With US Treasury interest rates as low as they are (although their rates have been slowly rising) and with rates on corporate and other non-government debt also very low, investors seeking a current return face a difficult choice. Either they invest in safe places – government debt, money market funds, or bank CD’s, for example – and earn a miniscule return, or take on substantially more risk in order to earn a current return. This choice has been made worse by the underperformance of the stocks of traditional dividend-paying sectors such as oil, telephone companies, and utilities. Investors looking for dividend-paying stocks have had to deal with a lot of risk and uncertainty.
The Future
What does the future hold for this Safety vs. Return trade-off? On the Return side of things, it is unlikely that the return an investor will earn with safe investments will improve significantly. The US Federal Reserve has stated it is unlikely to raise short-term interest rates for the next few years. The Yield Curve has steepened and I look for it to steepen more – meaning rates on 10 Year-or-more bonds will increase in my opinion. This could help somewhat, especially if one invests in mortgage-backed bonds or bond funds, because mortgage rates correlate to a spread over 10 Year Treasuries. However, an investor will need a whole pile of money if they want to live off of the interest from government- or even corporate-backed bonds.
Diversify Instead
Instead, investors looking for current return will need to get comfortable with the risk associated with dividend stocks, high-yield debt, and any other investment vehicles that pay them a higher current return. The best way to get more comfortable is to diversify their portfolio. Do you like the dividends that you can earn by investing in the major oil companies, but you don’t want to be subject to the ups and downs of the price of oil? Then don’t invest just in oil company stocks, as I know some investors do. AT&T has long been a haven for “widows” looking for dividend income, and it still does pay a hefty current dividend of in excess of 7%. However, AT&T has real problems and is looking to sell its DirecTV assets for about half as much as they paid for them 6 short years ago. If a substantial amount of your net worth is tied up in AT&T stock because you like the dividend, you need to think seriously about selling a chunk of it to protect your net worth, even if it means giving up the generous dividend. Live to fight another day. AT&T is an example of individual company risk that you can mitigate by diversifying your holdings. If you diversify your dividend-paying holdings among several or preferably many different companies, sectors, and industries, you can mitigate the risk that any one company or sector will tank your portfolio while at the same time maintaining a decent current return on your investments.
High Yielding Funds
One thing you might do is screen for dividends. By this I mean you would go to Finviz.com or another free stock quote service that has a screener function and screen for stocks that have a dividend of in excess of 4%, for example. What may turn up through your screen are Exchange-Traded Funds or Closed-End Funds that have high yields. If so, watch out! Not to say that you shouldn’t invest in these funds, but you need to understand what they do. Typically these funds invest in a lot of different equities or bonds, so that is good for diversification. However, a number of these funds use leverage in order to prop up their yield. For instance, for every dollar of investor money the fund has, the fund manager may also borrow a dollar and invest the borrowed dollar along with the investor’s dollar. If whatever the fund invests in pays an 8% dividend and the borrowed money costs only 3%, then the 5% difference gets passed on to the actual investors in the form of an enhanced dividend. This is great as long as debt an equity markets remain stable. However, volatility, especially in the debt and interest rate markets, is the enemy of these types of investments. As long as you understand what you are investing in and the risks associated thereof, then give it a go.
Another Alternative: Covered Calls
Finally, I will once again pitch an alternative for current yield that I have written about before. I write covered calls against long index futures positions. Calls against long index ETFs can accomplish about the same objective. I write calls at strike prices that are somewhat higher than the current trading price of the index, and I do so on a weekly basis. My objective is to provide a current return of at least 6% and preferably higher while still participating in some of the upside of the index. The bad news is that I also participate in 100% of the downside, but I do keep the premium of the call option that I sold. This strategy is diversified in that I am long in index futures, such as the S&P 500 or the Nasdaq 100 Index, so I own a whole portfolio of companies through one index position. By selling the call against the long position, I collect the premium price of the call while still owning the long position. If the price of the index exceeds the strike price of the call option when the option expires, my long position gets called away from me at the strike price, even if the price of the index exceeds the strike price. I hold on to the long position if the price of the long position is below the strike price of the call option at the expiration of the call option. It sounds complicated but it really isn’t once you do it a few times. Options sound risky but they’re not if you transact them as I have laid out here. To me, this is a great way to have a win-win on the initial problem I posed regarding the trade-off between safety and return.
IMO
It is a difficult choice between safety and return, but you can mitigate your risks by diversifying, by really understanding what you are getting yourself into, and perhaps by thinking outside of the box a bit with the covered call strategy I outlined. Want to learn more? Please contact me to ask.