Beware the

Carrying a high dividend yield is not a sign a strength in this bear market, a Merrill Lynch study warns. If anything, high yields should be viewed as red flag rather than an incentive to invest.

Rapid and extreme price depreciation on U.S. stocks has created what Savita Subramanian, head of U.S. quantitative strategy for Merrill Lynch, is calling yield traps, stocks which have low prices and likely unsustainable yields.

“During typical down markets, companies with above average dividend yield and dividend growth enjoy not just attractive total return, but price appreciation,” Subramanian says. “High dividend yielding companies have underperformed the market by an unusually wide margin this time around, as these are companies much more likely to cut dividends given the credit environment.”

By selecting stocks based purely on yield, investors risk being stuck with a stock with a depressed price that will likely soon eliminate its dividend.

“Roughly one of five dividend yielding companies in the S&P 500 have an ‘unsecure’ dividend,” Subramanian says. “In contrast, at the 1990 market low, one of twenty companies were considered to have risks to their dividend.”

Merrill Lynch’s research finds the payout ratio of the S&P 500 — 188% — is the highest it has reached in the history of the firm’s data. This suggests that risks to dividends are also likely at all-time highs, as they are being paid out against a backdrop of balance sheet deleveraging and declining earnings.

“To reset the payout ratio to its long-term average (about 50%) either dividends would need to be cut down to roughly a quarter of where they are today, or earnings would need to quadruple from current levels,” Sabramanian says. “Earnings and dividends will most likely meet somewhere in between, however this still means further dividend cuts.”

If an investor is going to employ a dividend strategy to get paid by stocks until the market recovers, Subramanian suggest looking for stocks with well capitalized balance sheet that can sustain a dividend, even if the yield is more modest.

“Until credit concerns abate, companies that conserve cash may be rewarded more than those that grow already high dividends at the risk of destroying their capital cushion,” he says. “Companies with reasonable, not stretched, levels of dividend yield have continued to offer downside protection. These companies generally have lower leverage than that of the market, and lower payout ratios than their peers.”

Finding “secure yields”

Income investors looking for an attractive yield and some upside potential may find investment grade corporate debt a more attractive opportunity than dividend stocks.

According to Michael B. Reed, vice president and fixed income portfolio specialist, with Franklin Templeton Investments, even the highest grades of corporate debt were already pricing in catastrophic default scenarios.

“A lot of the downside on investment grade corporate debt was priced in. When spreads were at their widest was when we started to increase our allocations. We felt very comfortable with that,” he says. “Spreads have rallied a bit since they’ve come off that all-time high. If you break out corporate debt the way we do, which is investment grade, high yield, and bank loans, probably of those three, investment grades would be the best.”

Of course, defaults are priced in for a reason. Downward pricing pressure on bonds tends to be top-down, meaning good companies can be lumped in with the bad. Reed strongly advocates a bottom-up individual security analysis when selecting bonds.

“The biggest part of our analysis is trying to figure out what companies are going to be able to meet their obligations, and which are not. Our shop does a lot of fundamental analysis. We do bottom-up analysis on all of [the issuer] balance sheets, so we’re actually tearing apart balance sheets. We look at capitalizations, business plans, prospects for growth, even barriers of entry to the industry,” he says. “We allocate to those companies most likely to meet their debt obligations.”

For this reason, Reed can’t offer any advice on what sectors have more secure yields.

“Our analysts are doing fundamental bottom-up work on each of the names, therefore our sector recommendations are really the outcome of where the analysts are finding value and not so much the result of top-down allocation.”

(04/17/09)