Investors Seeking Yield Face Unavoidable Risks: In Or Out Of The Market

Includes: AFC, JNJ, KO, NLY, PG, WMT, XOM
by: Philip Mause

I talk to a lot of investors who are looking for a "safe" way to obtain what they consider to be reasonable yield. Obviously, money market funds, bank deposits, and short-term treasuries may offer assurance of protection of principal - but in today's market they offer virtually no yield. There are a variety of fixed income strategies but none are without risk. We have reached the point at which merely going out the duration curve does not produce much yield as the 30-year treasuries hover around a yield of 3% (with the government immediately taking some of the money back in taxes). And there is a real risk that, if rates go up, the value of the bonds will decline and the investor will be faced with the choice of selling at a loss or waiting 30 years for maturity to get back what he paid.

Another strategy is to move up the fixed income risk curve and buy riskier bonds. Spreads on intermediate and junk bonds are still fairly high so that considerably more yield can be obtained this way. There is, of course, some risk of default and if bonds of long duration are bought, there is still the risk of interest rate increases. I generally advise the assumption of some risk in order to grab more yield. One bond I have held and continue to hold is Ares Capital (NYSE:AFC), a bond issued by Allied Capital, which has been acquired by Ares Capital (NASDAQ:ARCC) - it has a coupon of 6.875% and matures in 2046. Thus, an investor is taking both default and duration risk. It is trading a little below par so the current yield is 7%.

I have written extensively about Business Development Companies (BDCs), like ARCC, and Agency Mortgage Real Estate Investment Trusts (AMREITs), like Annaly Capital (NYSE:NLY). These entities pass through most of their earnings as dividends and double digit yields are available. There are various risks and problems including the tax treatment of dividends as ordinary income.

Any investor looking for long-term yield on an investment made today has to also look at dividend stocks. The major advantage of dividend stocks over these other investments is that, over time, dividends tend to increase. A dividend stock that is yielding 3% today and increases its dividend by 7% per year will be yielding 6% on today's investment in 10 years. Since we have to assume duration risk in the bond market to get any decent yield, the yield performance of dividend stocks should be compared with bonds over a similar duration. I may be getting 7% on my AFC bonds but by 2046 a portfolio of some of the stronger dividend stocks may be yielding much, much more on the original investment I make today. And it certainly is not too hard to put together a portfolio of dividend stocks that is virtually certain to yield more than 30-year treasuries over the next 30 years.

The problem with dividend stocks is that dividends are discretionary and can be reduced or eliminated. On the other hand, if we are willing to invest in riskier bonds, a case could be made that some of the stronger dividend stocks may not present much more of a risk of dividend reduction than the riskier bonds present of a default. The bigger problem with dividend stocks is, of course, that the stock price can go down. While bond prices can decline as well, bonds tend to be much less volatile than stocks and the risk of a precipitous price decline is less.

There is another risk that may be equally important in the long run. For an investor trying to find opportunities to grab yield, there is a real risk that stock prices will go up and that the opportunity to buy at a price that will generate an attractive original cost yield will be gradually removed. I have written about Wal-Mart (NYSE:WMT) and the strategy of buying shares whenever it dipped below 50. It may be that there will not be many or any more opportunities to get in at that level. As we review some of the "safer" dividend stocks like Johnson & Johnson(NYSE:JNJ), Proctor & Gamble(NYSE:PG), Coca Cola (NYSE:KO), and Exxon (NYSE:XOM), we may begin to see the opportunities to buy at attractive yields become more and more scarce due to price appreciation. In this regard, utility stocks performed very well last year and, in many cases are not available at prices that prevailed a year ago.

Looking at the long term, a failure to have at least a reasonable level of exposure to dividend stocks in a yield-oriented portfolio could dramatically reduce an investor's return - not only because he does not reap the capital gains associated with price appreciation but also because, in the long run, the failure to own securities with steadily increasing dividends may result in lower yield in the long term. Some of these concerns may explain why there seems to be a pattern of "buying on dips" that has been emerging.

Any investor who has not been in a coma the last 12 years knows that there is always a big risk that stock prices will decline. I think it is becoming apparent that there may also be a risk that increases in stock prices will remove one possible source of attractive yields on original cost investments.

Disclosure: I am long AFC, WMT, ARCC, NLY, XOM, PG, JNJ, KO.