Many investors seeking income turn to either bonds or dividend stocks. Both asset classes have their virtues, as well as their issues. For bonds, the issues relate to the relatively low yields in the bond markets these days. As for dividend-paying stocks, the issues are numerous.
For years, investors have been told of the virtues of dividend paying common stocks, such as Pfizer (PFE), P&G (PG), and AT&T (T). And it is true that all these stocks have, over long time horizons, done very well for dividend-oriented investors. But, the needs of every investor are unique, and we do not think that such stocks meet every investor's needs.
Investing for income is a strategy that millions of investors live by, and it is a strategy that millions of investors, especially retirees, live on. However, we caution investors to stay prudent, and avoid being sucked into the hoopla of dividend-paying common stocks. Many investors see the high yields (relative) on stocks such as AT&T or Pfizer, and cannot help but be carried away with them. And with current dividend yields of 5.8% and 4.14% respectively, it may seem tough not to.
What we want to remind investors of is what the intent of these dividends is. Companies like AT&T and Pfizer do not pay dividends to finance the lifestyles of their investors. They pay dividends to entice investors to invest in their companies, thus driving the share price higher. For common stocks, price appreciation is the end, and dividends are a means to achieve that end. Too often, we see investors touting the virtues of dividend-paying common stocks, while ignoring the inherent risks associated with common stock investing.
Are we saying investors need to ignore these stocks? Of course not. Dividend-paying common stocks certainly have their place in a well-diversified portfolio. And dividends do provide a "cushion" of sorts in rough markets to these common stocks. But for true income investors, who focus on current income over capital appreciation, we think there are many better alternatives to common stocks, alternatives that have both less risk and higher yields than almost all common stocks. We will not be focusing on bonds, simply because everyone already knows of their position as an alternative to stocks. Rather, we will focus on four alternative sectors that income investors should not overlook in their quest for yield.
Preferred stocks are a hybrid security, blending features of both common stocks and bonds. They are below bonds in the liquidation line, but senior to common stock, and companies, in general, are not allowed to pay dividends to common stockholders until all dividends on their preferred stock have been paid.
In general, preferred stocks carry no voting rights, and can often be converted into common stock at a pre-arranged price. Like bonds, many are rated by the credit rating agencies, and they are a favorite of financial firms when they need to fortify their capital positions and they do not want to dilute common stockholders.
Rather than invest in individual preferred stock issues, our favorite vehicle to invest in preferred stocks is the iShares S&P U.S. Preferred Stock Index Fund (PFF). This ETF has a current yield of 6.52%, trouncing the yields on almost any common stock. (And it is dominated by financial firms). This higher yield comes with far less risk. When measured by beta, this preferred stock ETF has a beta of just 0.57, far lower than the beta of the largest dividend ETF, the SPDR S&P Dividend ETF (SDY), which has a beta of 0.93.
The S&P Dividend ETF is linked to the Dividend Aristocrats Index, which is an S&P index of the companies that have raised their dividends consistently for at least 25 years. (The Dividend Aristocrats are a good proxy for dividend growth investing, but that is a strategy beyond the scope of this article). This preferred stock ETF carries an expense ratio of 48 basis points.
A note of caution, however. Preferred stocks, when compared against other high yield securities, do have more volatility. We highlight them here for the consistency of their payouts. This preferred stock ETF pays monthly dividends consistently, and for some investors, it could be a smart way to play both sides of the market, combining the virtues of both stocks and bonds into one security.
Mortgage REITs are a subset of the REIT sector that invest in mortgage backed securities, primarily in the residential sector. The best mortgage REITs, [think American Capital Agency (AGNC) and Annaly (NLY)] are those that invest in securities backed by government entities, eliminating credit risk since payment on those mortgages is backed by the American government. American Capital Agency is named as such because it, along with Annaly, invests in agency securities, which are backed by government agencies such as Ginnie Mae, guaranteeing both interest and principal payments. Yields in this sector are simply astronomical. American Capital yields over 16%, and Annaly yields almost 14%.
So how do these companies achieve such yields? Simply put, leverage. Now, before you run away from these securities due to leverage, it is important to understand exactly how leverage is applied here. Simply put, these mortgage REITs make money in a way that is very similar to banks. And in fact, many of these companies sport leverage ratios below traditional banks.
