As more investors dig for income, more investors are getting
themselves into trouble. Hidden risks from high yielding funds that
use leverage and interest rate risk from popular TIPS abound.
If you're searching for more cash flow from your investments,
how can you avoid the pitfalls? Let's analyze four income tips that
top my list:
High dividends are great, but can change on the dime
The three highest yielding stocks currently within the S&P 500
are Pitney Bowes (
) - 10.02%, Frontier Communications (NasdaqGS: FTR) - 10.44%, and
Windstream Corp. (NasdaqGS: WIN) - 10.36%. Each of these companies
is involved in business equipment, technology, and
Although the dividend yields for these companies is higher than
the S&P 500's (NYSEArca: SPY) average yield of around 2%, the
yield dynamic is in constant flux. Dividends are not guaranteed and
can be cut or even eliminated at any moment.
A few years ago, high dividends within the S&P were
dominated by banking and financial stocks (NYSEArca: XLF). At that
time, yields weren't high because of positive business prospects
for the financial sector. Rather, share prices had fallen a
staggering 73% from 2007-08 thereby increasing the juiciness of
financial sector dividend yields. Today, S&P financials yield
around 1.70%, which is less than the broader S&P 500. My how
Here's the lesson: Dividend yields are constantly changing and
today's hotshots (or high yielders) can easily become tomorrow's
turkeys (low yielders).
Leverage increases volatility
The idea behind leverage is to magnify the performance or yield of
an investment. But when used the wrong way, leverage can magnify
Many income investors flock to closed end funds (CEFs), like the
Gabelli Dividend & Income Fund (
), without a full understanding of what's driving those yields. GDV
has a distribution rate of 6.19%, but how does it get that type of
juicy yield? Is it because Mario Gabelli is an investment genius?
Not really. GDV borrows money and has a leverage ratio of 24.27%.
Three words: Juice, juice, juice!
Here's the problem: Funds that use leverage to obtain higher
dividend payouts tend to have greater volatility in yield, market
price and net asset value (
) than non-leveraged funds. Also, it's nearly impossible to hedge
your risk in a leveraged actively managed fund like GDV, because
there's no predicting what the fund manager will do next.
As a result of these shortcomings, shareholders in high yielding
leveraged CEFs subject themselves to larger drops in NAV compared
to similar non-levered funds, due to their sensitivity to changes
in interest rates. Any narrowing of spreads between short- and
long-term rates may damage potential profit margins for the fund
and potentially lower the dividend paid by the fund.
TIPS aren't a hedge for rising rates
Treasury inflation protected securities (
) were introduced in the late 1990s and promise investors their
principal value will keep up with the Consumer Price Index.
are quite popular and investors have pumped around $1 billion over
the past year into the iShares Barclays TIPS (NYSEArca: TIP),
despite a current yield of just 1.72%.
Newer TIPS ETFs like the PIMCO 1-5 Yr U.S. TIPS Index Fund
(NYSEArca: STPZ) and the PIMCO 15+ Yr U.S. TIPS Index Fund
(NYSEArca: LTPZ) have also had strong inflows.
Unfortunately, many income investors have flocked to treasury
inflation protected securities (
) with the misunderstanding they are safe from spikes in interest
If nominal Treasury yields (NYSEArca: IEF) increase because of
higher inflation, TIPS are protected. But if nominal yields rise
because of an increase in interest rates, the price of TIPS can
Put another way, if your TIPS have an average duration of six
years and real interest rates rise by 1%, your implied loss would
be 6%. A 2% increase in real rates would translate into a 12%
Add alternative income strategies
The definition of insanity (one of them) is doing the same thing
over and over - expecting a different result. The fact is income
focused investors are not able to get the same type of income
generation they did before.
Today, the S&P's dividend yield is greater than the 10-year
Treasury yield, which is only the second time since 1947 that's
occurred. These distortions have been caused in part by the Federal
Reserve Bank along with the aftermath of the U.S. financial
Here's the message: Investors better come up with a better game
plan for generating adequate income. You don't necessarily need to
take more risk, but rather, you need to look in the right
ETF Income Mix Portfolio
has generated $6,300 in monthly income year-to-date. The expense
ratio average for this portfolio is a rock bottom 0.18%, which is
five times less compared to a comparable mutual fund portfolio.
By using the right combinationof ETFs, options, and dividend
income, getting better monthly cash flow is possible.
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