For almost six whole years now, investors have been falling into a deadly trap. And they’re doing so with smiles on their faces, thinking they are pulling-off some very wise manoeuvres, not realizing they have short-changed themselves.
The trap they have been diving headlong into is the yield trap, where they invest in high dividend payers such as telecoms like Verizon (NYSE: VZ) and AT&T (NYSE: T) offering yields of 4.5% and 5.4%, and utilities like Duke Energy Corporation (NYSE: DUK) offering 4.0%, ONEOK Inc. (NYSE: OKE) paying 5.1%, and CenterPoint Energy, Inc. (NYSE: CNP) paying 4.5%.
But what most investors neglect to note is that such high yields come at a cost. When investing there is always a trade-off between two benefits: income and capital gains. You usually get one at the expense of the other, and will rarely get both.
Note that I say “rarely” get both, since there is one vehicle in particular that breaks the mould and does provide both. And it is neither a telecom nor a utility.
But before getting to that pick, let’s first look at the trade-off between yield and capital gains to help us better identify the investment trap that has hurt a great many investors during this marvellous six-year bull run.
The Investment Trade-Off
To get the high income generated by the telecoms and utilities noted above, investors have had to sacrifice capital appreciation, as graphed below.
Since the economic recovery began in early March of 2009, where the S&P 500 index [black] has gained 210%, all of the above listed high dividend payers (except one) have underperformed, ranging from 50% to 140% in capital appreciation over the six years.
Except for ONEOK [orange], which has skyrocketed 500%. Yes, there is always one stock in every bunch that bucks the prevailing trend. But only for a while. In due time, it too is eventually broken-down and ultimately falls back in with the herd, as graphed below.
Over the past 12 months, where all of our highlighted telecoms and utilities have underperformed the S&P, ONEOK has fallen more than all of them at some 22%.
The trade-off is clear to see; high yield comes at the expense of capital appreciation. But it doesn’t need to be that way if we consider how much in dividends the major index ETFs are paying.
As cases in point, the SPDR Dow Jones Industrial Average ETF Trust (NYSE: DIA) which tracks the Dow Jones Industrial Average has paid-out $3.61 in dividends over the past 12 months equalling a yield of 1.99%, while the SPDR S&P 500 ETF Trust (NYSE: SPY) which tracks the S&P 500 index has paid-out $3.83 in dividends over the past year equalling a yield of 1.81%.
Granted, these are about half of the pay-outs received from the telecoms and utilities. But considering the extra capital appreciation of the indices – amounting to some 70% to 160% more as noted in the first graph above – isn’t it worth it to trade 2 to 3 percentage points per year in dividends to capture 70 to 160% more in capital gains?
Of course it is, especially when you consider the tax implications. Remember that dividends automatically have 20% taken away from you right off the top through the Federal Withholding Tax. The 80% you end up collecting is then further taxed at your normal income tax rate. Capital gains, on the other hand, have no withholding tax removed off the top, and in most jurisdictions are taxed at half your normal income tax rate (given that 50% of capital gains are tax exempt – in most jurisdictions, that is).
The Reason for the Trade-Off
There is a good reason why investors are being forced to choose between either high dividend yields or high capital appreciation: the Fed wants it that way.
America’s central bank, the U.S. Federal Reserve, has lowered interest rates to all-time lows near zero, and has kept them there for these past six years for the simple reason that it wants investors to pull out of fixed income and migrate into equities. The intent is for investment capital to flow into the corporations in order to finance their expansion and spur job creation. By lowering interest rates, the Fed has squeezed down the yields of income vehicles like bonds, and income stocks like the telecoms and utilities, in an effort to dissuade investors from parking their money there, and encourage them to move over to the equity market.
Knowing, therefore, that the traffic cop is directing investment flow away from fixed income and toward equity, why would we hamper our own progress by going the other way? You know the rule: “Don’t fight the Fed”.
Of course, interest rates will begin rising at some point, possibly toward the end of this year or the beginning of the next. But they will rise slowly at first, keeping dividends and bond interest exceptionally low for several years more, strengthening the case to remain in equities for the extra capital appreciation that will continue to out-pace even the highest dividend yields.
But if you absolutely insist on dividend income, there is one rare gem to consider, one that provides the best of both worlds: high yield and high capital appreciation.
BDCL – The Best of Both Worlds
The UBS E-Tracs 2-Times Leveraged Wells Fargo Business Development Companies ETN (NYSE: BDCL) may be a mouthful to say, but it is music to the ears of investors who want a high dividend yield without having to sacrifice capital appreciation.
This ETN (Exchange Traded Note, similar to ETF, Exchange Traded Fund, in as much as functionality is concerned) is a fund that tracks the Wells Fargo Business Development Companies index, which itself holds all of the Business Development Companies (BDCs) listed on the NYSE and NASDAQ exchanges, some 41 companies in all.
BDCs are capital investment companies that lend to small and medium sized businesses that have difficulty raising capital from traditional banks. As such, the interest rate on these loans is higher than normal, meaning that BDCs generate higher than normal returns on the loans they issue, which often include equity stakes in the companies they are lending to.
Not only do BDCs generate higher than normal interest on their loans, but their BDC status is a special designation that eliminates any federal tax on such income. And since BDCs pay no federal income tax, their net profits are even greater.
But here’s the best part: one of the conditions of the BDC designation is that a BDC must disburse 90% of its net profits to shareholders. This results in some of the highest dividend pay-outs available on the market, with most BDCs paying from 7% to 12% annually.
BDCL, in turn, collects the dividends paid by the BDCs it holds and distributes them to its shareholders… but at twice the rate. Remember that BDCL is a 2-times leveraged fund, meaning that it holds twice the number of shares of each BDC it holds using margin. The payout is thus twice as large, currently yielding some $4 per year, or 18.26%.
OK. So BDCL is definitely a great dividend payer. But what about capital appreciation? Is there not a trade-off to be made here too? Not when we consider what makes BDCL’s stock move, as graphed below.
What makes BDCL move is interest rates, since Business Development Companies derive their income from the interest they collect on their loans. The graph below shows a remarkable correlation between the price of the BDCL (beige) to the yield of the U.S. 10-Year Treasury Note (black). The two rise together (green) and fall together (red) with remarkable precision.
Now, then, what do we know about the movement of interest rates going forward? We know that the Fed will begin raising rates at some point over the medium term, and will continue lifting them for the next several years until they return to their normal average near the 5 to 6% area.
And what do we know about the movement of the BDCL ETN? We know that when interest rates rise, its stock price rises with them, as graphed above.
Thus, even though BDCL has fallen in price by a significant amount over the past year in sync with the fall in the 10-year yield from the start of January 2014 until the end of January 2015, the next five years promise significant upside in BDCL’s price as interest rates and bond yields rise. And in the meantime, BDCL holders are still collecting between 15% and 20% per year in dividends.
While in most cases, an investment generally requires a trade-off of between yield and capital gain, where investors are forced to choose one over the other, BDCL does not impose any such demand on its shareholders – offering not only the best of both worlds, but in ample measure to boot.