By some measures, 2015 hasn’t been a total disaster.
Through the first three quarters of this year, S&P 500 constituents are only down an average of 6.2% on a total return basis (dividends reinvested).
The average stock in the Russell 2000, an index of small caps, is down 7.0%. That’s still not too bad.
However, these returns mask the devastation occurring in high-yield land.
The average U.S.-listed common stock with a trailing 12-month dividend yield of 5% or more is down 19.6%. Here, I’m looking at trailing yield because some of these companies have already cut their dividends.
Others, like Tronox Ltd. (TROX), will soon be forced to cut their payouts. TROX is down 80.7% this year.
In early 2014, I warned that this type of cyclical, high-beta stock would become “corrosive” to shareholders. Many investors have since been burned.
Investors have also been scorched by the dumpster fires known as master limited partnerships (MLPs). The average MLP has a total return of -24.4% this year, although many “upstream” energy MLPs have fared significantly worse.
The “yieldcos” are another noteworthy group of high-yield casualties.
Over the past few years, a plethora of these dividend-paying structures, which typically own renewable energy assets, have been formed by parent companies.
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Given the carnage in various high-yield securities, there’s got to be some value somewhere, right?
Well, caution is still warranted. We have to be worried about dividend and distribution sustainability in many cases.
Also, the commodity bust will continue.
As I said in November last year, I firmly believe that we’ll see some magnificent defaults in the commodity complex. The unitholders of many overly leveraged energy MLPs will be wiped out, and that’s a problem for all MLPs.
Despite these concerns, I do see some interesting opportunities amid the high-yield wreckage.
Mortgage REITs: Better Risk-Reward
Mortgage real estate investment trusts (mREITs) invest in mortgage loans and mortgage-backed securities rather than owning and managing properties like an equity REIT.
I warned about mREITs in early 2014 and suggested that their preferred stocks were a safer bet.
Since then, investors have punished the mREITs due to fears of rising rates (both short- and long-term rates). The average mREIT is down 7.9% on a total return basis this year.
Today, most mREIT common shares are looking far better from a risk-reward perspective. After all, we’re not looking for just high yield, but safe high yield.
As you can see from the chart below, the average (market-cap weighted) price-to-book value for mREITs is 0.86 times. Basically, the level of pessimism is at multi-year highs, and valuations are extremely attractive.
Granted, a flattening yield curve environment isn’t an ideal situation for these companies since the spreads between their short-term funding costs and yields on their investments are narrower. But this is already more than “priced in” given the large discounts to book values across the industry.
Investors who prefer diversification and don’t want to pick individual stocks should take a look at the iShares Mortgage Real Estate ETF (REM), an ETF dedicated to mREITs.
This is one bombed-out industry that both income and value investors should love right now.
Safe (and high-yield) investing,
Alan Gula, CFA