Markets

Uncovering Equity Yield Traps

March 28, 2012

7 minute read

by Stephen Petty, American Century Investments

As the low interest rate environment persists, numerous uncertainties continue to abide even as new marketplace concerns begin to emerge. This observation is especially applicable to certain investors that are desperate for current income (yield) opportunities. In their search for equity investments providing attractive returns, many will opt to screen for opportunities using current yield as the main filtering criterion. In situations such as this, those in hot pursuit of rich rates find themselves at risk of falling prey to nasty yield traps. Although yield traps exist in the fixed-income space, this piece focuses on yield traps involving equities.

Pursuing Equity Yield in Today’s Environment

An investment’s total return, at least potentially, has two sources: income and capital appreciation or depreciation. Income can be enjoyed from interest paid by fixed income investments, distributions, or equity dividends. Capital appreciation or depreciation consists of the net change in the market price of an asset. To calculate current yield, annual income is divided by the current price of the security. The stress on “current” in the term current yield is very important. Just because a bond pays a fixed coupon or a stock pays a stated dividend, it does not mean the actual rate of return (current yield) from these income sources will stay constant over time.

Current Yield = annual income (e.g., dividends, interest)
current market price of the security

The current market price is reflected in the denominator of the above current yield formula. As the security’s price rises, the current yield goes down. When the price falls, the current yield goes up. Yield is subject to fluctuation over time as market conditions change and price adjusts to reflect those changes.

Many investors are pursuing yield opportunities because of current financial considerations and global economic conditions. They are doing this in the aftermath of the 2008 Financial Crisis. After seeing equity and other risk-asset nest eggs suffer depreciation of 30% to 40% or more, many shunned the pursuit of capital appreciation and opted instead for income opportunities. Shell-shocked equity investors have been very gun-shy since 2008 and riskier assets have had trouble gaining traction given the on-again, off-again periods of stock market volatility.

For some, this can be viewed as pragmatic, especially in light of the fact that losses for the S&P® 500 Index were over 38% for 2008. Action of some sort needed to be taken to replace what was lost. In this case, many have chosen to pursue the income, as opposed to the capital appreciation, route to equity returns. This may seem like the path of least resistance. To pursue income, one must do a little digging, sniff around, and find the yield. To date, many risk-asset prices have not yet rebounded to pre-2008 levels. Due to that single fact, many investments, particularly those able to maintain dividend (or other income payment) levels, have seen their yields became relatively more attractive (apply the current yield formula above). It sounds simple. It also happens to be dangerously superficial.

The other route to consider is capital appreciation. This approach typically requires more up-front knowledge as well as substantial amounts of patience. Know-how and patience have not won the day. Each of the past four years have seen substantial net outflows from equity mutual funds and big net inflows for bond mutual funds. Resurgence in the capital appreciation approach has not happened, at least not yet. Instead, investors have flocked to bonds/bond funds, dividend payers, and other income products, en masse. As a result, many questions have arisen. Will the tide turn, with respect to which total return route is employed? If and when it does turn, what will bring it about? Will equity yield traps play a role?

The Basics of Equity Yield Traps

Yield traps are prospective investments that offer unsustainably high yields that lure investors in and can result in undesirable consequences, such as capital depreciation or lower-than-expected yields. The basic equity yield trap scenario starts with a security that, regardless of the reason, presents itself with an outsized income contribution to total return (e.g., a dividend-paying stock with an unusually high current yield). This high current yield will attract investors that are screening for income based on highest available current yields. This trap is now in play. The yield trap can spring if: 1) the security price rises significantly, 2) the firm is unable to continue providing the high yield, (e.g., cutting or suspending the dividend payment, or 3) a combination of the two.

In the case of a dividend-paying stock, when market conditions cause the stock price to rise but the dividend payment remains the same, the formula’s denominator increases in size, the numerator stays the same and the overall ratio (current yield) drops. When the stock price stays the same but the dividend is cut, then the denominator stays the same, the numerator decreases in size, and the overall ratio, again, drops. Note that if the dividend payment is suspended, the current yield becomes zero. Finally, if the stock price rises and the dividend payment falls, the current yield is doubly impacted; dropping once again.

