In this article I would like to explore some of the issues that come with investing in high-yielding stocks. These stocks, which are mostly constituted of MLPs and Mortgage REITs, have become very popular after the financial crisis. Some of the more prominent ones are:
mREITs and Mezzanine Finance: Annaly Capital (NLY), American Capital Agency AGNC, Invesco Mortgage Capital (IVR), Chimera (CIM), Hatteras Financial (HTS), KKR Financial (KFN), Ares Capital (ARCC), Starwood Property Trust (STWD), MFA Financial (MFA), CYS Investments (CYS), Prospect Capital (PSEC)
MLPs: Kinder Morgan Energy (KMP), Enbridge Energy (EEP), Energy Transfer Partners (ETP), Suburban Propane (SPH), Martin Midstream Partners (MMLP), Natural Resource Partners (NRP), Calumet Specialty Products (CLMT), AmeriGas (APU), Boardwalk Pipeline (BWP), Dorchester Minerals (DPM)
Through a combination of factors some of these stocks have yields north of 10%, which is phenomenal in a low rate environment. It should also be noted that although the yields have come down with the advance of the market (rising prices decrease yields), almost all of these stock could have been picked up with yields north of 13% after the financial crisis. That should bring about a question, however: If the yields on these things are so good, why aren't they more liquid and widely used, especially by the institutions?
The answer is these high yielding stocks do have a set of risks that are unique to them. Due to those risks, institutional investors are not exposed to these securities as much as they should. The lack of institutional investors leads to problems in liquidity on the secondary market. The following issues are a short overview of these issues and the resulting liquidity problems for investors.
Leverage: High yielding stocks can yield as much as they do because they use a great deal of leverage. A lot of the investors are already familiar with the leveraged structure of mREITs. However, MLPs are also basically leveraged investment finance companies. They undertake capital intensive projects and finance them with a lot of leverage, since these are stable projects. The difference between their financing costs and the income that the project produces is their dividend.
Unfortunately this leverage is a characteristic that scares many investors away. The mere mention of the word "leverage" is a deal breaker for some. While the concern is overestimated in many cases, these high yielding stocks are indeed very sensitive to developments in the credit market. A sudden shock to the availability of institutional credit pulls down the valuations of these stocks very rapidly.
Liquidity is a problem for investors seeking to sell their shares in such an environment. The credit squeeze decreases investor demand for almost all companies that depend on leverage to do business. This broad pressure makes it very hard for you to find a buyer for your shares in the secondary market, especially if you try to close a large position.
Liquidity in the Secondary Market: With the exception of Annaly Capital, many of these high yielding stocks have daily volumes around $20 million. This makes it very hard to move around positions in excess of $5 million in a single day. That is a problem for institutional investors and larger private investors. It also makes it very hard for investors to respond to extraordinary stock specific events, without causing a crash in the stock. As a result, investors should consider the risk that the high yielding stock that they invest might be down in excess of 10%, when the event that causes the decline warrants just a 2% decline.
Lack of Sell-Side Marketing: Money managers and sell side analysts don't like MLPs and mREITs. The reason is that the characteristics of these high yielding stocks go against the usual set of characteristics that sell-side analysts use to move securities.
The job of the sell-side brokers is to market fixed-income instruments that offer only a modest yield above the risk-free rate as if it was an exceptionally good investment. MLPs and mREITs are very similar to fixed income securities in many respects. Therefore it doesn't bode well for the sell-side finance guys if many investors know about these alternative stocks that, in some cases, offer yields well north of 1%5 above the risk free rate.
These alternative stocks also offer the opportunity for capital appreciation in addition to a phenomenal yield. How are the sell-side brokers supposed to sell paper that yields 5% if investors can get 15% elsewhere very easily. Therefore they don't market mREITs. They also try to cover them up by claiming that they are too risky compared to fixed income instruments.
Money managers don't like high-yielding stocks either. Many managers gloat for achieving a return of few percentages above the market indices. They also charge exorbitant fees for that performance. Not only that, but many managers underperform the market and still charge high fees. The existence of high-yielding stocks with dividend yields that approximate the market return with a similar risk profile are troublesome for money managers. Why would investors pay for money managers when they can just buy a few stocks, sit back and then collect their returns as stable dividends?
This lack of likability by sell-side analysts and money managers, however, results in underexposure to high-yielding stocks, especially by institutions. When institutions are not there, liquidity in the secondary market suffers remarkably.
Dividend Payment Delay: Since mREITs and MLPs have very high yields, their stock moves by a considerable amount on the ex-dividend day. This is a problem for investors who buy stocks with leverage. You receive the dividend payment a couple days later than when the stock adjusts itself to the payment. If your margin requirements don't allow it, you might need to post additional margin to cover the loss on the stock until you receive the dividend. This is probably one of the reasons that the stock prices of high-yielding stocks adjust much more than the dividend per share. Investors need to sell some of the shares to decrease the margin requirement, but since there are many investors in the same situation, there isn't enough liquidity to absorb all the sell orders.
Hedging Difficulties: The main way to hedge high-yielding stocks is to use options. However, the option markets that belong to these stocks are even less liquid than the stocks themselves. The implied volatilities (how expensive the option is) might seem very reasonable, but there is a considerable loss to the bid/ask spread in purchasing these options. Also if you are trying to hedge a large position, you will probably have difficulty finding sellers on the market, as option underwriters are not very interested and active in these options either.
I should also note that I do not hold any positions in these high-yielding stocks. The reason is the entry level to these stocks greatly affect their yield. In my opinion, the market is overbought, and after a market decline, possibly in May 2012, these high-yielding stocks can be bought at even greater yields.