The pursuit of yield

It is becoming increasingly difficult to find good-quality securities that offer a combination of respectable returns and reasonable risk. The great bargain-basement sale that followed the end of the income trust era ended about this time last year as savvy investors picked the last of the low-hanging fruit. The mid-level fruit quickly followed and now the whole tree looks rather bare.

With interest rates continuing to drift along at near record lows, the only viable option for decent cash flow is the stock market. But many investors continue to shy away from even the most conservative equities, fearful of a repeat of the crash of 2008-09.

Their concerns are valid. Despite recent developments, the future of the eurozone remains volatile and uncertain. European Commission president José Manuel Barroso was not happy about the recent criticism levelled by Prime Minister Stephen Harper and others. “We are not coming here to receive lessons in terms of democracy and in terms of how to run an economy,” he told a press conference at the G20 meeting in Mexico. But the inescapable fact is that Europe collectively has made a mess of the situation thus far, thereby increasing the risk of another global recession.

Meanwhile, worries increase over the slowing pace of the Chinese economy while the U.S. continues in its election year paralysis.

No wonder income investors are nervous. Only the brave dare venture into the stock market these days.

Unfortunately, the alternatives are not very enticing and in many cases don’t even generate enough return to keep up with inflation. The latest issue of Ontario Savings Bonds, which was on sale last month, promoted the theme “Peace of Mind” and used clever television ads with a “some people don’t like roller-coaster rides” punch line to encourage safety-conscious investors to buy. But the three-year fixed rate bonds paid only 1.5 per cent while the latest inflation rate is 1.2 per cent so the real net gain is negligible. If you were willing to tie up your money for a decade you could get 2.8 per cent but that’s a long time to be locked in.

Let’s face reality here: if you want a decent return, you have to take some risk and invest at least some of your money in the stock market or equity-related funds.

The return will correlate directly with the amount of risk you take. You can earn between 4 per cent and 5 per cent, and sometimes a little more, from high-quality preferred shares. Many of the big REITs are yielding between 4.5 per cent and 5.5 per cent although a few, such as Boardwalk REIT (TSX: BEI.UN), have dropped to the 3 per cent range because of their attractiveness and capital gains potential.

Dividend yields on blue-chip stocks we have recommended in our newsletters range from 1.7 per cent on CN Rail (TSX: CNR) to 5.1 per cent on BCE (TSX: BCE). Income trusts and limited partnerships offer yields of between 4.9 per cent for Brookfield Energy Partners (TSX: BEP.UN) and 8 per cent for Chemtrade Logistics Income Fund (TSX: CHE.UN).

The most promising hunting ground right now for investors who are willing to accept a little more risk is small to mid-cap energy stocks. Many of these are former income trusts whose prices have been beaten down by the prolonged weakness in natural gas and the recent sharp pull-back in oil and natural gas liquids. Some of these stocks are currently priced to yield upwards of 8 per cent, which says a lot about the high degree of risk the market is attributing to them.

There’s no doubt that a high yield may be the harbinger of bad news. An example is Enerplus Corp. (TSX: ERF). Less than a year ago, the stock price was in the $30 range. Then it began a long decline which accelerated in recent months on fears of a cut to the monthly dividend of $0.18 a share ($2.16 a year). On June 11, the stock closed at $13.17 on the TSX, to yield 16.4 per cent. Obviously, that could not last.

It didn’t. The next day, Enerplus’s management announced that the dividend was being cut in half to $0.09 per share ($1.08 per year) effective in July, slicing the yield to just over 8 per cent. Even that still looks very attractive and the new level is probably safe for the foreseeable future. Enerplus closed on July 13 at $13.12. Based on a 12-month forward projection, the new yield is 8.2 per cent. At this level, the shares appear to offer good value for investors who are willing to assume a higher degree of risk in exchange for an attractive return. Now that the dividend cut is behind us, we are unlikely to see another one soon.

Ask a financial advisor if any of the securities mentioned are suitable for your portfolio.

Photo © Chris Lamphear

For information on a three-month trial subscription to Gordon Pape’s Income Investor newsletter go here.

Subscribe to Gordon Pape’s Facebook page . Follow Gordon Pape’s latest updates on Twitter.