There is a dangerous dividend trap set in there. It’s easy to fall, and if you make this mistake, you could cause fatal damage to your nest egg – and your income stream – in 2021.
This is a classic mistake called “hitting yield”. This happens when investors place too much emphasis on an investment’s current dividend yield without considering what is behind that payout. More and more people are making this mistake today.
I know what you are thinking: “Michael, I can easily get around such a mistake.” It’s easy to say, but it can be hard to resist when you’re faced with, say, a 5% payout that seems safe at a time when income like treasury bills and stocks pay 0.8% and 1.5% respectively.
(By the way, this is where closed-end fund investors have an advantage: we can get many higher dividends on stocks and bonds – I’m talking about 7% + payouts – and downside protection when we buy our investments through discounted CEFs.
Buyers of unwanted bonds take more risk for a lower return
This brings me to where I see the next big yield trap forming: high yield (or “junk”) bonds. Yields on these assets actually fell to around 5%, on average, well north of 11% when the COVID-19 crisis hit in the spring.
Yields on these bonds fell because yield-hungry investors piled up, pushing their prices up (and, at the same time, their yields down). You may see desperate yield seekers bidding on the price of the SPDR Bloomberg Barclays High Yield Bond ETF (JNK)!
The problem is, with the surge in coronavirus infections, consumers are staying close to home again. This benefits some businesses, like Amazon.com (AMZN), Apple (AAPL) and Google (GOOGL), but their links are not high efficiency. In fact, some earn less than government bonds!
The companies most negatively affected are those that issue bad bonds. But that hasn’t stopped mainstream investors: They look at JNK’s 5% + yield, compare it to meager payments on stocks and T-bills, and dive nonetheless.
The bottom line is that the junk bond market does not calculate the level of risk involved, which is why we need to be extra careful now – and only buy (or hold) junk bond CEFs trading at healthy discounts. relative to their net asset value.
How to get a 7.2% dividend at low risk (no hitting required)
This brings me back to CEFs, which offer a practical solution to today’s income dilemma, as they give you high returns from investments we are all familiar with.
Take into account Nuveen S&P 500 BuyWrite Income Fund (BXMX). As the name suggests, it owns the stocks of the S&P 500 index. The main difference is that, unlike an index fund, BXMX gives you the bulk of your annual return in cash, thanks to its dividend of 7. 2%. This payout is five times that of the benchmark S&P 500 ETF, and it’s more than what JNK also pays.The fund generates this income stream by selling call options, a kind of contract. which offers speculators the opportunity to buy BXMX’s holdings in the future in exchange for cash now.
This strategy also helps reduce the volatility of the fund, which is why it has a five-year beta rating of 0.86, which means it is 14% less volatile than the S&P 500, even though it holds the same actions.
It also means that, if the market stalls in the future, BXMX will continue to pay its income while protecting itself from large losses. But if the market continues to rise in 2021, as good vaccine news emerges, BXMX will also rise. This is BXMX an attractive cover for the uncertain weeks ahead.
Michael Foster is the senior research analyst for Contradictory perspectives. For more great income ideas, click here to view our latest report “Indestructible Income: 5 trading funds with safe 8.8% dividends.“