Like getting a toothbrush for Halloween, some high-yield stocks are more trick than treat. To help dodge these potential losers we asked three of our analysts to give us one high-yield stock to avoid at all costs. Here's what they said.
Prospect Capital invests in debt and equity in private businesses. By law, it must pay out virtually all of its income to avoid taxation, resulting in a big dividend yield.
Its monthly dividend may soon take a haircut, however. Prospect Capital paid out more in dividends than it earned in any quarter of its fiscal 2014 year, and future earnings face high hurdles. It recently restructured many of its portfolio companies in a way that would reduce its net investment income.
Finally, its management team has demonstrated that it doesn't have the best interests of shareholders in mind. As its shares fell by more than 15% to trade below book value, Prospect Capital issued new shares to the public, diluting the wealth of existing shareholders. The external management team benefits from the decision, however, as it results in more assets under management and more fee income for the external management company.
Prospect Capital isn't a mispriced stock; it's a stock where high yields are the result of high risk. Buyer beware.
Eric Volkman: Seadrill (NYSE:SDRL) shares have taken a pounding lately, and I think there's more hammering on the way no matter if the broader stock market recovers. At the moment the company's operating against several negative factors, chiefly falling oil prices and reduced exploration budgets from potential clients.
Seadrill operates in a sector that's hotly competitive. That, combined with a fading outlook for oil, has resulted in a glut of undersea drilling rigs (its stock in trade).
And those rigs aren't cheap. Although the company has lightened its debt burden somewhat of late, it was still on the hook for nearly $11 billion in long-term borrowings at the end of Q2. Its cash and short term investments totaled only $1.7 billion at the time. In terms of cash flow, Seadrill's been spending much more than it's been making for several quarters now, pushing its fat dividend further into unsustainable waters.
The company has certain advantages – a relatively young fleet, and a strong presence in the traditionally lucrative ultra-deepwater segment, to name two – but the overall business is not strong just now, and doesn't look like it'll be for some time. Seadrill is a stock to swim far away from at the moment.
Dave Koppenheffer: High-yield investors owe 2013 a great deal of thanks.
Between 2009 and 2012, falling 30-year mortgage rates made even the weakest of mortgage REITs look attractive. This is because their assets, residential mortgage-backed securities, increase in value when mortgage rates fall.
Then came 2013, which effectively separated the strong from the weak as 30-year mortgage rates rose by one percentage point. Mortgage REITs as a group got hammered, but ARMOUR Residential REIT (NYSE:ARR), in particular, gave shareholders a whopping -35% total return for the year. This was a 10% greater loss than peer Annaly Capital Management.
Since then, ARMOUR has adjusted its portfolio to better manage another rise in rates. However, the defensive actions have lead to feeble returns, a smaller dividend, and a beat-down valuation.
Moreover, with mortgage rates the lowest they have been since the 1950s, mortgage REITs can't earn a big enough yield to benefit from another fall in rates. Therefore, investors need to be very selective because no matter what direction interest rates move the environment ahead will be difficult. So, despite the company's 15% yield, ARMOUR Residential REIT has consistently been one of the industry's worst performers and is one stock investors should avoid.
Dave Koppenheffer has no position in any stocks mentioned. Eric Volkman has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.