Retirees: The Risks, Dangers And Advantages Of Reaching For Yield: Part 2B by Chuck Carnevale, F.A.S.T. Graphs

Introduction

There is an undeniable fact that differentiates investing when in retirement versus investing while you are still working.  When you are employed, you are working for your money.  However, once a person truly enters their retirement years, the situation reverses itself.  When in retirement you begin the stage in your life where your money must work for you.  In my opinion, this changes the investing dynamic considerably.

This change in the individual’s investing dynamic primarily relates to suitability.  When a person is younger and earning a paycheck, it can make sense to employ more aggressive growth-oriented investing strategies.  Both time, and ideally, a steady paycheck are working in your favor.  If you make investing mistakes along the way, as most everyone does, you have the luxury of time and fresh capital coming in to bail you out.

In contrast, when a person matures and enters their retirement years, the capital they have accumulated is logically more precious.  Consequently, preservation of the capital that you have spent a lifetime accumulating often does, and should, take precedence over making more.  This often reminds me of a couple of relevant quotes attributed to Will Rogers where he said: “I am not so much concerned with the return on capital as I am with the return of capital.”  And perhaps more apt to the thesis of this article: “Live your life so that whenever you lose, you’re ahead.”

At this point I want to clarify what I speaking about.  I am not simply suggesting that age in its own right should automatically change your investing dynamic.  In other words, I am not suggesting that a person automatically loses their edge or acumen simply because they have become older.  The central issue is time – not advanced age.  One of the most important benefits with investing is time in the investment.  Compounding is a powerful investment attribute; however, it is an attribute that functions best over long periods of time.

In the same vein, I am not a fan of the adage “I don’t buy green bananas anymore” that many mature investors often declare.  Stated more directly, I am not suggesting that retired investors should avoid taking any risk with their investment portfolios.  Frankly, all investing entails a certain amount of risk.  Therefore, avoiding all risk is literally impossible.  On the other hand, I am a believer in taking only calculated and thoroughly reasoned risks that are commensurate with your financial situation or status.

In other words, no investor, whether retired or still earning a paycheck, can avoid all risks.  However, they can to a great extent mitigate the risk they are taking by clearly understanding what they are, where they come from and how they can be controlled.  At the end of the day, and as it relates to all investing, there is no substitute for comprehensive research and due diligence.  Knowledge is power for every investor in every stage of their life.

To summarize, it is often okay and even appropriate for retired investors to assume a certain amount of risk.  However, it’s critically important that the risk taken is clearly understood, and even more importantly, continuously monitored.  Perhaps there is no area of investing where these principles more appropriately apply than in the high-yield investing arena.  Therefore, this article is offered to reveal and articulate the risks, dangers and advantages of reaching for yield.

Common Sense and Reaching For Yield

It is no secret to anyone that interest rates are near all-time lows.  As an alleged attempt to stimulate growth, the United States has implemented a zero interest rate policy (ZIRP).  In part 1 of this series found here I laid out the current yields on Treasury bonds from 6-month bonds up to 30-year bonds.

Almost unbelievably, a 30-year Treasury bond currently only yields a little over 2.9%, let’s call it 3% for expediency.  As I did in the above article, and will do it again now, knowing the yield currently available from the lowest risk fixed income investments should serve as a common sense and most conservative benchmark for the yields you can expect on your investments.

Consequently, when evaluating the yields available on any theoretically riskier classes of investments, the 3% available on riskless investments should serve as a guide.  In other words, when you come across any investments with yields above 3%, you should automatically recognize that there is greater risk involved.  In that context, the higher the yields are that you come across, it only logically follows that the risk taken to achieve them must become proportionately greater.  When the yields get extremely high, you should immediately recognize that the risks become extreme.

In part 2A of this series found here I also presented a broad review of the current yields available from what I consider 4 primary categories of quality dividend growth stocks.  Those yields generally ranged from a low of 1.1% to a high in the 7% range.  However, there were a few outliers above that in the REIT category.  Therefore, we have a perspective of what level of yield we can reasonably expect from riskless Treasury bonds and relatively high-quality dividend paying stocks.  My point being that anything significantly above that should automatically raise red flags.

