High yield stocks can be both a blessing and a curse to income investors. Most of these companies pay out a significant amount of income as dividends or distributions so may have to raise funds frequently. This can result in a big hit to shares on dilution or the fear that the dividend could be cut.
These companies need strong catalysts to support their yield and send shares higher and I think I've found three catalysts that could send three of my favorites higher.
Linn Energy (NASDAQOTH:LINEQ) has been rocked by several negative articles in Barron's over the past year alleging that its accounting practices misrepresent distributable cash flow. Units pay a monthly distribution and a 9.4% yield with the price up 30% since the first article was published last summer. The company is an upstream energy producer so unit prices will be more correlated with energy prices than midstream energy transporters that own pipelines.
Linn completed its delayed acquisition of Berry Petroleum and has largely laid to rest rumors about cash flow. Fool contributor Matt DiLallo highlighted the company's recent asset trade with ExxonMobil (NYSE:XOM) and found one source of upside overlooked by the rest of the market. Linn Energy agreed to trade a portion of its Permian Basin properties for a portion of ExxonMobil's interest in Hugoton Field, in which Linn has identified more than 400 future drilling locations.
The company picked up 2,400 shallow-decline, liquids-rich natural gas wells in the Hugoton Basin, including the Jayhawk Gas Plant in the deal for $1.2 billion in 2012. While Linn has improved throughput volumes, the plant is still only at 44% capacity. Production from the new asset at Hugoton Basin will yield another 85 million cubic feet per day, 75% more than the current production and could significantly boost the capacity utilization at the Jayhawk Gas Plant. The company has continuously proven its ability to squeeze production out of mature wells and there could be a stronger upside to the swap than even the catalyst for higher utilization.
Higher natural gas prices have benefited Pengrowth Energy Corporation (NYSE:PGH) and should support the company's 6.4% yield. Pengrowth is also an upstream producer with resources in the Western Canadian provinces of Alberta and Saskatchewan. Natural gas has found support around $4.50 per million BTU, and storage is 35% below its five-year average. Production in North America has continued to set records, but greater consumption and the possibility of larger-scale exports to Asia and Europe should support prices over the long term.
Shares fell hard through 2012 but have since stabilized and are up 37.5% over the last year. The company has guided lower for 2014 production, but most of the decline is on $713 million in asset sales last year. Funds from operations should easily support the company's commitment to the CAD0.04 per month dividend, which would be a 6.3% yield in USD terms. The upside to the near-term weakness in production is that the asset sales were used to fund growth projects, including the company's Lindbergh project in East Central Alberta. The Lindberg project alone is estimated to produce 50,000 barrels per day by 2018, boosting total production by as much as 70% from this year's guidance.
Not only might the company benefit from stronger production, but the shares also carry a potential upside for U.S. dollar-based investors. The Canadian dollar has weakened considerably against the greenback to CAD1.08, a depreciation of 6% over the last year and well off the CAD0.95/$ high in 2011. Slower imports and an oil export boom have helped the country reach a trade surplus this year and achieve a 14-year low in its account deficit. I'm a big believer in top-down investing, and Canada's macro situation is extremely strong relative to the United States and other developed markets. A stronger Canadian dollar against the greenback could not only increase returns in dollar-terms but also prove a strong catalyst for sentiment on the shares.
Fifth Street Finance Corporation (NASDAQ:FSC) is a business development company (BDC) that specializes in lending to small- and medium-sized companies and pays a 10.4% yield. Dividends are not "qualified" so you will pay ordinary income taxes on cash, but this can be avoided by holding the shares in a tax-deferred account like an IRA.
The company announced solid second quarter results with net investment income of $34.2 million, slightly lower than the $36.2 million booked in the previous quarter. Net asset value of the shares was $9.81 and no investments were in non-accrual status.
The company's reported results highlight why it is one of my favorite investments. Fifth Street Finance is able to access the institutional high-grade bond market for a fixed coupon of 4.875% and lend this money out at 10.8% to small and medium-sized businesses. Nearly three-quarters (74%) of the loan portfolio is floating-rate, so the company's margin will increase as rates go higher. Not only could margins improve over the year but investors are able to buy the 10.4%-yielder at a 4.4% discount to its net asset value.
The NFIB small business confidence index surged to 96.6 in May for the third consecutive increase and the highest reading since 2007. The most recent Senior Loan Officer Opinion Survey showed strengthening demand for business loans but only 9.9% of banks easing standards for lending. This all sets the stage for higher demand for loans for BDCs like Fifth Street and results for the rest of the year could surprise higher.
High-yield payers can be more volatile than the general market because of funding needs but that doesn't mean risk-adjusted returns cannot be high as well. Watch for significant catalysts that the market may have missed and keep an eye on dividend coverage.