Mortgage REITs use leverage to amplify their returns on their portfolio of mortgages. They issue equity to buy up mortgages, and their net interest spread is the difference between the yield on their mortgages and the cost of funds to acquire them. Then, leverage is applied to boost that spread to double digits. The REIT structure forces these companies to pay out almost all of their earnings to their investors. Below is a simple illustration of how these REITS generate returns.
Mortgage REITs face three primary risks, and they are addressed in various ways. The first is credit risk. Non-agency REITs, which we are hesitant to recommend, invest in mortages that are not guaranteed by the American government. Agency REITs such as Annaly or American Capital do not have such risk because the mortgages they hold are backed by the government.
Secondly, mortgage REITs face prepayment risk. Prepayment risk means that mortgages are either refinanced or simply paid off early, therefore altering the cash flows of the underlying securities. Truthfully, there is no real hedge against prepayment risk. So far, government refinancing programs have been rather ineffective, and not many households can afford to pay off their mortgages early. And the third risk, or rising interest rates, can affect the second risk by increasing rates, thus making refinancing less attractive.
Mortgage REITS face interest rate risk because of their inherent operating structure. They borrow in the short term and invest in the long term. Through a variety of market factors that are beyond the scope of this article, short term rates are at historic lows and the spread between short-term rates and long-term rates is historically high. A rapid rise in short-term rates will depress book values at mortgage REITS, and inevitably affect their payouts.
These factors all influence mortgage REIT dividends, and several have recently cut their payouts, including Annaly Capital and American Capital Agency, which cut its first quarter dividend to $1.25 per share, down from $1.40 per share previously. While no one likes dividend cuts, it is important to note that even at this level, American Capital yields over 16%, and Annaly yields nearly 14%. These dividend yields are far and above anything that common stocks payout, and these REIT's all have far less beta. American Capital has a beta of 0.49, and Annaly Capital has a beta of 0.33. (As a side note, the beta of these REITs is almost always expressed as a function of the three risks mentioned above, for they are what drive results at mortgage REITs).
For investors looking to diversify into multiple REITs, we recommend the iShares FTSE NAREIT Mortgage Plus Capped Index Fund (REM), which invests in a basket of mortgage REITs, and currently yields over 12%. The fund has an expense ratio of 48 basis points and a beta of 0.75. While this is an ideal way to diversify mortgage REIT exposure, we recommend investors look to either Annaly Capital or American Capital Agency. Both are run conservatively, have no credit risk due to their agency mortgage holdings, and have a consistent history of great execution.
Royalty Trusts are an often overlooked sub-sector, but we believe that they can be useful for certain income-oriented investors. Royalty trusts are almost always found in the natural resources sector, for their title says it all. They are trusts set up to collect royalties, almost always from entities such as oil fields, natural gas wells, or mineral holdings.
Royalty trusts have the benefit of avoiding dual taxation if more than 90% of income is redistributed to shareholders, similar to MLPs or REITs. But before we continue, we must remind investors of one crucial feature of royalty trusts: Time. Unlike other non-bond securities, which at least in theory can pay out income in perpetuity, royalty trusts pay royalties only as long as there are underlying resources to pay it.
The BP Prudhoe Bay Royalty Trust (BPT), for instance, will cease paying dividends and will become, in essence, worthless when the underlying oil in the field runs out. Royalty trusts can only pay dividends as long as the underlying natural resource can still be extracted. The BP Prudhoe Bay Royalty Trust, for example, expects to pay dividends until at least 2024. Distributions after that depend on the state of the oil field at that time.
We do not currently know of an ETF set up specifically to invest in royalty trusts as a whole. Therefore, investors will have to do research on their own to see which royalty trusts suit their needs. As an example, the BP Prudhoe Bay Royalty Trust is the largest royalty trust in the United States, with a yield of almost 8% and a beta of 0.63.
Royalty trusts are found primarily in the United States and Canada, with several key legal distinctions between the two nations' treatment of these entities. In the US, royalty trusts are restricted to the assets they have on hand at inception, which is why they are always depleted over time. In Canada, however, these trusts are allowed to acquire new properties and are usually actively managed. However, with certain tax law changes in Canada, most Canadian trusts have converted to traditional corporations.