Aggressive High-Yield Investments: Are They Suitable For Retirement Plans?

Just as I did with presenting the 4 categories of quality dividend growth stocks in part 2A of this series, I offer the following listings of the most prominent categories of extremely high yielding investments.  However, there is a material difference between what I’m offering here and what I offered in the previous installment.  With the quality dividend growth stocks, I screened the overall universe and only presented companies that I considered fairly valued or close to it.  With these more aggressive investments, I am simply listing the most prominent that I was able to find.

Therefore, I want it to be crystal clear that I am not recommending any of the stocks on the following lists.  Instead, I am simply offering a listing of what is available in high-yield investments.  Frankly, as a stickler for only investing in stocks when they are fairly valued, I will readily admit that I find it difficult if not impossible to value most of the entities listed below.  There are reasons for that which I will elaborate on as I discuss each category.

However, this also leads me to state that in the general sense, one of the great disadvantages of investing in the most aggressive high-yield entities lies in the complexity of analyzing them.  Consequently, and based on what I submitted in the introduction to this article, as a general rule I do not consider most of the following entities suitable for retirement accounts.

Of course, there are exceptions to every rule.  Therefore, I am not emphatically stating that retired investors should never invest in any of the following entities.  On the other hand, I do believe that they should only be invested in based on comprehensive due diligence and/or a clear understanding of the characteristics they possess, especially those relating to risk.

Aggressive Yield: BDCs and MLPs

For efficiency’s sake, I have grouped business development companies (BDCs) and master limited partnerships (MLPs) into one heading.  Although there are significant differences between these two business structures, there are also similarities that motivated me to group them together.  The primary similarity is that both BDCs and MLPs generally offer high yields.  Additionally, both entities have complex capital structures and significant tax ramifications and considerations for investors.

Following the table which lists many of the prominent BDCs and MLPs I will feature examples utilizing the F.A.S.T. Graphs™ research tool on each entity where I will offer some general discussions about the nature of each entity.  Additionally, since the scope of this article is more general in nature, I will not be delving deeply into discussions about what either of them is or how they work.  However, I will provide links to research on each that the reader can go to in order to learn more about BDCs and MLPs.

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Main Street Capital Corporation (MAIN): A Reasonable Quality Fairly Valued BDC

I offer the following brief explanation of BDCs courtesy of Wikipedia:

“A business development company (BDC) is a form of unregistered closed-end investment company in the United States that invests in small and midsized businesses.  This form of company was created by Congress in 1980 as amendments to the investment Company act of 1940.  Publicly filing firms may elect regulation as BDC’s if they meet certain requirements of the investment Company act.

BDCs are similar to venture capital or private equity funds since they provide investors with a way to invest in small companies and participate in the sale of those investments.  However, VC and PE funds are often closed to all but wealthy investors.  BDC’s, on the other hand, allow anyone who purchases a share to participate in the open market.  This feature often attracts money to newly public BDC’s, thereby giving them a faster way to raise capital for investments than VC funds.”

I believe the above brief overview of BDCs provides insights into some of the risk associated with this asset class.  BDCs are often investing in small startups, and there is an inherent risk that the small new enterprises will prove to be successful.  I believe this also explains some of the operating inconsistencies found in many BDCs.

My first example in the business development company space is Main Street Capital Corporation.  I specifically chose this example because its current yield is on the low end of what is often available from BDCs.  This is consistent with my general theory that risk gets higher as yields get higher.  In the same context, Main Street Capital Corp has one of the highest S&P credit ratings of any BDC on the list.

Furthermore, as the following earnings and price correlated F.A.S.T. Graphs™ reveals Main Street Capital Corp also has produced a consistent record of earnings and dividend growth, and price has tracked and correlated to earnings consistently over time.  On that basis, this particular BDC also appears to be attractively valued.  Given everything I have said so far on Main Street Capital Corp, it is one BDC that I might feel comfortable about recommending for investment in retirement portfolios.  But frankly, my conviction is not high.

