Over the last several years we have operated in a low interest rate environment. This has been particularly difficult for investors who rely heavily on investment income for the purposes of servicing living expenses. This has led to countless investors taking undue risk in order to make up for the gap between income and expenses.

To illustrate my case I will use an example of a couple living in the US who retired prior to the Financial Crisis and who have no lucrative defined benefit pension plan.

Our Hypothetical Couple and Their Dilemma

While this couple doesn’t have a defined benefit pension plan, they have lived financially prudent lives. This couple has:

• Worked hard and smart
• Lived well within their means
• Put their children through college/university
• Paid off their mortgage and any other debt

In addition to the above, they have amassed a $2 Million investment portfolio.  At the beginning of 2007 they invested these funds in CDs since they were concerned about the financial stability of most Americans and suspected not all was well; they did not want to run the risk of a permanent impairment to their capital if the economy hit the wall.

At the time, this couple decided they would ladder their CDs with terms ranging from 6 months to 5 years. At the beginning of 2007, they would have been able to purchase CDs in the ~3.5% – 4% range (historical CD rates). Using an average rate of 3.75% they would have generated $75,000 in pre-tax interest income on their $2 Million.

Fast forward to 2016 and none of their CDs are generating yields close to 2007 levels; we’re now in the 0.15% – 0.85% range.

Let’s suppose this couple pulled a rabbit out of the hat and found a financial institution which, out of the goodness of their heart, was willing to pay them 1%.

On $2 Million of CDs, this couple is now generating only $20,000/year in interest income. That is insufficient to sustain their lifestyle and they will need to encroach on their capital for the basic necessities of life.

If this hard working couple, who has done all the right things in life, needs to maintain an annual pre-tax income of $75,000 they would have had to save $7.5 Million. Keep in mind that $75,000 in pre-tax income in 2016 is not the same as $75,000 in pre-tax income in 2007! Imagine what income will be required 10 years from today to be equivalent to $75,000 in 2007!

Alarm Bells Go Off

Longevity is in their genes and this couple realizes the math just doesn’t add up. They will outlive their money unless they make some changes to their investment strategy.

This couple has a lot of free time on their hands so they watch a lot of television. They used to watch entertaining programs but now these entertaining programs are mostly investment news channels.

After being bombarded with a ton of irrelevant garbage they get this ‘AH HA!” moment. There are companies out there that are paying attractive dividend yields. 1% from safe CDs? Forget it! Sub 3% dividend yields from high-quality companies? Forget it! Man, there is a ‘boat load’ of companies paying high single and double-digit yields!

What does this couple do? Well, they don’t really know how to analyze companies so they talk to their neighbors. Their neighbors tell them about ‘stock screeners’ where you can filter information and narrow down a vast universe of companies to a small subset from which you can pick and choose your investments. ‘It is like fishing in a barrel’.

Huge Mistake!

If this couple had accessed the Sure Dividend site they would have found a list of companies with 5%+ dividend yields. Sure Dividend would have also warned them that high dividend stocks make great investments if:

1. the dividend is sustainable
2. the company is still retaining adequate earnings for internal growth

If either of these two ‘ifs’ is compromised, this couple will likely realize sub-par investment returns.

In order to ascertain whether a company meets these two key criteria, it is imperative this couple conduct proper due diligence. Only after doing so can they expect to make an informed decision that the high dividend yield is:

• a warning sign of a company in serious trouble OR;
• a sign a company is experiencing a temporary hiccup because of an isolated situation which the company has identified and for which a strategy has been developed to rectify the situation.

This couple’s research may also reveal that the current high dividend yield is the result of the cyclical nature of the industry in which a company operates (eg. oil and gas industry).

Let’s See If We Can Help This Couple

In order to help this couple avoid the pitfalls of investing in high dividend yield companies of dubious quality, we start by looking at the daily treasury yield curve rates.

Our next step is to select 3 companies from Sure Dividend’s list of companies with 5%+ dividend yields.

We decide to:

• Exclude companies with market caps under $2B and in excess of $50B. The rationale for excluding these companies is that sub $2B market cap companies typically are thinly traded. In addition, this couple is retired so we want to avoid companies that would likely be more susceptible to encounter financial difficulty in the event of an economic downturn;
• Excluded $50B+ market cap companies as they typically have far more levers to pull in order to strengthen their financial position. These mega-cap companies (eg. AT&T) are likely to have a sustainable dividend (that does not mean it will grow quickly) and would very likely be suitable investments;
• Eliminated companies based outside the United States. Sure Dividend’s list of companies includes foreign companies but these stocks are typically thinly traded in the US;
• Removed companies with an average trading volume under 1Million shares. This threshold was arbitrarily set for the purposes of identifying 3 companies.

After narrowing down the universe of companies, we decide not to select the highest dividend yielding companies from this subset and to avoid selecting companies which are all in the same sector.