With royalty trusts, the newer the trust, the better, because it allows for more time for the dividends to roll in. To own this kind of investment requires careful long-term time management, for they have a finite lifespan. However, if royalty trusts are indeed suitable for your portfolio, they allow investors to both collect current income and participate in the profits associated with the long-term growth in the demand for oil and other natural resources.
Since 2002, the BP Prudhoe Bay Trust has dramatically outperformed the major oil companies, and it had to do none of the exploration, drilling, or management that these traditional oil companies had to do. All this trust had to do was collect royalty checks and redistribute them to unitholders. Investors seeking income for a set period of time would be wise to consider adding royalty trusts to their portfolios.
Master Limited Partnerships
The last asset class we would like to bring to investors' attention is the master limited partnership (MLP). Like royalty trusts, they are almost always found in the energy sector. And like royalty trusts, they have very little of the volatility associated with the energy business. At their simplest, MLPs can be thought of as toll roads. They generate revenues and income by transporting natural gas, oil, or other liquids through their vast pipeline networks.
Kinder Morgan Energy Partners (KMP), probably the most well-known MLP, has over 38,000 miles of pipeline in the United States. MLPs combine the tax benefits of the limited partnership structure and the liquidity of public securities. Like REITs, they must pay out substantial portions of their income to unitholders. Furthermore, under IRS rules, they must earn at least 90% of income from "qualifying sources," usually the transportation of petroleum or other fuels (hence, the majority of MLP's are pipelines).
However, some financials, most notably Blackstone (BX) and Fortress Investment Group (FIG) are structured as MLPs. It is why they report consistent losses under GAAP accounting, while still being able to pay out hefty dividends to their unitholders. In regard to energy exposure, MLPs have little exposure to the actual fluctuations of the sector. A prime example is the operational setup of the Kinder Morgan pipeline. Kinder Morgan Inc (KMI) operates pipelines and other assets, while Kinder Morgan Energy Partners actually owns the underlying pipelines. And Kinder Morgan Management LLC (KMR) owns an operating interest in Kinder Morgan Energy Partners, thereby allowing tax-deferred investors to invest in these products.
At this point, readers may ask why Kinder Morgan Management need be involved in the first place. MLPs are not suitable for all investment accounts. The tax nature of these partnerships makes them difficult to manage in tax-sheltered accounts such as IRAs. The reason is this: under IRS rules, most of an MLP's distribution is considered a return of capital, which can be deferred. It reduces the cost basis of the MLP and the distributions are only taxed when you actually sell the fund in question. This is why MLP investors receive K-1s at tax time instead of 1099s. And this is also why GAAP earnings are essentially useless for MLPs. They have an incentive to increase non-cash charges because they are what allow investors to treat distributions as a return of capital.
For investors looking to simplify the tax issues of MLPs, there is an ETF solution. The Alerian MLP ETF (AMLP) is an ETF that tracks a basket of MLPs. It has an expense ratio of 85 basis points, pays dividends quarterly, and for income tax purposes, issues 1099 forms like any other security, and is therefore better suited for tax-advantaged accounts such as IRAs.
MLPs may not be suited for all investors, but for those that are able to take advantage of them, the benefits are numerous. Most MLPs have betas that are far lower than the market. Kinder Morgan Energy Partners has a beta of just 0.38, and yet it has been able to trounce the market since it made its debut in 1992.
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We are not saying that dividend-paying common stocks do not have their place in a well-rounded portfolio. They certainly do, and many studies have shown just how important such stocks are. But common stock has, and always will be, primarily a means to generate a return on invested capital. And dividends are a way to achieve that return on your investment. But they should not be seen as the actual goal of investing.
Common stock needs to be treated for what it was designed for, capital appreciation. Investors who are seeking income, and need little to no capital appreciation, would do well to look at the four sectors above. All have yields that go above and beyond those found in the vast majority of common stocks, and they all have much less risk that the average common stock. And we think that an investment that can generate a consistently solid dividend yield superior to that of most common stocks, all while doing so with less risk, is a great investment for income-oriented investors.
Additional disclosure: We are long T, PFE, and PG via our holdings of the SPDR Dow Jones Industrial Average.