KBWD: Steepening Yield Curve Is Positive, But Dividend Does Not Adequately Compensate For Risk
- KBWD is an ETF that invests in smaller lending institutions that pay very high dividend yields.
- While the fund has a dividend yield of over 9%, its expected purchasing-power return is far lower when you account for principal drag, taxes, and inflation.
- The fund's relative performance is tied directly to the shape of the yield curve. As the curve steepens, it is possible that KBWD outperforms the S&P 500.
- However, growing credit risk today largely offset the curves bullish trend and indicates a growing downside risk for KBWD.
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The Invesco KBW High Dividend Yield Financial ETF (NASDAQ:KBWD) invests in smaller companies in the financial industry that pay high dividends. The fund currently boasts a very high yield of 9.7% which makes it one of the highest yielding ETFs on the market today.
In theory, I love this ETF. It has cheap stocks with high dividends that should make it a long-run outperformer. That said, most of its holdings are mortgage REITs, business development companies, boutique investment banks, and insurers, all of which carry significantly higher-than-normal liquidity and credit risk. Thus, investors may want to hold off on buying the stock until the smoke clears in the equity market.
An Update on the Yield Curve
As explained in previous Seeking Alpha articles, the ETF has very high exposure to the yield curve as most of its holdings borrow at short-term rates and lend at much higher yield loans with a long-term maturity. While the yield curve does appear to be returning to a steepening phase, most of the companies in KBWD operate at extremely high leverage which means that interest-rate volatility could prove deadly.
Still, the current pattern of the yield curve generally indicates outperformance. To demonstrate, first take a look at the relatively strong correlation between the curve and the relative performance of KBWD to (SPY). This relative performance is shown through their total-return-ratio.
As you can see, the ratio may be finding support just as the curve has made its bottom. Further, it is generally clear that the two are correlated. Of course, this is because the profits of companies in KBWD are directly dependent on the curve since it determines the net-interest-margin available on lending.
Now, the yield curve has made many false-bottoms before over the past decade. Most notably in 2016 during the "reflation trade" which was fully-reversed over the preceding years. This could happen again and, quite frankly, with the curve as flat as it is many companies in KBWD will struggle to make ends meet if it becomes more inverted. That said, the recent aggressive emergency cut to rates by the Fed is likely to promote steepening which could pull KBWD's holdings out of their current hole.
A Look at KBWD's Subindustries
Problematically, subindustries in KBWD carry much higher credit-risk than most stocks. Its allocation toward those industries is shown below:
If you've followed my articles, you'd know that I have followed many of these industries closely over the past few months. Most notably is Mortgage REITs which is discussed in-depth in "Ranking The Mortgage REITs From Most Undervalued To Overvalued".
I maintain conviction in my view that the underlying U.S mortgage market is very strong. Defaults are low, deleveraging has been beneficial, and house prices remain cheap outside in most of the U.S. That said, despite evidence that suggests they should rise, mortgage rates have declined to extreme lows with a 30-year mortgage average of 3.25%. This means that lenders are not able to lend at a high enough rate to ward off potential credit risks. Until mortgage rates rise, these lenders may be forced to take on too much risk in order to maintain their current high dividend yields.
The same is true for business-development-companies (included in asset management) though their credit-risk is even higher. The ongoing sell-off, as well as the 2016 sell-off, had a significant impact on KBWD's performance and that of its underlying subindustries. To compare, take a look at the total performance (which includes dividends) of KBWD as well as that of the Business-Development-Company ETF (BIZD) and the mortgage REIT ETF (REM):
Is KBWD Undervalued?
High dividend yield does not equal undervalued as some seem to believe. Sometimes it does, but we must ask ourselves where those dividends come from and whether or not income is stable and adequately account for balance sheet risk.
As I mentioned earlier, dividends in the companies in KBWD generally come from net-interest margins earned on loans (which become distributable cash-flows). However, there are also loan losses and managerial fees. In fact, KBWD's current total expense ratio currently equates to 1.58% which largely comes from 1.23% in "acquired fund fees and expenses".
This "drag" is illustrated well when we look at the total returns of KBWD and its subindustry-peer ETFs vs. their price. They all have delivered positive total returns, but have seen principal depreciate overtime:
Looking solely at KBWD, we can see that pattern generally holds in the long-run:
Since inception, the value of KBWD has declined by roughly 1.5% per year, though it is highly inconsistent. Given that, I believe that it is fair to say that KBWD's expected return is not 9.7% as its dividend yield would imply, but closer to 7.2%. Account for a 20% tax on that 9.7% (depending on income level and other factors) and we're down to 5.26%. Add on the current 2.5% inflation rate, and we're at a 2.75% post-tax and inflation net return.
Obviously, there are other factors where this figure could change this result and it is likely that the post-tax/inflation return on the stock market as a whole is similar. That said, it goes to show that KBWD is not a great investment opportunity today.
Remember, its principal value declined 30% in 2016 without a recession occurring. In my opinion, the fund needs to have a dividend yield of over 12% before it is worth buying.
Not a Great Time for High-Risk
Overall, KBWD is a high-risk mediocre-reward proposition. It offers very high dividend yields, but there is a risk that those dividends will be cut unless the curve sees significant steepening. Importantly, steepening without a significant increase to economic credit risk since a rise in defaults could significantly hurt the earnings of KBWD's holdings.
As shown below, KBWD has a very low weighted-average valuation:
While these figures are certainly beneficial in the long-run, small-cap value stocks tend to be value-traps during recessions.
Are we headed into a recession? Perhaps, but unfortunately, the current virus situation is, quite literally, unprecedented so its economic impacts are far from clear. Importantly, the current bull market has been among the longest in U.S history and global/U.S debt buildup has been extreme. Not to mention very high valuation in both stocks and bonds. Thus, if a bearish trigger is pulled, the economy and markets have a lot of potential downside risk. From a matter of portfolio safety, it is worth assuming that the virus is the trigger.
I do not believe we are on the edge of a 2008 financial crisis repeat, but it sure seems like we are on the edge of poor economic times. As has been said, "recessions rhyme, but do not repeat".
So, if you're a long-term buyer looking for value and do not plan to sell for over a decade, KBWD could be a great pick. Over the long-run, small-cap value stocks usually outperform by a wide margin. Even more, because they have underperformed over the past decade they are likely to be even cheaper than usual, improving their long-run potential.
That said, if you are not willing to suffer a potential 50% drawdown that could last years, KBWD should be avoided. Its holdings have high credit risk and leverage. Further, because the curve is this flat, they are struggling to be profitable and many are resorting to riskier investments and/or even greater leverage.
Overall, I'm slightly bearish on KBWD. I expect the fund to decline with the market, but I do expect it to outperform once the bottom is in as that will allow the cash-flow benefits of a steeper curve to be safely passed on to investors.
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