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  • Protect Your Capital: Never Chase High Yield

    by Donald Cassidy

    While several versions of the so-called efficient market hypothesis (EMH) have lost many adherents in recent years, the opposite proposition—that the market is definitely not totally stupid—is clearly valid. This is crucial for investors to remember when investing for yield.

    Higher current yield reflects greater risk. This is true across asset types and among securities within the same type. Investors who chase yield are gambling, knowingly or naively, that the market is wrong and that their principal will not be significantly impaired. In the current artificial low-yield climate, risk to capital is real but is being ignored more than usual, as investors seek to replicate the income streams available pre-2007.

    This article covers several income-oriented asset types: high-yield bonds, preferred stocks, so-called hybrid preferreds, real estate investment trusts (REITs), master limited partnerships (MLPs), closed-end funds and utility common stocks. While the capital soundness differs by asset type, one key caution is equally true for all: High yield means high risk.

    Unfortunately, some securities salespeople gravitate to high-yield offerings since they are an ‘easy sell’ to clients, who seldom ask penetrating questions about attendant risks. Such pitches should be refused, as they are clues to the offerers’ character. The aftermarket, readily accessed via numerous screening tools, can be just as dangerous for do-it-yourself investors without a salesperson making titillating offers.

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    Donald Cassidy was senior research analyst for Lipper Inc., a Reuters Co., from 1990 to 2006. He recently founded the Retirement Investing Institute, a nonprofit educational foundation, and is the author of five books on personal investing, including “It’s When You Sell That Counts” (now in its third edition). Contact the author at don@R-I-I.org.


    Discussion

    James Vanek from AZ posted over 3 years ago:

    Excellent article! Sorry to say there are
    no free lunches.


    Fernando Robles from FL posted over 3 years ago:

    Many valid points in the article, unquestionably. However, regarding T's dividend, a look at its free cash flow seems to indicate that the dividend is well-covered. The key is nimbly to get in and out when appropriate in all situations because long-term holding is a killer of returns.


    Fernando Robles from FL posted over 3 years ago:

    Many valid points in the article, unquestionably. However, regarding T's dividend, a look at its free cash flow seems to indicate that the dividend is well-covered. The key is nimbly to get in and out when appropriate in all situations because long-term holding is a killer of returns. Interesting that the writer is the author of "It's When You Sell That Counts".


    Erik Rosaen from MI posted over 3 years ago:

    Interesting that T is an AAII dividend pick.


    Kenneth Smith from NJ posted over 3 years ago:

    Good basic article. I agree that Quantum on line is a very valuable resource. I have used it many times to find preferred stocks and it has kept me out of some potential disasters (some RBS preferred shares three years ago).


    Robert Albers from IL posted over 3 years ago:

    I truly applaud you for the reasoned research that went into this article. I have copied it out to my collection of materials on income investing in general. One thought: If you take the word "current" out of "current yield", then a certain type of dividend growth investing (with a concentration of the growth part)would result in a higher income each year one held the asset. Thus, the income goes up, and really, most income oriented investors would be OK with this. The catch is that they have to start with 3%-3% yields, and work higher over time. If someone has the time, then this is a way to reach for yield, but not "current" yield

    Robert Albers, dividendgrowthinvesting.com


    Robert Hardy from MI posted over 3 years ago:

    i have invested in 10 MLP Pipeline over the last 15 years and have found them to be an excellent investment. Pick the best. Tax are paid on about 20% of the mony received and 80% is return of capital.....


    David Fulcher from KY posted over 3 years ago:

    I have made good money on preferred stocks and have been investing in them for years. I only invest in investment grade stocks and never pay over the call price. They have taken a hit lately but most was priced well above the call price.I just collect the dividends and hold on.


    Mary Niedermeier from WI posted over 3 years ago:

    How do you feel about the 5- and 10-year stats for NLY? Can it be looked at longer term?


    Ryan James from AL posted over 3 years ago:

    What about BDCs like MAIN, TCAP, ARCC, and HTGC?


    Henry Hanau from NY posted over 3 years ago:

    I've always been fearful of Preferred Stocks, not because of call features, but the fact that they have the longest maturities of any fixed income instrument.


    M Hinnant from GA posted over 3 years ago:

    An excellent article. I hold all of these instruments with the exception of High Yield Bonds, Hybrid Preferreds, and Mortgage REITS which I have avoided for exactly the reasons given. CEFS (Muni & Corp) have been on a declining price trend since talk (May) of Fed tapering began. I think these could be attractive in the next couple of months.


    Patrick Calby from IL posted over 2 years ago:

    Good basic summary of different kinds of yield producing investments, but a rather short sighted view of how to invest in them. Not much help for the average investor on how to access these types of investments or how to invest in them. They are like most any investment you get involved in. You need to understand it and the risks, buy at good prices, cut back or get out if the prices get too high or they decline more than your tolerence, and in general stick with high quality and good management. Either be a good analyst or have a trustworthy advisor.

    You would be hard pressed to tell anyone who has been invested in MMP for the last 10 years or O and OHI between 2009-2013 that MLPs and REITs are high yield traps. AMLP has been a good investment since it was started in 2010. T and VZ were also very profitable for and pay nice dividends while you are waiting for price appreciation. JNK had a very long run of dividends plus appreciation and the only mistake would have been to sell it. I've been watching junk bonds for going on 20 years and there have been only a few short periods where investing in them would have created a substantial loss. Preferreds have also been an excellent place to invest the last five years. High yield investing can be very profitable investment style and especially for retirees or others with specific income goals. As always the investments need to be monitored and higher yield may may need to be monitored more closely due to potentially higher risk. Risks may be different for these assets now in a rising rate environment than in the long declining rate environment, but to suggest they should be avoided is misleading. High yield definitely has a place in a diversified portfolio. Like any investment style, too much of it can be a problem.

    This is a typical surface type review article that doesn't really offer any meat other than a vocabulary review.


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