iStock_000003184927XSmall-Money-Grabber-304-300x175Has the high-income crowd made the high-yield, high-dividend stock trade too risky for you and me?

Yes – and no.

Yes, most of us are looking for additional income in a “low interest rate” environment and many of you may be already invested in higher-yield, risky investments to generate cash.

When I do investment seminars, everyone gets excited about Apple’s valuation and growth prospects or my latest biotech thoughts but they always ask hard, specific questions about dividend income stocks and other high-yield aggressive funds or partnerships. I tell them it is a pretty crowded trade but there are some good companies out there, and that means good stocks, and there are also ways to boost that dividend yield if you have the energy to do so.

So, yes, the trade is risky because most high-yielding stocks are fairly valued or overvalued and income investors can ill afford to risk any capital impairment, so people looking for income must be very selective on the names they choose.

No, the trade is not risky if you are a longer-term investor, and there are outfits that have had yields forever independent of the economy and even the market because of the nature of their business.

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Best bets for high yield

Where can you avoid risk and yet still get high yield for income?

First, let’s define risk – it is the risk the business is going to stall or head south, possibly reducing the dividend, it is the risk the stock will trade with the market if the market turns down and it is the risk the stock will turn down because interest rates on other securities, notably U.S. Treasurys, go up.

Second, what is high yield? Investors should think 8% or more to start. Yes, 8%.

Where to you look?

Mortgage REITS: A mortgage REIT is an outfit that uses its own capital and borrows money to buy mortgages. The only REITs you should look at are those that have all of their mortgages insured by the federal government. Not only does this eliminate any risk of default; by eliminating the risk of default they get better terms on the money they borrow and they can leverage up their balance sheet, borrowing several multiples of their core capital since their balance sheet is essentially risk free. The only risks to the business are a sudden rise in short-term interest rates and acceleration in re-financings. Ben Bernanke has told us short-term rates are staying put for three years and anyone who could refinance has done so.  That means rates are staying low so the number of refinancings will be small and manageable. These companies are REITs, and that means they pay out 90% of their profits in the form of dividends and avoid corporate taxes.

Since I have a bias towards great management, my favorite in the sector is Annaly Capital Management (NLY). It currently yields above 12%. I own it. Why? There is zero risk on the balance sheet, if it cuts its dividend by a third you still have a greater than an 8% yield and I believe the business is bottoming, meaning its profits should climb beginning in Q2 2012.

NLY-Chart

 

Pipelines: Energy pipelines were investment orphans a few years ago, they are now the darlings of the high-yield crowd, which has pumped up their stock up and lowered the effective dividend yield. Piplines make money regardless of fluctuations in the price of gas or oil; more importantly, it takes a lot more time to build large pipelines than it does to produce more oil or gas. The current boom in energy production in the U.S. has made their assets more attractive even as the price of natural gas falls. And this is going to go on for a very long time.

But, you note, their yields have fallen well below that 8% level I referenced above. True – the two big fellas I like the most, Kinder Morgan Energy Partners (KMP) and Enterprise Products Partners (EPD), yield 5.4% and 4.9% respectively. But you should consider owning them and creating a blended income portfolio that mixes the above-mentioned mortgage REITs and the pipeline outfits.

Yes, I am risk-averse and to reduce risk you can blend the two yields and come up with an 8%-9% yield per annum. You can also do two other things to either lower risk or boost returns on the positions.

  • When you own a high-yield stock, you can sell a call and buy a put, locking in the price and value of the shares, preventing you from taking any capital losses, using the cash from the sale of the call to purchase the put. You are, in effect, creating a high-yield bond. 
  • You can simply sell calls to boost the yield on an already high-yielding stock. If you sell calls on NLY several times a year, you can boost the current 13.9% yield to more than 18%.

Also if you want to own a fund, take a look at the iShares S&P U.S. Preferred Stock Index Fund (PFF). It yields just under 7%. The fund has – you guessed it – holdings in preferred shares of big outfits like GM, and these are the safest equity to invest in if you are worried about capital impairment.

The Crowd is there because many investors need income, and they are now chasing high-yield stocks. 

My Bottom Line: Do not join that crowd.  You need to be selective, be risk-averse, and do not let the promise of a high quarterly payout put your capital at risk. But don’t think small, either.  If you settle for 5%, you are leaving money on the table.

My Income Secret…Over $1000 of Extra Income in Your Account in the Next 30 Days?

In just 3 weeks, my followers reaped over $600 in instant extra cash income, just by following “MY INCOME SECRET”. Earlier this week I released my NEXT ‘easy to follow’, instant cash trades for my followers.  (It’s not too late to get in on them, either! And they’re already moving in our favor!).  Get in on “MY INCOME SECRET”

 

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