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.

Schwab YieldPlus Funds Tank

For years, Charles Schwab marketed the YieldPlus funds as "a safe alternative to money market funds that preserve principal while being designed with your income needs in mind." Charles Schwab also represented that its YieldPlus funds were designed to provide "high current income with minimal changes in share price."

The Schwab YieldPlus Fund Investor Shares (SWYPX), and Schwab YieldPlus Fund Select Shares (SWYSX) have declined over 30% since July of 2007. Unfortunately for investors these funds had large investments in risky mortgage-backed securities. Morningstar now ranks these two funds as last among ultra-short-term bond funds. So much for the Schwab claim in the marketing literature, “The [YieldPlus] funds provide higher yields on your cash with only marginally higher risk [and therefore] could be a smart alternative.”

An earlier HingeFire article from October (see Grandma’s Money Market Fund feels the SIV pinch) outlined the risks of brokerage money market funds, and why investors should be wary of these instruments.

Now Schwab is offering investors a mere 5 to 12 cents on the dollar of their losses, and demanding that the account holders quickly take the offer. This, of course, drove investors to contact law firms to launch class action suits on their behalf.

Generating Yield – Muni Bond and REITs

Many investors focus on traditional yield-generating instruments such as muni-bonds and REITs when seeking income. Both of these investments have taken significant hits in the recent market turmoil and there is increasing concern over their expected performance in 2008. The underlying economic conditions that have caused their recent dismal performance during the past year have not changed, and investors should be aware of the risks facing these income vehicles.

At first glance the beaten-down municipal bond sector appears to be a solid alternative for income seekers. Proponents such as analysts from Nuveen have talked up the muni market recently stating that there should be a solid recovery into 2008. Others doubt this sunny outlook.

Due to their tax-exempt status, muni bonds usually have lower yields than comparable U.S. Treasuries. However due to the price dive in the muni sector, the yields are now in the same region. The typical triple-A rated 10-year muni bond is yielding 3.9%, while comparable 10-year Treasuries are yielding 4.2%. That means an investor in the 33% federal tax bracket would have to earn more than 5.8% in a taxable bond to beat the muni. Similarly with 30-year bonds, the muni (4.7%) and Treasury yields (4.6%) are virtually the same. To outperform the 4.7% muni, an investor would have to get more than 7% in a taxable bond.

Does this make muni-bonds a good income oriented investment for 2008 – not necessarily. The muni market is fraught with risk and the pricing is merely a reflection of the deteriorating situation. Traditionally muni bonds are thought of as safe because communities can normally increase taxes to cover payments, and local governments tend not to go bankrupt. These simple truths may no longer hold water in some instances, nor have they held true in the past; one example is New York City's fiscal problems of the 1970s and another is Orange County’s (CA) earlier bankruptcy situation.

The issues facing munis were discussed earlier in “ The Muni Bond dilemma". In summary, there are several notable risks facing munis which include:

• The pension payment crisis unfolding in many states and communities.
• Increasing budget shortfalls for basic infrastructure projects.
• Reduced tax collection due to foreclosures.
• Rejection of tax increases by voters in communities facing economic stress.
• Probable insolvency of bond insurance firms (ACA Capital, MBIA, Ambac Financial)
• Falling revenue from community projects.
• Impending court rulings about state tax interest deductibility.
• Community investment fund losses (see Will State SIV Funds bankrupt local communities?).
• An increasing number of bond downgrades from rating agencies.

For those investors evaluating new municipal bond investments, the focus should be on quality and the general financial strength of the backing community. Avoid bonds from areas with high levels of foreclosures, projects with single sources of revenue (theaters, stadiums, etc.), and those insured by agencies on the edge of failure.

REITs are in no better shape. The average apartment REIT was down 27% during 2007. Despite the expectation that many people will move from owning homes to renting, apartment REITs are normally the worst performers during a recession.

Many other REIT segments have not fared much better. The outlook for the coming year shows no improvement. Hotel REITs such as Sunstone Hotel Investors Inc. (SHO) have recently endured down-grades and sunk to new lows. Office and Industrial REITs have demonstrated slowing growth expectations; capitalization leaders such as Boston Properties Inc. (BXP) are down over 24% over the past year. Retail property owners are down over 20%, the Simon Property Group Inc. (SPG) hit new lows recently. While the drop in price makes the valuation on some REITs appear attractive, there is an increasing risk that the dividend payouts may be cut.

One bright spot is Health Care REITs. This REIT sector has more upbeat outlook than others even in the face of a slowing economy. There is a growing demand for health care office space and the lending credit crunch has not slowed build-out. An article from December outlined some of the leaders - Sector Glance: Health Care REITs Rise.

Another sub-sector of REITs that normally holds up in down markets is apartments for college students. The growing demand for college housing is likely not to be impacted by the economic cycle. One REIT focused on this segment is Education Realty Trust (EDR) with a 7.60% yield.

In summary, Muni-Bonds and REITs have numerous headwinds looking forward into 2008. Other yield oriented investments in the energy and natural resource sectors may offer better performance with lower economic risk (see In Search of Yield) Investors should carefully evaluate the potential risks before allocating money to Muni and REIT investments over the upcoming months.

Disclosure: The author does not have a position in any of the income equities mentioned in this article. The information provided does not constitute a solicitation to buy, or an offer to sell securities.