Tiptoeing Across the Income Minefield

07/23/2009 9:06 am EST

Focus: GLOBAL

Carla Pasternak

Editor, The Income Investor

Carla Pasternak, editor of High-Yield International, is finding bargains among exchange traded bonds and European banks.

Q. Is the coast now clear for income investors?

A. The market seems to be stabilizing. But Standard & Poor's recently said 2009 is expected to be an abysmal year in terms of dividend cuts and infrequent dividend raises. That said, there are still good values in exchange traded debt and telecoms with predictable cash flow.

Q. I would have thought that a lot of the dividend cuts would have taken place last year.

A. The second quarter of 2009 had 233 S&P 500 companies increasing their dividends, the lowest count and breaking the old record of 265 from 1958. On the other hand, the April through June period included the second-highest number of dividend decreases—250. Foreign equities won't fare much better. According to Bloomberg, European dividend payers are expected to chop payouts by about a third this year and [as much] again in 2010.

Q. What are you doing to distinguish companies whose dividends should be safe from those that might cut further?

A. If it's a fund, I look at the sources of the distribution, go back into the balance sheet and the available tax records, the annual report and notes to the financial statements. I want to see how much of the distribution comes from investment income and of that how much comes from earnings and how much from currency gains, because those are less predictable. How much comes from capital gains, like selling stock or selling options? And how much comes from return of capital, which is the lowest-quality distribution because that's basically grinding down the asset value. A couple that so far seem to have pretty high-quality dividends are the PowerShares Emerging Markets Sovereign Debt (NYSE: PCY) ETF and the Templeton Global Income Fund (NYSE: GIM).

Q. As you look at funds and stocks across a range of geographies and asset classes, where are you finding the best values?

A. Recently I have found wonderful value in exchange traded bonds that are either the lower tiers of investment grade or the upper rungs of sub-investment grade. I featured one—AAG Holdings' 7.5% Senior Debenture (NYSE: GFW)—in January when it was trading at $12.89 and today it's above $18, plus it still pays a 10% yield. These exchange traded bonds are senior debt that trades on the New York Stock Exchange usually. I also like [exchange traded bonds from] Deutsche Bank (NYSE: DKT), US Cellular (NYSE: UZV), and General Electric (NYSE: GEA).

Q. Canadian trusts seem to be offering very nice yields right now.

A. You have to be really careful. I live in Calgary—it's income-trust land right here—and I've done their annual reports and know the CEOs pretty well. A lot of the companies are gas plays, and gas prices are pretty depressed. So, you want to look at the oil/gas production mix and reserves mix. And you want to look at the quality of the oil—pure light crude is where you get the best money. The other thing you want to look at is the hedging—how far out it is and what rate they've hedged at. Some of these guys are smarter than others; some of them have hedged oil prices at $60 and some of them hedged it at $120. So, you can't just grab for the highest yield.

I don't just go for yield—I look at the stability of the yield and the security of the yield. And I end up in the remote corners of the income universe that the carry trade people and institutions don't bother with. So, for example, exchange traded bonds provide unusually high yields but they don't have enough units outstanding and so not enough liquidity for a large institutional investor to move in and out of without really affecting the price.

Q. What sort of value are you seeing in closed end funds?

A. I used to love closed end funds in 2007 before this whole credit crisis hit. And then I got hurt by a couple of them where their asset-coverage ratios were insufficient (a symptom of excessive leverage—Editor) so that they had to suspend or cut their dividends. So that even saying the words closed end funds I get butterflies in my stomach.

But I haven't been able to find anything wrong with the Templeton Dragon Fund (NYSE: TDF). It's a China play with a pretty good yield and a great long-term record. But Chinese plays are so trendy now that I'd rather buy it on a retreat even though it's still trading at a discount [to net asset value].

Q. What about Europe, which no one seems to like?

A. Credit Suisse (NYSE: CS), HSBC (NYSE: HBC; LSE: HSBA), Banco Santander (NYSE: STD), Deutsche Bank (NYSE: DB; XETRA: DBK), and National Bank of Greece (NYSE: NBG) are really turning around. With Citigroup (NYSE: C) crippled and Lehman Brothers and Bear Stearns defunct, the banks that have repaired their balance sheets quickly are ready to gain market share. There is going to be a new banking elite, and some of these European banks are going to be a part of it.

Q. Thank you.

—Igor Greenwald
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