Playing The Yield Field
Investors in common stocks may pay a steep opportunity cost for fleeing to the safety of 10-year Treasury notes, now paying a miserly 2.4% yield.
Low money-market and bond yields are encouraging income investors to explore other pastures. And while the Forecasts favors common stocks with decent yields and strong dividend-growth potential, we occasionally write about preferred stocks, master limited partnerships (MLPs), and royalty trusts. These asset classes are very different from traditional common stocks, and not only because they often pay yields of more than 5%.
Consider the securities listed in the table below. Most trade near their highs, and although investors have probably missed the bulk of the rally, they can still find good yields. Here are a few other things to consider about each investment vehicle before going after the income:
MLPs collect cash flows from tangible assets, such as real estate or energy pipelines. MLPs are run by general partners, who typically own a small stake in the entity. Limited partners buy units — rather than shares — that trade on stock exchanges.
Three main factors contribute to MLPs’ high yields.
• First, MLPs are required to distribute 90% of their earnings to unitholders.
• Second, tax laws allow the entities to keep more of what they bring in. Many MLPs generate their income from depreciating assets, rendering it exempt from federal taxation, leaving more to distribute.
• Third, general partners often have financial incentives to raise the dividend payout for limited partners.
In the past year, a surge of new money has rushed into this corner of the market without a significant fundamental change to its growth outlook. Many MLPs appear fully valued.
Royalty trusts earn income from natural resources, including coal, oil, and natural gas — all assets that deplete over time. Royalty trusts are financing vehicles rather than operating companies, with no real management or physical operations. They collect royalties on resources developed by other companies. Some distribute dividends monthly, others quarterly. Fluctuations in commodity prices can cause dividend payments to vary from one period to the next.
In most cases, federal tax laws do not classify dividends funded from depreciating and depleting assets as income. As such, dividends do not incur an immediate tax hit, instead lowering investors’ cost basis in their shares of the trust. While the investor must eventually pay taxes on any capital gains, they are deferred until the sale of the shares. Investors must also pay income taxes for any states where the royalties are generated.
Preferred stocks are the middle child of the investment world, junior to bonds but senior to common stocks. If a company declares bankruptcy, bondholders are paid first out of the assets, then preferred stockholders, then common stockholders. Unlike dividends of common stock, preferred dividends are often cumulative. That means that in the event of a dividend suspension, preferred shareholders must receive payments in arrears before the common dividend is restored.
While preferreds trade on exchanges like common stocks, they generally behave more like bonds than stocks, with prices highly sensitive to the issuer’s creditworthiness. Financial companies account for almost 90% of the preferred-stock market.
Many preferred stocks carry a call provision that lets the issuer repurchase the stock any time after the call date. That repayment possibility presents reinvestment risk for investors. Companies are more likely to call preferred stock after interest rates decline, when investors could find it difficult to reinvest the proceeds at a similar rate.