Aggressive Yield

When you examine the performance of MAIN associated with the above graph, you can gain some insight on why I might potentially be comfortable with this particular BDC.  Dividend payments have been reasonably consistent and have grown rapidly.  Additionally, capital appreciation has correlated closely with the company’s earnings achievements over time.  Therefore, total return generated by this BDC has been significantly above average and its distribution of cash to shareholders extremely high relative to the average stock.

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As previously mentioned, this article is offered as an overview of available high-yield investments.  Therefore, I will not delve deeply into the ins and outs of these asset classes.  However, for those investors interested in learning more about BDC’s I are the following links found here and here.

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TICC Capital Corp (TICC): A BDC offering Extreme Yield- Suspect Fundamentals

My second example in the BDC space goes to the opposite extreme of what we saw with MAIN. TICC offers a current yield of 16.8% which is quite enticing in today’s low to moderate yield environment.  It is understandable that income hungry investors might be enticed by such a generous dividend yield.  However, current yield is rarely the whole story.  In contrast to what we saw with MAIN, this BDC has a significantly less attractive earnings and dividend history.  Consequently, I personally would not be comfortable recommending this BDC for investment in retirement portfolios.

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When you examine the performance of TICC Capital Corp associated with the above graph you discover some rather troubling results.  Although income is important to retired investors, capital appreciation should also be an important consideration.  In this case shareholders would have seen their capital depreciate by more than 55% from an original $10,000 investment to a current worth of $4,430.  I believe this places a bright spotlight on the risks associated with investing in extremely high-yield entities.

On the other hand, total cumulative dividend distributions have been exceptional albeit inconsistent. TICC cut their dividend dramatically in 2008 and 2009, and there was virtually no growth in 2014.  Importantly, consensus expects a significant dividend cut for 2016.  This brings into question what the actual future yield on this BDC might turn out to be.

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KCAP Financial, Inc. (KCAP): Another BDC offering Extreme Yield- Suspect Fundamentals

Since this article is significantly oriented towards the risk and dangers of investing in high-yield securities, I offer a second example of a BDC I would not be comfortable recommending for investment in retirement portfolios.  In this case I will let the earnings and price correlated graph and performance report speak for itself.  My purpose for providing a second example is to drive home the risk aspect associated with investing in BDC’s.

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Energy Transfer Partners,L.P. (ETP): An Apparently Fairly Valued, High Yield Midstream MLP

MLPs have very complex business and ownership structures.  For example, there are four publicly traded partnerships in the Energy Transfer family. ETP is but one of them.  Additionally, MLPs technically pay distributions, not dividends.  Consequently, investments in MLPs produce a K-1 which must be filed and reported on the investor’s tax forms including IRAs.  Therefore, although MLPs can be utilized in IRAs, the K-1 filing discourages many investors from utilizing them.

Additionally, there are three primary different types of MLPs each with different risk profiles.  These are upstream, midstream and downstream. ETP is a midstream MLP which are considered the least risky MLP category.  However, all MLPs contained a higher degree of risk than most traditional corporations, in my opinion.  To learn more about MLPs, their complexity, advantages and disadvantages there were 2 recent articles on seeking alpha with contrasting viewpoints found here and here.

In my opinion, the greatest disadvantages of investing in MLPs relates to their complex ownership structures and tax filings.  Consequently, as I previously indicated, I believe they are most appropriate for either sophisticated investors, or individual investors desirous and capable of performing comprehensive due diligence.

Moreover, as most regular readers of my work will attest, I am a stickler for only investing when I believe fair value is manifest.  However, I have found MLPs extremely difficult to analyze when utilizing traditional fundamental valuation techniques or tools.  The following earnings and price correlated graph on Energy Transfer Partners illustrates that there is a very poor correlation between price and earnings.  However, upon closer examination, you will discover that there is a meaningful correlation between price and dividends (the honeydew green or white appearing line on the graph).

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Consequently, when I have analyzed MLPs I have discovered that the price to dividend (distribution) expression provides a reasonable perspective of fair value on most every MLP.  Admittedly, I do not have a precise analytical thesis or principal to base this on.  However, I have reviewed virtually every known MLP and have found that the relationship between price and dividend (distributions) to be highly correlated and therefore, valuable as a valuation expression.

