Retirement Income: High Yield Is High Risk

 |  Includes: FTR, GOGL
by: Doug Meeks

This may generate some arguments, but I'm going to say that any yield above 6% is too risky for retirement income. The market is full of people and information that keep it very efficient in pricing future income streams. The capital needed to purchase safe income drives the yield down by driving up the price. Furthermore, if the income is growing, you'll need even more capital. I'll offer some examples:

  • Coca-Cola (NYSE:KO): Yield = 2.7%
  • Abbott (NYSE:ABT): Yield = 3.3%
  • Johnson & Johnson (NYSE:JNJ): Yield = 3.9%*

*In the case of JNJ, I'm watching the yield and it's getting to the high end of safe. The news from JNJ has not been that great the last few years. I'm still bullish on JNJ; however, leaning on the words of Ronald Reagan:"Trust but verify."

An investment with a yield of 10% has a very good chance of some volatility. The price could go up as the yield becomes safe, or the yield reduced by a cut in payout. In most cases, a high yield is the result of an increase in risk. Let's be careful in our discussion because price and yield are very related. I know this is elementary, but the price is moving much faster than the payout. With that in mind, let's look at price-driven yields forecasting payout reductions.

Let's consider Knightsbridge Tankers (VLCCF).

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Knightsbridge brought back its dividend payments after the 2008/2009 turmoil, with a payment of $0.25 per share in Q1 2009. That dividend was raised over three quarters to settle in at $0.50/share (per quarter) in September 2010.

In the middle of 2011, the fundamentals shifted to put the dividend at risk. It was a combination of the day rates for shipping crude oil, a tight market, and the loss of some long-term contracts. Knightsbridge is a solid shipping company and it is trying to remain profitable. When trading at $25 per share, this company had been paying out an 8% dividend. That is well above what I consider safe. The price began to drop as the market became more convinced that Knightsbridge was not going to be able to maintain the payout level. Once Knightsbridge reached a $15 share price, that put the $2 annual dividend at a yield over 13%. That's very risky. The dividend was cut this quarter to $0.35 per share.

Frontier Communications (NYSE:FTR) is another good example:

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The quarterly dividend payment was lowered from $0.25 per quarter to $0.1875 in Q3 2010. The stock rallied almost $2.00 per share on the hope for sustainability of the new dividend. Six months later, Frontier cut the dividend again down to a quarterly payment of $0.10 per share. The yield was forecasting the risk in both cases. Investors looking at the high yield and using it to justify a purchase have seen substantial losses.

In mid-2007, Frontier's yield was 6.3%. By the time the first cut was in place in September 2009, the yield was 13%. While the dividend was held at the new level, the yield dropped to 8.75%. Still, a risky level and the following stock decline drove the yield up to 18.5% before the second dividend cut. I read several articles about using Frontier for a high-yield investment during that time frame, and that turned out to be some poor advice.

A stock can deliver year after year of high yield -- it is possible. But it is the exception for that to happen with stable or rising prices. The market can create conditions where it happens, but it takes work to find those conditions and then to understand them enough to invest. Most often, high yield signals high risk. I deal with retirement income; it has to be stable and dependable. Always do your due diligence and do it twice when you see above 6% annual yield.

Disclosure: I am long KO, ABT, T, VLCCF, JNJ.