A Bubble in High Dividend Stocks?

By Markets Fool.com

In a world where the S&P 500yields as much as 10-year U.S. Treasury notes, it's not surprising that investors are using stocks as income investments. If an average portfolio of stocks provides a 2% dividend yield, a portfolio of high-dividend stocks can do even better.

Continue Reading Below

But what if the hunt for yield is just creating a bubble in high-yield stocks? Is the current market for yield stocks indicative of a bubble? To get the answer, we'll look at two high-yield options in the financial sector -- equity REITs and business development companies -- which can offer yields as high as 6% to 12% per year.

The market's biggest income play
Equity REITs buy real estate with leverage, making money on the spread between their funding costs and the rents received from their tenants. One way to test for a bubble in equity REITs is to look at their yields relative to U.S. Treasuries. Over the past 25 years, equity REIT dividend yields have been about 1% higher than 10-Year U.S. Treasury yields.

And if we compare current dividend yields -- dividends are a good proxy for earnings, since REITs pay out virtually all of their earnings as dividends -- we can see that the current spread of 1.33% is well above its historical average.

During the most bubbly market conditions, one would expect spreads to be negative. In bubbly markets, investors pay up for REITs under the generally faulty and somewhat dangerous assumption that perpetually rising real estate values and rental increases can make up for low current yields.

Continue Reading Below

If you look back, you'll see that spreads were the lowest during periods of extreme bullish markets for real estate. REITs rose roughly 20% in 1997, for instance, only to give it all back in 1998. Likewise, REITs swelled in value by nearly 75% from 2005 to mid-2007, only to lose half their value over the next two years.

Are REITs 5% or 10% overvalued? Potentially. But based on their yields relative to risk-free U.S. Treasuries, it would be difficult to make the case that REITs are 50% or 100% overvalued -- the kind of valuation error that happens in a true bubble.

Stepping on the gas pedal for double-digit yields
BDCs, on the other hand, earn money by lending and investing in private companies. Where banks lend to companies based on their assets (real estate mortgages or auto fleet loans, for example), BDCs lend money based on a company's earnings and cash flow generation. This kind of lending is inherently riskier, since there is typically little in the way of collateral to back any given loan. But the rewards are larger, too. BDCs frequently offer dividend yields of 8% to 12% per year.

Anecdotal evidence suggests that the industry is closer to a top than a bottom. Nonaccrual rates -- a measure of how many BDC loans are underperforming -- were near-zero for virtually every BDC from 2010-2014, but are starting to tick up. In addition, loan yields have come down, showing lenders' willingness to compete on price to win new deals.

Finally, regulators and many conservative lenders like JPMorganChasehave warned about a bubbly market. "It is quite likely that the bad loans in the industry are getting done today, when the credit market is so benign and everybody is lending," Doug Petno, chief of commercial banking at JPMorgan, recently said in an interview about buyout financing, a key part of the BDC industry's deal flow.

For the most part, valuations aren't high enough to think that BDC stocks are in bubble territory. Some of the best underwriters, like Ares Capital Corporation , trade at small single-digit premiums to book value. The highest valued of the group, Main Street Capital , trades at about 1.4x book value, or roughly 12 times net investment income, a measure of steady-state earnings power.

So while I don't see signs of a bubble in how they are valued, there is probably some froth in the values of the investments on their balance sheets.

It's important to remember that BDCs, unlike banks, do not and cannot create reserves for future losses. Therefore, I think investors should assume that any BDC's current book value is probably overstated over a full cycle in which losses will inevitably take their fair share of profits.

For the best performers, you'd be smart to assume a 10% discount to reported book value. For the lower-quality BDC stocks, a bigger margin of safety may be more realistic. The best way to test the underwriting quality of any BDC is to see how it has performed on investments it has exited in market transactions. Good BDCs generate more capital gains than losses. Bad BDCs report more capital losses than gains year after year.

The table above should give you a clear look at which companies have a history of quality underwriting. Those with a history of managing risk well -- and producing less volatile results -- probably deserve less scrutiny when it comes to their asset values than those that performed poorly in the last downcycle from 2008-2010.

As for a "bubble" in BDC stock valuations, I think that's a bit of a stretch. However, I think it's clear that the future won't be as friendly to BDCs as the recent past -- a period defined by low losses and rising asset values across the board. A rising tide lifts all ships, but only the most careful risk managers perform well when the tide goes out.

The article A Bubble in High Dividend Stocks? originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.