Finding a decent income stream in early 2010 was a difficult
task for investors. After all, global stocks were still reeling
from the aftershocks of what was arguably the worst global economic
downturn and credit crisis since the 1930s.
To fight the crisis, global central banks slashed short-term
interest rates to near zero in most developed markets and pushed
down longer-term interest rates by purchasing government
bonds
and
mortgage
backed securities in a process known as "quantitative easing."
And that was only the beginning.
Governments around the world took extraordinary measures to stave
off a global credit freeze. They recapitalized banks with public
funds, guaranteed deposits at financial institutions, and even
nationalized companies on the brink of collapse.
The world's savers were one unintended casualty of central banks'
largesse. While rescuing banks and driving down rates may have
helped resuscitate the credit markets and bailed out borrowers, it
also pushed down yields on most traditional low-risk savings
vehicles, including U.S. Treasury bonds, high-grade corporate debt,
bank savings accounts and certificates of deposit.
Rather than settle for the paltry yields these other
investmentsoffer , investors have been increasingly looking to
income stocks instead. But this presents pitfalls of its own.
Consider the case of Paramount Energy Trust. This small Canadian
energy producer sported a
yield
of close to 14% back in 2009. A yield that high would have been
tempting to many investors. But we steered clear of recommending it
to
High-Yield International
readers. Here's why...
The company's acreage in Alberta looked like a low-risk
asset
. After all, producers have been extracting natural gas from this
part of Canada for years, and the geology and characteristics of
the fields are well-known.
Formed in 2003, the trust had a long history of paying monthly
distributions. And while distributions were cut during the
2007-2009 financial crisis, it was not unusual -- many energy
producers cut their payouts as oil and gas prices plummeted after
mid-2008. And Paramount had sustained its C$0.05 per month
distribution since April 2009. Some investors undoubtedly reasoned
that even if Paramount cut its distribution another 20% or so, the
yield would remain attractive and far higher than what most other
Canadian royalty trusts were paying at the time.
Shares
in the trust steadily climbed from lows around C$2 in mid-2009 to
around C$5 by early 2010.
But Paramount faced one huge problem: natural gas prices.
The trust's heavy focus on producing natural gas from fields in
Alberta was a tailwind as gas prices climbed steadily for much of
the period from 2003 to 2008. But unlike crude oil prices, gas
prices in North America never regained their footing after the 2008
financial crisis.
The culprit: a jump in low-cost gas production from North America's
vast shale plays such as the Marcellus Shale in Pennsylvania and
the Haynesville shale in Louisiana. A rush of gas from these fields
pushed prices so low that production from Canada's shallow gas
fields was no longer competitive.
Two years later, Paramount, now renamed
Perpetual Energy (Toronto: PMT)
, is trading below C$1 per share and hasn't paid a distribution
since October 2011. The company is taking steps to improve its
fate, including adding exposure to oil, but even under a best-case
scenario it's likely to be a long while before this company pays a
dividend
again.
Paramount is only one example of the perils of blindly chasing
high-yield investments. While there are some quality companies
yielding north of 10% in the current low interest rate environment,
the double-digit yield universe is replete with income traps --
companies that face fundamental headwinds that may soon force them
to slash payouts to investors.
A better bargain for investors: stocks yielding 7% to 9% that have
the potential to grow their payouts steadily over time.
Consider the case of two companies
offering
sizeable dividends at the end of 2009, offshore drilling contractor
Seadrill (
SDRL
)
and U.S. mortgage
real estate investment trust (REIT)
Hatteras Financial (
HTS
)
.
At the end of 2009, Seadrill was yielding roughly 7.5% and paying
$0.50 per quarter, while Hatteras offered a yield of more than 17%
and was paying out $1.20 per quarter.
The chart above shows the value of $10,000 invested in each
stock at the end of 2009. Both companies have performed well,
besting the S&P 500 and most other developed-world
market
stock indexes over an equivalent
holding period
.
While Hatteras now pays $0.90 per quarter (good for a yield of
nearly 13%) instead of $1.20, the drop is mainly a function of the
decline in yields for the government-backed mortgage securities
that the REIT buys rather than any management missteps. Still, I'm
glad I steered clear of Hatteras.
Investors solely looking for dividend yields at the end of 2009
might well have chosen that 17% yield over Seadrill's high
single-digit payout. But Seadrill has been the better performer by
far. A $10,000 stake in Hatteras is now worth about $13,600
including dividends, while a similar investment in Seadrill is
worth more than $18,000. And if you purchased $10,000 in Seadrill
at the end of 2009 and reinvested your dividends every quarter,
you'd now be earning more than $1,500 per year in dividends -- a
15% yield on your initial stake.
That's because Seadrill is now paying a quarterly dividend of $0.80
per share, up 60% since the end of 2009. And with Hatteras now
cutting its distributions, Seadrill is also on track to pay more in
total dividends this year than you're likely to earn out of the
mortgage REIT if you purchased the same $10,000 stake two years
ago.
Risks to Consider:
Just as with the double-digit yielders, you can't automatically
assume a company's dividend is sustainable just because it yields
7% or 8%. Look at metrics like
cash flow
and
payout ratio
, along with company and analyst projections, to determine if you
think the payments are likely to remain safe and grow over
time.
Action to Take -->
In my
High-Yield International
portfolios, I recommend several companies offering high
single-digit yields and the potential to grow their payouts by 7%
to 9% annualized over the next few years, including Seadrill. And
while the yields on these securities may not be as exciting as a
stock offering a 12% or 13% payout, their history of steady
dividend increases over time makes the total return potential
compelling.
-- Paul Tracy
Paul Tracy does not personally hold positions in any securities
mentioned in this article. StreetAuthority LLC does not hold
positions in any securities mentioned in this article.