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Chasing Yields and Avoiding Taxes - Buybacks May Be the Only Answer

(Guest Commentary by Rick Konrad – July 29, 2010)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in our regular guest commentator, Mr. Rick Konrad for a guest commentary.  Rick has been a regular guest commentator for several years and offers his unique insights to us in his twice-a-month mid-week commentaries.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will offer his views on the dangers of “chasing yield,” as many investors are still afraid to take on equity risks and thus have been buying bonds and bond funds en masse.  The “chase for yield” has led to significant premiums being priced into fixed income closed-end funds – which is always a danger.  This is a must-read for those subscribers who are heavily invested in fixed come.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “It Ain't Easy to Quit” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


Hard to believe that July is almost over and that before we know it, another year will grind to an end. As I travelled through Florida visiting some of the brokers who carry our products, the reports are very similar: clients are afraid to commit to these markets.

What's bothering them? The market's choppiness has worried many investors especially the still inexplicable flash crash. Bonds seem to represent a great "head in sand" investment. The only game in town is yield and unfortunately, many of the high yield instruments that are out there lack sustainability. We remind readers that chasing yield for yield's sake is a dangerous pursuit!

Consider the sad tale of the Alpine Total Dynamic closed end fund:

Unfortunately, for holders of this high yielding closed end fund, a dividend cut resulted in a very traumatic cut in value. Here is the company's release: http://tinyurl.com/28d86hs

The rationale for the dividend cut was to reduce dividends to a sustainable level. As the release indicates:

"The combination of uncertain European equity prospects and reduced assets with lower dividend income in U.S. dollars was a principal factor leading to this decision to change the dividend amounts and reduce the dividend. The Funds' basic strategies remain one of providing a high level of dividend income together with seeking long-term capital appreciation. Historically, a significant portion of AGD's dividends has been comprised of income benefiting from lower federal tax rates (called Qualified Dividend Income, or QDI). Due to difficult dividend market conditions globally, the Funds have used a more rapid rotation of holdings in its dividend capture program to increase income, thus reducing risks during this market volatility. This has resulted in a reduction in the percentage of QDI distributable by the Fund. In addition, to enhance the execution of its increased rotation in its international holdings, the Funds have utilized swap transactions to gain efficiencies in foreign markets, with the income from these swaps not being qualified for QDI. The Fund's investment advisor has advised AGD's Board that the amount of QDI may continue to be adversely affected by these strategies."

We have often been intrigued by closed end fund strategies. The notion of buying a portfolio at a significant discount to its net asset value is music to a value investor's ears. However, it is becoming a little difficult in the fixed income closed end fund world to find many "bargains."

For example, here is the PIMCO Strategic Global Government Fund (RCS). PIMCO, as we all know, is a highly regarded money manager with over $1 Trillion under management featuring Bill Gross and the innovative thinking Mohammed El-Erian. People have been willing to pay up for this investment expertise. RCS trades at a 15.5% premium to NAV. The expense ratio (according to the www.cefa.org website) is a fairly expensive 1.63%, much higher than the average closed end fund. Here's a look at a few other fixed income closed end funds and their premium to NAV.

Closed end fund

Premium to NAV

Expense Ratio

Income only Yield

PHK

48.72%

1.25%

16.69%

PHT

19.48

1.23

14.92

RCS

15.55

1.63

13.84

MFV

12.67

1.64

10.17

PTY

12.16

1.32

16.16

PCM

12.12

2.67

12.86

WEA

12.12

1.95

16.17

VLT

10.14

2.31

14.13

I see little reason to ever pay more than one buck for one dollar's worth of underlying asset, even less inclined when the money manager is being paid a fairly steep management fee. All of the above closed end funds also utilize a significant amount of leverage, borrowing anywhere from 26% to 55% of the total assets. This drives up management fees, obviously, since a larger asset base is created.  Moreover, the larger asset base also drives up income so long as yields on the portfolio exceed the cost of borrowing, but which increases the risk. Unfortunately, when yields become unsustainable, or dividend payout ratios become unbearable, or short interest rates rise...look out below.

In short, the chasing of yield regardless of risk and regardless of what you pay for the underlying asset is always a dangerous pursuit.

On the topic of yield, one thing on my mind is after-tax yield. Another clear message from brokers is that most clients seem ill-prepared to contemplate the tax changes that are coming around after the end of the year. Politics is an incredibly divisive issue in this country and the fiscal policy and taxation policies that originate from this are at the back of many investors' minds but haven't quite crystallized. By and large, most of the brokers I encountered had supported Obama in the past but have become entirely disillusioned. Healthcare reform seems to have almost no support from them. Financial regulation changes seem to be too vague. Their industry seems under attack. Changes in 12B-1 fees on mutual funds will be under intense scrutiny by investors and most likely draw to a close. The good news from my standpoint, is that perhaps more brokers will shift to a managed money model or to unit investment trusts which do not support these kinds of fees. Let's have a look at some of the taxation changes that are forthcoming. It ain't pretty, and is less than half a year away. P.S. forget about the campaign promise that no one making less than $250,000 will get a tax increase.

Currently all federal tax brackets will be hit:

    • The 10 percent bracket will rise to 15 percent
    • The 25 percent bracket will rise to 28 percent
    • The 28 percent bracket will rise to 31 percent
    • The 33 percent bracket will rise to 36 percent
    • The 35 percent bracket will rise to 39.6 percent
    • Itemized deductions and personal exemptions will be phased out, which is the same thing as raising taxes even higher than just the effect of the above bracket increases.
    • George Steinbrenner may not have been lucky this year but his estate's beneficiaries were. The estate tax exemption will be $1 million, and the top bracket for the death tax will be 55 percent.
    • Capital gains will rise from 15 percent to 20 percent.
    • Forget about QDI, qualified dividend income which had been designed to avoid the double taxation of income at both corporate level and at the personal level. The dividend tax when stock is held for less than one year goes from 15 percent to 39.6 percent. This will then rise another 3.8 percent, to 43.4 percent in 2013.

Margaret Thatcher got it right when she said, "Socialism always fails because eventually it runs out of other people's money." As others have said, it's not what you make that's important, it's what you have left.

Though we have seen a number of very satisfying dividend increases over the last few weeks (check this site: http://tinyurl.com/3agwcw9) with many increases of more than 10%, reflecting a period of very good free cash flow, we may want to start to focus on companies that share value and return capital to shareholders through successful share buyback programs rather than dividends.

As Buffett has always said, there are many ways to get to heaven. Return of capital to shareholders through buybacks if done in a value creating way, can be very effective. Though many companies merely buy back stock to offset dilution of share option issuance, the only effective buyback is one that buys back stock at a discount to its intrinsic value. We have seen far too many companies that have utilized buybacks in a haphazard fashion without regard to underlying value or without regard to how they were adding risk to the capital structure.

Nevertheless, buybacks may become far more popular as a means of returning capital to shareholders in a tax effective way as compared to dividends.

Disclaimer: Neither I, my family or clients own any of the securities mentioned in this post

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