The following F.A.S.T. Graphs™ on Energy Transfer Partners is presented with only dividends (distributions) and price.  In other words, earnings and the normal P/E ratio have been removed.  By analyzing this view, we discover clear periods of time when price is above the dividend (distribution) line and therefore overvalued.  Several times when price is touching the dividend (distribution) line and therefore appearing fairly valued, and finally, times when price is below the dividend (distribution) line and therefore appearing undervalued, as is the case with Energy Transfer Partners currently.

I will repeat that this might not be purely scientific analysis, but the correlations are certainly evident.  Consequently, I will be utilizing the same expression of price and dividends (distributions) on the additional MLPs I present.  The reader can judge for themselves whether they see any value in this analysis when attempting to make buy, sell or hold decisions on MLPs.

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When evaluating the performance associated with the above graph, note that Energy Transfer Partners started the timeframe fairly valued based on the price and dividend (distribution) analysis, and on that same basis, appears currently undervalued.

Nevertheless, Energy Transfer Partners has produced impressive returns over this timeframe.  Both capital appreciation and cumulative dividend income has exceeded the S&P 500 by a strong margin.  However, I remind the reader that there are tax implications associated with those distributions.

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Linn Energy, LLC (LINE): A High Risk Upstream MLP with Deteriorating Fundamentals

Upstream MLPs are universally considered the most risky class of MLPs.  The following graphs on Linn Energy clearly validates and justifies that view.  Note that the yield listed on the FAST FACTS box to the right of the graph is technically in error.  This is primarily due to the current volatility and fluidity of their distribution policy.  Here is a link to their website which announced their current suspension of distributions.

Nevertheless, the recent deterioration and operating results places a bright spotlight on the risk associated with investing in high-yield MLPs, especially upstream MLPs.  Admittedly, when things were going their way, LINE produced a high level of income distribution.  However, the recent turmoil in the energy sector changed things dramatically and abruptly.

Aggressive Yield

Just as I did with the Energy Transfer Partners’ example above, I offer the price and dividend (distribution) only graph on Line Energy below.  The correlation between price and distributions is quite profound.  However, this also points out that valuations can change dramatically when fundamentals change.  In the case of Line Energy, the biggest fundamental change has been the recent collapsing of dividends (distributions).

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When you evaluate the performance associated with the above graphs you discover a high level of cumulative dividends (distributions) over time.  However, you also discover the potential capital appreciation (depreciation) risk that is associated.  High-yield can be very attractive when things are going well, but if you’re not careful and diligent, it can bite you hard on the capital appreciation front.

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Aggressive Yield: Mortgage REITs (mREITs)

Mortgage REITs are another high-yield, high-risk asset class that I personally do not consider suitable for most retirement portfolios.  When you consider the baseline availability of current yields previously discussed, the extremely high yields available from mREITs should cause you to take pause and ask an important question.  How can mortgage REITs provide such a high level of current yield relative to bonds and blue-chip dividend growth stocks?

The answer is simple and straightforward – leverage.  Mortgage REITs are highly-leveraged investments, and although leverage can dramatically increase returns, it can also wipe you out in a heartbeat.  To learn more about how this works I offer the following link found here that discusses the risks associated with mREITs.

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Annaly Capital Management, Inc. (NLY): High On Yield Low On Growth

Annaly Capital Management is perhaps one of the best-known and most widely-held mREITS.  It offers a current yield of almost 12% and trades at what might at first glance appear to be a low P/E ratio of 8.4.  However, closer scrutiny would dictate that this has been a normal valuation level (normal P/E ratio) for the company over time.  I believe this chronic low valuation is indicative of the market’s attitude regarding the risk associated with investing in mREITs.

But perhaps the most important takeaway from analyzing the long-term graph on Annaly Capital Management is the inconsistency of both historical earnings performance and historical dividend performance.  When investors see a high yield reported as a mere statistic, it can be very misleading.

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When you review the associated performance with the above graph on Annaly Capital Management you discover that total cash distributions have been enormous over time.  Cash distributions alone would have generated approximately 2.7 times your original investment.  This is one of the advantages of investing in extremely high-yielding investments such as mREITs.