Our 3 Subject Companies

In this section we perform a very high-level overview of the financial statements, stocks charts, and dividend track record for 3 companies; we do not perform a comprehensive industry and business review.

Ares Capital Corporation

• Market Cap: $6.74B
• Average Daily Volume: 1.77 Million shares
• Dividend Yield: 9.69%
• Additional metrics can be found here.

Ares Capital Corporation (ARCC ) is a specialty finance company that is a closed-end non-diversified management investment company; it is regulated as a business development company (BDC). It provides one-stop solutions to meet the distinct and underserved financing needs of private middle-market companies across diverse industries.

ARCC was founded April 16, 2004, and completed its initial public offering (“IPO”) on October 8, 2004. It is one of the largest BDCs in the US with approximately over $9B of total assets.

Its investment objective is to generate both current income and capital appreciation through debt and equity investments. ARCC invests primarily in U.S. middle-market companies, where it believes the supply of primary capital is limited and the investment opportunities are most attractive. It may, however, periodically invest in larger or smaller (in particular, for investments in early-stage and/or venture capital-backed) companies.

Our couple would be well advised to closely read ARCC’s December 31, 2016, 10-K with particular attention being paid to page 3 of 241 where ARCC indicates its investments are speculative in nature.

“The first and second lien senior secured loans in which we invest generally have stated terms of three to 10 years and the mezzanine debt investments in which we invest generally have stated terms of up to 10 years, but the expected average life of such first and second lien loans and mezzanine debt is generally between three and seven years. However, we may invest in loans and securities with any maturity or duration.

The instruments in which we invest typically are not rated by any rating agency, but we believe that if such instruments were rated, they would be below investment grade (rated lower than “Baa3” by Moody’s Investors Service, lower than “BBB–” by Fitch Ratings or lower than “BBB–” by Standard & Poor’s Ratings Services), which, under the guidelines established by these entities, is an indication of having predominantly speculative characteristics with respect to the issuer’s capacity to pay interest and repay principal. Bonds that are rated below investment grade are sometimes referred to as “high yield bonds” or “junk bonds.” We may invest without limit in debt or other securities of any rating, as well as debt or other securities that have not been rated by any nationally recognized statistical rating organization.”[emphasis added].

If that is insufficient cause for concern for our couple, we encourage them to review ARCC’s Consolidated Schedule of Investments which commences on page 126 of 241 of the 10-K. Our couple reviews same and notes that most of ARCC’s borrowers are paying high single digit and low double-digit interest rates on their loans!

In addition to the above, our couple notices that ARCC investors have been ‘rewarded’ with a historical dividend track record that certainly has not been favorable. To make matters worse, investors have also not fared well from an appreciation in stock price other than if an investment in ARCC was initiated at the height of the Financial Crisis.

This couple decides ARCC is definitely not a suitable investment.

NuStar Energy L.P.

• Market Cap: $2.8B
• Average Daily Volume: 507 Thousand shares
• Dividend Yield: 14.71%
• Additional metrics can be found here

NuStar (NS) is a publicly held limited partnership engaged in the transportation of petroleum products and anhydrous ammonia, and the terminalling, storage, and marketing of petroleum products. It conducts operations through its subsidiaries, primarily NuStar Logistics, L.P. and NuStar Pipeline Operating Partnership L.P.

NS operates through 3 three business segments: pipeline, storage, and fuels marketing.

This couple reviews NuStar’s most recent quarterly financial statement (Q3 10-Q as at September 30, 2017) and notices that a considerable amount of Goodwill and Intangible Assets are reflected; combined they represent ~30% of NuStar’s assets.

They also notice that NuStar also has a considerable amount of long-term debt. In reading the notes which accompany the financial statements they see on page 44 of 61 in the Q3 10-Q that the following credit ratings have been assigned to NuStar’s long-term debt.

These credit ratings are classified as non-investment grade speculative by all 3 ratings agencies.

Given that this couple is looking for a steady stream of income that will hopefully keep pace with, or will exceed, the rate of inflation they have a quick look at NuStar’s distribution history. What they find is that it is less than impressive; there has been no increase in the quarterly distribution since 2011.

They also notice on the September 30, 2017, Balance Sheet (page 3 of 61) a dramatic increase in the ‘Partners’ Equity’.  What they find is that NuStar completed the acquisition of Navigator Energy Services, LLC for approximately $1.5B on May 4, 2017. In order to fund the purchase, it issued:

• 14,375,000 common units for net proceeds of $657.5 million;
• $550.0 million of 5.625% senior notes for net proceeds of $543.3 million;
• issued 15,400,000 of 7.625% Series B Fixed-to-Floating Rate Cumulative Redeemable Perpetual Preferred Units (Series B Preferred Units) for net proceeds of $371.8 million.

