios will tend to exhibit higher dividend yields than stocks with lower payout ratios.

The problem is that higher payout ratios and higher levels of business risk are associated with a higher risk of dividend cuts. There is no free lunch. Once the risk of future dividend cuts are taken into account, a portfolio of high dividend yielding stocks may ultimately provide less income than a portfolio of stocks with moderate dividends.

Investors are lured by the high dividend yield but are not taking into account the risk – which over time and on average will be realized - of dividend cuts that will lower both income yields and total returns over time.

High yield versus dividend growth trap. Again, there is no free lunch. Stocks with very high current dividend yields will tend to grow their dividends at a lower rate than stocks with more moderate yields. This occurs for two reasons. First, companies that pay out a very high percentage of net income will tend to grow their dividends at a lower rate than companies that reinvest a more significant portion of their profits. Some studies have suggested that dividend-paying stocks may grow earnings at a faster rate than non-dividend paying stocks. These studies have misled many investors into arriving at improper conclusions. First, there is a clear self-selection problem in these studies: companies in distress and with poor fundamentals do not tend to pay dividends. Second, these studies fail to segment stocks according to different payout ratios. It is very different to compare stocks that pay some dividends to those that pay no dividends, than to compare stocks with low payout ratios to stocks with moderate payout ratios. Over time, investors will be better served by purchasing stocks with more modest current dividend yields but with better growth prospects and lower risk.

Dividend Duration Trap. In times of high levels of risk aversion, investors tend to seek lower duration. In stock investing, high dividend yields lower duration. Thus, risk aversion tends to drive investors to high-dividend yielding stocks, much like bond investors are driven toward short-term Treasury bonds. The problem is that risk aversion exhibits clear mean-reverting tendencies: It’s here today, and gone tomorrow. Investors that pay too much for high current dividend yield will tend to underperform when risk aversion wanes. The present situation presents exactly this risk. Investors have been flocking to low duration, high-payout and high dividend stocks driving up the valuations of these stocks relative to their earnings and cash flow. At the same time, investors are undervaluing lower-duration, faster growing stocks (dividend and non-dividend) with much more attractive valuations relative to earnings and cash flow. Ultimately, following the herd toward high dividend yielding stocks, without proper regard for payout ratios, growth prospects and valuations based on earnings and cash flow are a guaranteed formula for underperformance – indeed, even if we measure income performance over the long term.

Conclusion

It is my view that investors, in their search for yield, are being improperly lured into high yield bonds and high-payout and high yielding stocks. In the long run, investors will be better served by purchasing stocks such as Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC) or PepsiCo (NYSE:PEP) than high dividend yielding stocks in sectors such as mREITS (e.g. Annaly (NYSE:NLY), American Capital (NASDAQ:AGNC)), MLPs (e.g. Enbridge Energy Partners EEP, Kinder Morgan Energy Partners (NYSE:KMP)), Royalty trusts and specialty closed end-funds. Similarly, income investors should be careful in their selection of bonds so as to not fall into the trap of purchasing current yield at the expense of long-term returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Income Traps To Avoid