Tuesday, May 27, 2008

Dividends: Selecting the best instruments

In an environment where the market is tanking, dividends have returned to the mindset of many investors.

As outlined in earlier HingeFire material, the best place to find straight out dividend yield with some degree of safety is within Master Limited Partnerships (MLPs), Trust Preferred Securities (TruPS), and Royalty Trusts.

A number of recent articles point to Bond ETFs, REITS, common stocks with dividends, and bank stocks as a source of possible dividends. One recent article from Ben Stein pushes investors in these directions. This advice is faulty for many reasons; this is not the time to over-weight these instruments in your portfolio. There are better dividend yield opportunities with less risk.

Bond ETFs normally do not outperform actively managed bond mutual funds. In an environment where the credit risk of bonds is increasing, and spreads increasing while base interest rates are falling; simply bolding a basket of bonds in an index ETF is a recipe for under-performance.

The yields on REITs are dropping as well as their price. Shortly the payouts on many REITS will be on par with safe bank CDs. Investors in REITs are likely to suffer the continued double whammy of falling yields and an equity price drop.

As the economy further deteriorates, the dividends on many stocks will be cut. The most at risk are bank stocks; the earning results due to the subprime crisis have been dismal. Most banks have already cut their dividend payouts; giants like Bank of America (BAC) are likely to still cut their dividends by close to 50%. This would bring the yield to 3.5% rather than the cheery 7.1% gleefully outlined in the article.

From a risk versus yield perspective, the best situations in the market are Master Limited Partnerships (MLPs), Trust Preferred Securities (TruPS), and Royalty Trusts. Investors in search of yield should focus on these instruments over the upcoming 24 months. As always, it is best to hold these types of dividend securities in a tax-free account such as an IRA. Keep in mind that dividend-bearing securities are simply one component of a properly diversified portfolio.