Be selective when hunting for high yields and dividends

IN a zero-rate world — in which Singapore is no exception — income investing remains the strategy of choice, says BlackRock, the world's largest asset management firm. But the hunt for yield has also led to inevitable side effects in financial markets. The rush of investors has created pockets of overheating, while narrowing valuations between the top-quality and the less-desirable income assets.

Risks have clearly grown in the markets, with certain investors skating close to the edge on safety and liquidity simply to gain a few extra basis points (bps) of yield. What is the careful and risk-aware investor to do in these circumstances?

According to BlackRock, a multi-asset and multi-geography approach to income investing is the preferred solution. "If some assets are going to win big and others lose a bit, a balanced approach is the way to go," says the firm in its investment outlook for 2013. Apart from a balanced approach, building a higher margin of safety in your investments is also a sound and prudent strategy for the year ahead.

Invest for income only

Starting with the fixed-income market, BlackRock reminds investors to remember their key objective: Invest for income only — and don't count on the capital appreciation of these bonds. This is especially true for investors in the high-yield space. These markets should also be only for long-term investors, who are able to hold their bonds until maturity and are unaffected by the potential price volatility in between.

On the plus side, the (relatively) high yield of these bonds offers a safety cushion against interest-rate hikes. "It took a yield rise of just 15bps in the 10-year German bund to trigger a price decline that would wipe out a year's worth of yield in late November 2012. By contrast, it took a 178bps yield spike to cause the same losses on high-yield bonds of US utility companies," says the firm.

That said, not everything is hunky-dory in high-yield land, says BlackRock. The stampede into high yield has created risks as well as opportunities for smart investors. "The companies issuing the bonds have not changed — they are just more in demand by investors," notes BlackRock. For instance, spreads of lower-rated CCC bonds are closing in on those of B-rated bonds as investors bid up the first group in an almost blind grab for yield. Their spreads are now 70% lower — in the lowest quintile — since the 1980s. Balanced against that is the fact that CCC-rated bonds have arguably become better value than they have been historically because of their lower leverage and improved balance sheets.

Dividend stocks still attractive

Where equities are concerned, BlackRock remains a fan of many dividend-paying stocks as an asset class. It cites the fact that dividend growth has proved itself to be a "great indicator" of future equity returns. "It was the single-largest contributor to nominal returns in the past 40 years across developed markets," says the firm. Dividend-paying stocks also tend to outperform in both bull and bear markets, according to a study of Standard & Poor's 500 stocks since 1970 by Ned Davis Research.

And even as hordes of investors have flocked to dividend-paying stocks over the past few years, the good news is, by and large, they "do not look pricey", especially in the developed markets of Europe and the US, says BlackRock. "Most are still trading at a discount to broader market indices — albeit at shrinking premia," says the firm, with notable exceptions such as US utility stocks, which currently trade at a premium to the S&P 500, from a sizeable discount before the global financial crisis struck.

When deciding which dividend-paying stocks to hold, BlackRock has some advice for investors. "The first rule is to pretty much ignore the yield. Free cash flow, dividend growth, the payout ratio, a clean balance sheet, earnings and revenue growth are much better indicators for success," says the firm.

And when a company offers an outsized payout to attract investors, the questions that should be asked are: Is the dividend safe and is it likely to grow? One way to assess this is to review a company's cash flow after deducting its capital expenditure. By this measure, an alarm sounds delete on US utility stocks, which currently pay out more than is covered by the post-capex cash flows of the companies.

BlackRock also has encouraging views on the outlook for real estate investment trusts (REITs), which have performed strongly on a global basis. The firm says global yields on REITs currently average about 3.7% — a figure it describes as "not bad in a zero-rate world". "More importantly, we expect global dividends to grow 6% to 8% annually in the next two years," adds the firm. And in terms of separating the good from the not-so-good REITs, it advises investors to put a lot of stock into analysing leverage and payout ratios. "The lower, the better," says BlackRock of these ratios. REITs with these qualities also tend to generate stronger earnings growth and returns than others with higher ratios.

This story first appeared in The Edge Singapore weekly edition of Dec 24-31, 2012.

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