After looking at the less than stellar dividend track record, this couple has a quick look at NuStar’s stock chart to see if there has at least been some consistency in the growth of NuStar’s stock price. What they see are wild fluctuations which certainly does not give them comfort.

They do a bit further digging and notice that NuStar’s share count has increased over time (and not just for the Navigator acquisition). A little bit more research reveals that like all partnerships that pay out substantially all of their cash flow, NuStar must rely on external funding sources for growth or acquisitions.

This couple decides NS is definitely not a suitable investment.

Retail Properties of America, Inc.

• Market Cap: $2.99B
• Average Daily Volume: 1.81 Million shares
• Dividend Yield: 5.07%
• Additional metrics can be found here.

Retail Properties of America, Inc.  (RPAI ) is a real estate investment trust (REIT) that owns and operates high quality, strategically located shopping centers in the United States. As at the company’s most recent fiscal year end (December 31, 2016), it owned 156 retail properties representing 25,832,000 square feet of gross leasable area.  Its retail operating portfolio included:

• Neighborhood and community centers
• Power centers;
• Lifestyle centers and multi-tenant retail-focused mixed-use properties;
• Single-user retail properties.

As at September 30, 2017 (Q3 2017) RPAI reported that:

• Total same-store portfolio percent leased, including leases signed but not commenced was 94.2% at September 30, 2017, down 50 basis points (bps) from 94.7% at June 30, 2017, and down 100 bps from 95.2% at September 30, 2016;
• Retail portfolio percent leased, including leases signed but not commenced was 92.7% at September 30, 2017, down 100 bps from 93.7% at June 30, 2017, and down 180 bps from 94.5% at September 30, 2016.

Those results are certainly not encouraging!

In addition, the company’s website indicates it continues to optimize its portfolio by disposing of assets in non-strategic markets as a key component of its strategy.

This suggests that some of its tenants which operate in the traditional bricks and mortar environment have likely been unable to adapt to the changing retail environment. As a result occupancy levels have dropped off thus resulting in certain properties no longer being attractive long-term investments.

This couple looks at the company’s recent dividend history (2012 – 2017) and notices the quarterly payments on the units have remained unchanged for several years. They also take a gander at the 2003 – 2011 dividend history and notice distributions used to be made monthly. They further notice that in March 2012 RPAI:

• triggered a ten to one reverse stock split (this is not a good sign);
• redesignated all its common stock as Class A common stock and paid a stock dividend whereby each outstanding Class A common stock received one share of Class B-1 common stock, one share of Class B-2 common stock and one share of Class B-3 common stock.

This couple realizes the dividend history is unattractive and then becomes more disenchanted with RPAI when they look at the company’s stock’s performance.

This couple decides RPAI is definitely not a suitable investment.

Other Shortcomings

This couple is starting to understand the bigger picture. They perform a similar rudimentary analysis on other 5%+ dividend yield companies. What they find is that in some cases, the yields reflected on stock screeners are not entirely a ‘return ON capital’. In some cases, the yield is also comprised of a ‘return OF capital’.

The more this couple delves into this list of companies the more they uncover! There are actually companies out there that are raising debt to sustain their dividend. In other cases, more shares are issued for ‘general purposes’. Who is to say some of these proceeds are not being used to sustain the dividend?

Yikes! Most of the companies on this 5%+ dividend yield list are far from suitable investments. This couple now suspects their neighbors who told them ‘It is like fishing in a barrel’ really have no clue what they are investing in. It is as if their neighbors have no common sense. Perhaps common sense isn’t common!

What Will Happen When Interest Rates Rise?

One evening while watching the evening news, this couple learns that the Fed has forecast 3 interest rate hikes in 2018. This couple puts two and two together and realizes that this will impact returns on investment vehicles of lower risk. If the gap in yield between lower risk investments and these somewhat more risky investments narrows, what is the likelihood investors, are going to find the 5%+ dividend yielders attractive.

This couple begins to wonder if the luster of these juicy dividend yielding stocks will wane as we enter a rising interest rate environment. In essence, if the shine comes off, will investors ‘head for the exits’ thus putting pressure on the stock prices?

This couple also begins to wonder why on earth people would invest in companies of dubious quality when there are countless great quality companies to choose from. Perhaps investing in sub 3.5% dividend yield companies will not generate sufficient income to service living expenses, and therefore, an encroachment on capital will be required.

While not an ideal situation, at least high-quality companies increase their dividends consistently. In addition, the probability of a permanent impairment to capital is much lower.

This couple ultimately decides investing in great companies really is the strategy to adopt.

Final Thoughts

It is apparent this couple realized that chasing yield can be a recipe for disaster. You can’t target higher yields without reducing your exposure to other favorable metrics.  High yield stocks tend to have lower quality and growth scores, as an example.  Extra caution must be taken when analyzing and investing in high yield stocks.

If, after having read this, you still insist on chasing yield I suggest it may be wise to remember the old adage ‘if it seems too good to be true it probably is’.