We have learned a lot throughout the Stock Market Investing Series (101, 102, 103, 104, 105). We went from the basics of capital appreciation and dividend growth investing methods to how to reach our passive income goals.
Now, we can get into some of the more in-depth yield-producing securities. First, I will review some of the use-cases for these high-yield products. Next, I will spell out why these investments are considered high-risk or sub-optimal. Finally, I’ll discuss the six types of products that can juice up your returns if employed correctly and in moderation.
A quick story about high-yield products. So, there I was in Afghanistan. Just kidding. I didn’t always know about the different stock market products- shockingly, and I didn’t always read either. The first thing I learned about the stock market was dividend growth investing. The DGI community is adamant that your capital gains don’t matter, so if your overall account is down, it is okay as long as your dividends keep flowing in.
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A mentality like this can lead you to buy into yield traps that produce heavy losses. I was buying only dividend growth stocks when I stumbled across a high-yield ETF, Invesco High Dividend Yield Financial ETF (KBWD). The yield was over 10%, and the price was appreciating. So I bought KBWD hand-over-fist. Then March 2020 happened, and everything changed. Slowly all my other stocks were recovering, except KBWD- it stayed down over 50% for a long time.
After a few months, I sold out of all my positions at KBWD. My overall portfolio health improved dramatically. I started investing in index funds for growth. I wanted my dividend portfolio also to experience growth. As I learned more, I discovered that KBWD is almost 100% allocated to the financial sector. The financial industry makes its money when interest rates are high. In March 2020, the Federal Reserve cut interest rates to zero- almost immediately, shares of bank stocks declined severely.
I was over-allocated in KBWD and the financial sector. If I had known anything (about anything), I would have appropriately allocated it into KBWD. From there, when prices were at 50%, I should have bought even more, knowing that when interest rates rose, so would the cost of banks and KBWD. This story proves why you need to understand the bigger picture of the stock market, different sectors, leverage, various instruments, and high-yield products.
High-Yield Use-Cases. Your portfolio may have a use-case for high-yield products. I like to think of my high-yield products as my base income generators. For example, if you were to start a business, you would probably want to keep your day job until your business took off, correct?
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Well, high yield is your day job. I don’t expect my high-yield products to give me capital appreciation. What these products do for me is give me stable and consistent 7-11% yields. I like to think of my dividend portfolio as a seven-layer dip. I first layer on my high-yield products, then older dividend companies, newer dividend companies, index funds, and finally pure growth companies. Using high-yield will keep your portfolio with an excellent yield and covers zero dividends from your pure growth positions.
An example would be if you owned $1,000 of Telsa and $1,000 of KBWD. Tesla would pay no dividend, yet KBWD would. You would not expect KBWD’s price to appreciate (unless you bought at a great time), but you would for Telsa. Your dividend yield would be roughly 5%, and your growth would be astronomical because of Telsa. Not a bad way to have the best of both worlds. Your use-cases may vary.
The risk of high-yield products. Most of these high-risk products use leverage- this means that they borrow money to get high returns. It is the same as buying rental property; you may put down 20% and finance the 80% with a bank loan. The 80% is considered leverage, and the terms of your loan will affect the amount of profit you can squeeze from your rental.
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Because these high-yield products are highly leveraged, they are susceptible to interest rate fluctuations. They usually do better in low-interest-rate environments; as interest rates rise, these products could sell-off in the stock market.
Interest rates are one of the reasons why these products are deemed risky. If protecting capital is your main concern, you will want to limit your investments into the high-yield category. Trust me; I watched my high-yield product take a 50% dip for over 4-5 months. It wasn’t fun at all. I use high-yield as intended now that I have a better understanding of its principles. To supplement a portfolio and juice the gains- not as the cornerstone of your long-term strategy.
I look at companies like Microsoft, Apple, Ally Bank, and Abbvie as my long-term dividend plays that will keep my portfolio growing and paying dividends for a generation or two. I will layer in KBWD and PCI to get a portion of my portfolio, consistently paying me 10%.
The main questions you need to ask before you buy high-yield products are, “How much capital appreciation would I like to earn?” “What dividend yield do I seek from my portfolio?” and “What is my risk tolerance?”
Types of high-yield products. Now it is time to review some of the different high-yield products on the stock market. You may want to dabble in each of these, but before you put in serious money, read more material on each one. They all react to the market individually, and they all have their nuances; the more you know, the more you grow (your profits).
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Real Estate Investment Trusts. REITs are companies that pool money to purchase real estate. I wrote an entire mini-series on REITs; please read that for a deep dive.
Preferred Shares. Preferred shares are outstanding shares that a company sells to shareholders that sit above common stocks. Preferred shares act more like a bond in that they have a face value- when the company redeems them, you will receive the face value.
To maximize the effective yield of preferred, you should attempt to buy them when trading far below par. Buying low allows you to earn a higher profit and receive capital appreciation if it calls the shares. For more on preferred shares, read the book “The Billionaires Secret.”
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Business Development Centers. BDCs are companies that invest in small and mid-sized companies. Mandates for BDCs require them to pay out at least 90% of their profits to shareholders, just like REITs.
BDCs use high leverage and will sometimes take over troubled companies- this may make them a high-risk investment for many investors. For more on BDCs, read this Investopedia article.
Master Limited Partnerships. MLPs can be complex entities to understand, so I recommend reading this Investopedia article. The jest of the article is that an MLP is a partnership, not a single company. You do not buy shares of a company; you buy units.
MLPs offer steady dividends and some capital appreciation. Most investors stay away from these types of investments because the income is not documented on a 1099. Investors receive a K-1. A K-1 can be extremely difficult to file and will most likely require a tax professional.
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Closed-End Funds. CEFs seems kind of vanilla compared to REITs, BDCs, and MLPs. CEFs are mutual funds that have a set (closed) amount of shares. CEFs also trade throughout the business day, unlike mutual funds that trade after hours.
CEFs use leverage as well, which can make them risker than vanilla mutual funds. I buy CEFs for the income and not necessarily for the capital appreciation. CEFs, like all the other high yield investments, are sensitive to interest rates. For more on CEFs, read the book “How to Retire on Dividends.”
The stock market has many investments that can produce high-yield income for you- just ensure you invest in something you understand. If you are unsure, buy a few shares and monitor the security for a year.
I made the mistake of buying KBWD just for the yield, and I got burned. However, I learned a lot from experience, and I unwinded my positions to build a more balanced group of stocks. I still invest in KBWD, but my position is smaller, and I know what the security is and how it performs.
Learning experiences in the stock market are invaluable. No matter how much I write, you will need to jump in and invest for yourself. From this, you will learn your style. High-yield investments are a great way to supplement your dividend or growth portfolio. I love the consistent income, and any capital appreciation is welcome but not expected. I plan to dig deeper and write more about BDCs, Preferred, MLPS, and CEFs. Stay tuned.
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Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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