Various cyclical and secular factors can act as catalysts for changes in the price of a security or changes in the interest income or dividend payment of a security. Changes in these catalysts can trigger existing yield traps and contribute to new potential yield traps entering into play. Not very long ago, it was the bursting of a huge housing bubble that helped set the stage for a new round of yield traps to come about. A wide range of investors, including soon-to-be retirees, lost a great deal of their invested capital and accumulated retirement income. As these investors have sought to recover and recoup from their losses, many have faced temptation from attractive yield opportunities that actually represent yield traps.

Are Equity Yield Traps a Concern in the Current Financial Landscape?

The low interest rate environment in the U.S. has persisted since coming out of economic recession in 2009. By the Federal Reserve’s reckoning, we can expect low interest rates to continue into 2014. Against this backdrop we can identify quite a few uncertainties that are weighing heavily on equity investors’ minds. These uncertainties, individually or collectively, have the ability to become game-changers in terms of their impacts on financial markets. Having described what yield traps are, how likely they are to come into play and what can cause this to happen is discussed next.

A sampling of economic and financial market uncertainties is listed below:

Slow growth – annual real GDP is expanding at 3% or less;
The specter of inflation continues to lurk in the background;
The pain from the 2008 Financial Crisis is still remembered;
International headlines continue to show they can move markets;
The election year signals potential regulatory and legislative consequences;
The rise of global securities and whether they will have staying power.

How each of these plays out will determine, to a large extent, how sectors, markets, and individual equity securities will be impacted from a yield perspective. Although the first quarter of 2012 has shown that some traditional equity income sectors (e.g., real estate, utilities) have underperformed the broader market, yield play opportunities and yield trap concerns really never go away. The speed with which any one or more of the uncertainties above can impact income prospects deserves respect. It’s possible for reversals of fortune to take place relatively quickly in traditional income sectors, as well as others. Other yield sectors, newer on the scene, (e.g., global securities) are yet another source of yield opportunities and yield trap concerns.

Slow growth continues to wear on the economy. Labor markets have been slow to pick up in some regions, resulting in changes in consumer spending habits, lower sales tax collections, and cuts in state budgets. All this contributes to anxiety and serves to make investment prospects with higher yields more enticing. The looming threat of inflation has the potential to roil fixed income and income-generating equity markets in a big way. Higher inflation in the next few years could make many investments currently on the books look very unattractive.

The persistence of memory regarding the Financial Crisis of 2008 continues to keep many investors on the sidelines with respect to pursuing capital appreciation opportunities. This contributes to the investment spotlight shining brightly on income prospects. International headlines have shown that they can jumpstart volatility in the equity markets at any time. Another round of these headlines has the potential to wreck our current bull market.

This year is a presidential election year. Whether or not the incumbent administration is returned to office will go far in determining the legislative agenda in 2013 and beyond. Financial regulation and health care markets, specifically, could find themselves impacted to a large degree by election results. Lastly, whether or not global securities have the ability to deliver sustainable and attractive yields in this environment remains to be seen. Transparency and geo-political issues associated with these products make it difficult to evaluate true levels of risk.

How Equity Investors Can Navigate this Environment

A fine-tuned picture regarding equity income investing is difficult to bring into focus. Given the uncertainties existing in our current low interest rate environment, the challenges are formidable but not necessarily insurmountable. Individual investors, financial advisors, and retirement plan sponsors can all benefit from securing investment know-how from asset managers pursuing long-term, low volatility investment goals by employing repeatable processes that avoid chasing yield.

The long-term perspective typically includes features that emphasize selection of securities that tend toward stability, avoiding large price swings. The long-term perspective fares well when applied to income investing because it focuses on the staying power of firms to continue generating income and increase these payouts, prudently, over time. Finally, asset managers that employ repeatable investment processes benefit from the mechanism that allows them to gauge success in a consistent manner. The right asset manager can bring to bear resources that allow the consideration of many important investment factors. This is counter to the myopic approach of maintaining a chief focus on screening for high yields.

Displaying patience, securing the know-how, and adopting the long-term perspective are helpful considerations in understanding and avoiding pitfalls such as yield traps in this financial landscape.

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