ENB - Deluxe Bonds And Dividend Traps

2023-11-07 01:14:00 ET

Summary

• Deluxe bonds can play a useful role in your portfolio, but dividend traps can seriously hurt your retirement.
• A dividend trap is a stock that has nothing to offer besides its yield.
• Having high-yield stocks in your portfolio is not a bad strategy as long as they provide dividend growth.

Deluxe bonds and dividend traps are high-yield stocks. Deluxe bonds can play a useful role in your portfolio, but dividend traps can seriously hurt your retirement. Know the difference between them.

After writing at length about the qualities of low-yield, high-growth stocks, and the reasons you should have some, it's time I offer some insight about high-yield stocks.

To be fair, high-yield stocks are not all bad investments. Some companies provide a source of high income that is fairly sustainable for investors. Some even outperform the market! Having a few of those in your portfolio might be a good idea.

What's a deluxe bond?

I coined the term "deluxe bond" to label stocks from which I don't expect much capital appreciation but that offer a good yield (above 4%) and a dividend growth policy that is enough to keep inflation in check. A "real" bond would give a high yield with no growth, so these companies are "deluxe bonds" because they are mature businesses that still generate enough growth to qualify as a dividend grower.

Finding deluxe bonds

To find deluxe bonds, I used the DSR stock screener with the following metric values as filters:

This initial search produced a list of 23 Canadian stocks (down from 28 a year ago) and 74 U.S. stocks (down from 85 a year ago), with some duplicates due to companies trading on both markets. They are all companies with a relatively high yield (4%+) that show minimum growth and a respectable dividend triangle.

To refine the research, I would exclude all companies with a market cap under $2B to avoid fluctuations, which goes against the peace of mind one would expect from "deluxe bonds", and increase the minimum PRO rating to 4 to narrow down the list to fewer than 50 companies.

Canadian deluxe bonds

Canadian banks fit the bill as they provide both revenue and growth. BNS and CM are the closest to being deluxe bonds: they have less growth perspective, but higher yield. However, any Canadian bank could be placed in that category right now due to their generous dividend yields.

Telecoms are also another classic although I prefer Telus ( TU ) ( T:CA ) (T.TO) by a wide margin.

You can't forget pipelines either. Enbridge ( ENB ) ( ENB:CA ) (ENB.TO) and TC Energy ( TRP ) ( TRP:CA ) (TRP.TO) are not known to generate double-digit returns, but they won't fail to make generous dividend payments regularly. Also in the energy sector, is Canadian Natural Resources ( CNQ ) (CNQ:CA) (CNQ.TO) which offers a yield barely above 4%.

Labrador Iron Ore ( LIFZF ) ( LIF:CA ) (LIF.TO) also fits the bill for a deluxe bond. It comes with a bit more volatility, but it certainly has provided investors with some solid dividends in the past.

With the recent drop in stock price, some utilities appeared on that list too! Fortis ( FTS ) ( FTS:CA ) (FTS.TO) and Emera ( EMRAF ) ( EMA:CA ) (EMA.TO) are great companies that recently reaffirmed the dividend growth policy through 2026.

U.S. deluxe bonds

If we ignore Canadian companies, the list of interesting deluxe bonds in the U.S. is quite short. Of course, you find a bunch of regional banks and energy stocks, but I see them more as speculative plays.

Target ( TGT ) makes the list as its yield is now around 4%. TGT lost more than half of its market valuation from its peak in 2022. I didn't understand the previous hype and it seems the market came back to its senses. TGT will continue to grow inside the US but don't expect much growth here.

UPS ( UPS ) is another that recently joined the 4% club. The company will likely face some headwinds and serious competition going forward, but its dividend is definitely safe.

Realty Income ( O ) and NNN REIT ( NNN ) with yields of 6.1% and 6.4% can be interesting if you want to increase your exposure to REITs.

Caution about deluxe bonds

I use the term "deluxe bond" to describe a company with poor stock price appreciation potential but with a decent yield (above 4%) and a minimal dividend growth policy (at least 3%). However, the wind can turn quickly, turning these deluxe bonds into dividend traps…

What's a Dividend Trap?

A dividend trap is a stock that has nothing to offer besides its yield. Little to no capital appreciation potential and no steady dividend growth in step with inflation.

Most of the time, the company fails with its total return, but income-seeking investors turn a blind eye to this and focus on their dividends. In other words, the stock price declines but as long as the dividend is paid, investors keep smiling. The most pernicious traps are the ones that don't cut their dividend, even increase it to keep the hope alive. Think of a stock like Altria (MO). Many investors like to say " Mo money ", but are they really getting more? I'll let you be the judge:

Over the past 5 years, the stock price lost almost 30%. However, when you consider the dividend, MO's total return comes back to positive territory at 3.4%. Maybe you're tempted to say it's "okay" since you didn't lose money. However, if you had invested in the S&P 500 instead, you would be up 71%. That's a costly choice, in my opinion.

If you want to identify a dividend trap, start by looking at your high-yield stocks and consider their dividend triangle. Is the stock price steadily declining, while the dividend is flat or slightly increasing occasionally? Is there any growth? If there is, is it sustained growth in revenue and earnings? Also, consider your investment thesis. If the word "yield" is part of your thesis, you're on the right track to identify the trap.

Final thoughts

Having high-yield stocks in your portfolio is not a bad strategy as long as they provide dividend growth along the way to cover inflation and perhaps modest capital appreciation. Keep an eye on your high-yielders to make sure you're not falling into a dividend trap.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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