On the other hand, capital appreciation has been nil, but thanks to the total amount of cumulative dividends paid, Annaly Capital Management has actually outperformed the S&P 500 on a total return basis.  However, for investors relying on the income their portfolios generate to live on, numerous dividend cuts could be very trying.

Aggressive Yield

Resource Capital Corp. (RSO): Extreme High Current Yield But Spotty Long-Term Record

Resource Capital Corp. provides an excellent example where enticing current yields only tell part of the story.  Once again, I will let the graphs speak for themselves.  However, note the very poor record of historical earnings growth as well as the continuous drop in dividend distributions leading to under performance against the S&P 500 on a total return basis.  Dividend distributions were significantly higher, but capital was significantly destroyed.

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Aggressive Yield: Royalty Trusts

The following is a brief description of royalty trusts courtesy of Wikipedia:

“A royalty trust is a type of corporation, mostly in the United States or Canada, usually involved in oil and gas production or mining.  However, unlike most corporations, its profits are not taxed at the corporate level provided a certain high percentage (e.g. 90%) of profits are distributed to shareholders as dividends.  The dividends are then taxed as personal income.  This system, similar to real estate investment trust, effectively avoids double taxation of corporate income.

Royalty trusts typically own oil or natural gas wells, the mineral rights of wells, or mineral rights on other types of properties.  An outside company must perform the actual operation of the oil or gas field, or mine, and the trust itself, in the United States, has no employees.  Shares of the trust generally trade on the public stock markets, but the trust itself is typically overseen by a trust officer in a bank.”

The following links to MorningStar’s Stocks 500 Investing Classroom found here and here describe the advantages and drawbacks of investing in royalty trusts.

There are advantages and disadvantages to investing in royalty trusts and they are clearly articulated in the above links to MorningStar.  However, for simplicity sake, the important factor is to recognize that royalty trusts own a finite amount of resources, and once those resources are depleted, the trust is typically closed.

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Sabine Royalty Trust (SBR): One of the Most Successful Of All Royalty Trusts

When Sabine Royalty Trust was originally formed in 1982 it was expected to have a life of approximately 10 years.  Today, more than 30 years later, it has produced an extraordinary amount of profits and distributed cash flow for its shareholders.  However, as I will later illustrate, this particular royalty trust appears to be the exception rather than the rule.

Aggressive Yield

Sabine Royalty Trust could be the poster child for proponents of investing in high-yield securities.  Since 1996, the trust has produced almost $75,000 of distributable income based on a one-time $10,000 investment.  This represents a significant advantage of investing in successful royalty trusts when things work out.  Additionally, Sabine Royalty Trust has also outperformed the S&P 500 on a capital appreciation basis.

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Dominion Resources Black Warrior (DOM) and Hugoton Royalty Trust (HGT)

I offer the following royalty trusts, Dominion Resources Black Warrior and Hugoton Royalty Trust, as examples of how royalty trusts are theoretically designed to work.  Once again, I will let the graphs and associated performance reports tell the story.  However, I direct the reader’s attention to the continuing depletion of earnings and distributions over time.

On the other hand, I also direct the reader’s attention to the significant amount of cash distributions that both of these royalty trusts have generated.  One of the great advantages of royalty trusts are large distributions.  However, one of the great disadvantages is the likelihood of eventual termination of the trust when all assets are depleted.  Consequently, I don’t consider most royalty trusts suitable for retirement portfolios.

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As a bonus, I have prepared a free analyze-out-loud video on my website MisterValuation, which provides a more in-depth and detailed look at advantages and disadvantages of investing in high-yield securities.

Summary and Conclusions

As indicated in this article, there are many high-yield investment opportunities that investors can consider.  However, high-yield alone does not tell the whole story.  Each of the major high-yield asset classes offer numerous risks that should be carefully considered before laying your money down.  There can be great advantages to investing in high-yield securities when things are going well.  On the other hand, when things get bad, they can get very bad and it can happen very quickly.  Consequently, I suggest only the most sophisticated or diligent retired investors include high-yield securities in their retirement portfolios.  If you reach too high for yield, you have to be careful you don’t fall off the roof.

Disclosure:  Long ETP.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.