Warning: Avoid These High-Yielders At All Costs

David Sterman's picture

Thursday, July 24, 2014 - 12:00pm

by David Sterman

When it comes to double-digit yields, there's always a catch.

Some investments, such as the Sandridge Mississippian Trust I (NYSE: SDT) or the Whiting USA Trust II (NYSE: WHZ) offer dividend yields in excess of 20% simply because the market clearly understands that projected income streams will soon peter out. After accounting for the present value of future cash flows, these investments can make sense to investors who want to front-load the timing of income streams.

Other high-yielders, such as oil refiners Alon USA Partners LP (Nasdaq: ALDW) and CVR Refining (NYSE: CVRR), each of which offers a yield in the 15% range, offer erratic dividends (thanks to unpredictable refining profit margins), but can still be suitable for yield-seekers who can stomach that kind of bumpy dividend performance.

Yet in many other instances, a double-digit yield can simply be a trap for unwitting investors. They may have the appearance of steady dividend production, but face tremendous challenges that likely spell a reduction -- or outright elimination -- of the dividend. Here are two examples of the kind of double-digit yielders that you should avoid.

1. Javelin Mortgage (NYSE: JMI)

This company is structured as a real estate investment trust focused on mortgages (mREIT). It borrows at a low cost and buys mortgage bonds that carry relatively higher yields. The difference creates income for investors. But as we get ever closer to the eventual rise in interest rates, this strategy will start to wither away. It's not a risk for 2014, but could start to impact company cash flows (and the dividend) by 2015. The trouble is that investors are already looking ahead to the era of smaller dividends for Javelin, and they are starting to see an overvalued stock.

Analysts at Citigroup, for example, expect Javelin's stock will settle near $11 once the market digests the impact of rising interest rates on this business model. In effect, the current downside of 18% is even greater than the current 13% yield, implying you'd actually lose money on this yield play over the next 12 month.

It's hard to pinpoint how much Javelin's $1.80 a share annual dividend would need to be reduced to reflect any change in rates, but a drop down to $1 or $1.50 might be a suitable range. An even bigger headwind: The value of Javelin's existing mortgage assets will lose value as interest rates rise, as less risky fixed-income investments start to diminish the after-market price of mortgage bonds. So investors may flee this stock before a dividend cut or an asset value writedown.


2. NTELOS Holdings (NasdaqNTLS)

This wireless service provider is already feeling the heat of tough national competition. It's had to heavily invest in its network, which has zapped free cash flow.

NTELOS generated $55 million to $70 million in annual free cash flow in 2009, 2010 and 2011, which supported a robust dividend in excess of $2 a share. Yet over the past two years, free cash flow has averaged just $6 million. The dividend has already been cut to $1.68 a share, which still consumes about $35 million in company cash each year.

Trouble is, NTELOS has nearly $500 million in long-term debt to service and needs to make sure that enough cash flow is kept in reserve to meet future bond obligations. A lack of pricing power in an industry dominated by larger rivals will likely lead management to cut the dividend anew in coming quarters. This is an instance where the current 13.5% dividend yield implicitly suggests such a move is coming. 

Risks to Consider: Many high-yield stocks have benefited from an era of low interest rates and a resulting low cost of capital. But that pillar is slowly going to disappear, and a wide range of today's high-yielders won't be offering such robust yields a few years from now. The market always looks ahead, and these stocks may lose as much on terms of share price drops as they produce income from their dividends.

Action to Take --> Before you look at any high-yield stocks, you need to assess the potential impact of changing interest rates or industry dynamics. Also, take a close look at any high-yield stocks' payout ratios. Whenever a company is paying out more in dividends than it is generating in cash flow, a dividend cut appears almost certain.

America's wealthiest investors have long used REITs to generate safe, rising income for years. But in our latest High-Yield Investing research, we've found another little-known group of investments the wealthy have used to generate dividend yields of 12% or more for decades. To learn more about these special investments, click here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.