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The Danger In Reaching For Yield

Despite the Federal Reserve increasing interest rates, investors looking for income continue to struggle.

With rates stuck near zero for much of the last nine years, investors have cast a wider and wider net in search of yield. This has been especially true for retirees attempting to stretch fixed pension income. No longer can savings accounts or high quality bonds be counted on to provide decent interest. However, this runs the risk of reaching too far.

As desperation intensified, many investors turned to anything producing an above-average yield, especially in the energy sector. A good example is Houston-based Kinder Morgan, the largest domestic transporter of petroleum products, natural gas and carbon dioxide. Kinder owns more than 80,000 miles of pipeline and 180 storage terminals.

It does not take a rocket-scientist to recognize there is tremendous value in their collection of assets. Furthermore, it would be rather difficult for a competitor to duplicate the footprint of these assets.

Additionally, the cash distributions from Kinder have often been well in-excess of 10% to 12% per year. Compared to money market producing nothing, and government bonds paying less than 3%, the Kinder dividend appeared to be heaven sent.

However, a strong “economic moat,” alone, does not make Kinder a good investment. Many investors were reminded of this recently as Kinder stock fell more than 60% in seven months. In the process, the value associated with the outsized distributions was quickly wiped out.

Going forward, were there warning signs and can these be used by investors to protect in the future?

Currently, the ten year U.S. Treasury bond pays about 2.2% interest. The world recognizes this as a proxy for “default-free.” If you are contemplating an investment that is paying out five or six times the “risk-free” rate, the wise investor will recognize there are other issues and risks at work. If it sounds too good to be true, it usually is.

Secondly, the energy sector—especially those firms structured as Master Limited Partnerships, often engage in aggressive behavior regarding the use of their common stock and debt.

Between 2011 and 2015 Kinder increased their shares outstanding by 180%. In doing so, they used their common stock as currency to make additional acquisitions, expand current operations or to prop up their dividend. Unfortunately, this diluted the ownership and pro-rata earnings of existing shareholders. This strategy can work, but only as long as growth continues and their stock has value. Strategies like this run into a wall at some point.

Between 2009 and 2015 the pipeline operator went from $13 billion in long term debt to more than $40 billion—an increase of more than 200%. Increasing debt alone is not necessarily a bad thing if a firm is growing wisely. Debt does not make you right or wrong, but it magnifies the amount by which you are right or wrong. Furthermore, if your business hits a snag, your banker does not care. They still expect the debt to be serviced.

Understanding this, since 2009 the most that Kinder has earned was $1.2 billion. In a best-case scenario, this represents a 28 to 1 ratio of debt to net income—well above what most investors should be comfortable with.

Lastly, a wise investor should recognize an investment cannot pay out more in the form of dividends than it earns. Since 2009, Kinder has paid out well in-excess of its net earnings to shareholders in the form of a distribution. If the distribution is not supported by internal earnings it is not sustainable long term.

As such, it should be no surprise that Kinder recently announced they would be forced to cut their dividend by 75%. This is bitter medicine for investors who rely on Kinder for cash flow. While management’s decision to cut the dividend probably saved the company, it reinforces the many dangers of reaching for yield in a world of low interest rates.

Kinder Morgan is just one example. Others have suffered even more ruinous results reminding us that there is no such thing as a free lunch. Instead of getting enamored by too-good-to-be-true yields, investors would be wise to stick to quality businesses that provide, plausible, predictable, and consistent returns.

Dave Sather is a Victoria certified financial planner and owner of Sather Financial Group. His column, Money Matters, publishes every other week.

Originally published Decebmer 18 2015, Victoria Advocate