Don’t get suckered in by these dividend traps – Here’s a better path to 10%+ yields

Who knows if we will be in a sideways market for a while. But the possibility serves as a good reminder of a key investing tactic that everyone should use.

Own dividend yield stocks.

The reason: Over the long run (since 1936) dividends contribute 37% of the S&P 500 total return. You don’t want to miss out on this major contributor to market gains. Dividend stocks aren’t just for “old people.”

What’s more, if we really are in a sideways market, you’ll want to earn some money while you wait for the new bull market to resume. (I think it is already underway, but that’s another story.)

The dividend trap

People who hunt for yield often turn to covered call exchange traded funds (ETFs).

These own underlying stocks and generate income by selling covered calls against the positions. They brandish enticing yields like 12%. So, I understand why people get suckered in to them. YouTube channels tout the high yields, with the requisite photo of a young person blissfully relaxing in a hammock “living off the income stream.”

Sadly, the YouTube videos (one unfortunately has 1.4 million views!) leave out a pesky little detail. You lose a lot of money in covered call ETFs. Do not buy them.

The reason is that selling covered calls for income works out great until a stock rockets up and blows through your strike price. Then you are obligated to sell someone the stock at a price well below market levels, giving up a lot of upside. Since markets generally go up over time, this happens a lot.

Let’s take one quick example of how bad the damage is. The Global X S&P 500 Covered Call ETF (XYLD) pays a sweet 12.8% yield. Just looking at that, visions of hammocks come to mind. The problem is, people who owned this ETF lost a lot of money. Over the past five years, this ETF posted annualized total return of 4.8% vs 9.6% for the underlying index, according to Morningstar. Note that “total return” includes that 12.8% yield. In other words, you lost nearly half the return you would have gotten by just owning an S&P 500 index. Like I said, do not buy these. That sound you just heard was a covered call ETF investor falling out of a hammock.

A better path to 10%+ yield

Instead, a better way to stretch for yield is to go with business development companies (BDCs). These typically finance other companies via debt and equity stakes. BDCs are obligated to pay out a high percentage of earnings. So their yields are high.

There are risks here. But I mitigate those risks by looking for the right combination of qualities (more on this below). There are risks because BDCs with attractive yields are probably lending to more marginal companies that have a higher risk of going belly up. But when the right insiders are buying a lot of the BDC stock in the right patterns, it suggests to me that the risks may be mitigated. Of course, in a severe recession, defaults could pile up. But I am not forecasting a severe recession, so I am not too worried about this. The high yield spread to treasuries remains contained. This is the wisdom of the bond market telling us a severe recession is not on the way.

I recently suggested a BDC to my subscribers that pays a 13% yield. What’s more, you are likely to get outperforming capital appreciation with this name. The last time I suggested it in April 2020 when the same buy signal popped up in my system, it went on to more than double in two years. (Plus, you booked all the yield.)

This BDC invests in small companies but it reduces risk by owning a lot of first lien and second lien secured debt. Here is another interesting factor in the mix. This BDC trades for 30% less than its net asset value. It just upped distributions by 12%, a sign of management confidence. And the right kind of insider buying signal has popped up in this name. All of these factors reduce the risk when owning BDCs.

If you want to learn about the BDC I just suggested, and other stock dividend plays offering 4% yields or more and the potential for capital appreciation (which are a regular part of my stock letter), consider subscribing here. Anyone who subscribes to the yield product in the next two months will get a special deal (to be disclosed when you subscribe).

Thank you for taking a look!

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