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Don't Get Caught Holding these Dangerous Income Stocks

The opinions expressed by columnists are their own and do not necessarily represent the views of Townhall.com.

Finding a decent income stream in early 2010 was a difficult task for investors. After all, global stocks were still reeling from the aftershocks of what was arguably the worst global economic downturn and credit crisis since the 1930s.

To fight the crisis, global central banks slashed short-term interest rates to near zero in most developed markets and pushed down longer-term interest rates by purchasing government bonds and mortgage backed securities in a process known as "quantitative easing."
And that was only the beginning.

Governments around the world took extraordinary measures to stave off a global credit freeze. They recapitalized banks with public funds, guaranteed deposits at financial institutions, and even nationalized companies on the brink of collapse.

The world's savers were one unintended casualty of central banks' largesse. While rescuing banks and driving down rates may have helped resuscitate the credit markets and bailed out borrowers, it also pushed down yields on most traditional low-risk savings vehicles, including U.S. Treasury bonds, high-grade corporate debt, bank savings accounts and certificates of deposit.

Rather than settle for the paltry yields these other investments offer, investors have been increasingly looking to income stocks instead. But this presents pitfalls of its own.

Consider the case of Paramount Energy Trust. This small Canadian energy producer sported a yield of close to 14% back in 2009. A yield that high would have been tempting to many investors. But we steered clear of recommending it to High-Yield International readers. Here's why...

The company's acreage in Alberta looked like a low-risk asset. After all, producers have been extracting natural gas from this part of Canada for years, and the geology and characteristics of the fields are well-known.

Formed in 2003, the trust had a long history of paying monthly distributions. And while distributions were cut during the 2007-2009 financial crisis, it was not unusual -- many energy producers cut their payouts as oil and gas prices plummeted after mid-2008. And Paramount had sustained its C$0.05 per month distribution since April 2009. Some investors undoubtedly reasoned that even if Paramount cut its distribution another 20% or so, the yield would remain attractive and far higher than what most other Canadian royalty trusts were paying at the time. Shares in the trust steadily climbed from lows around C$2 in mid-2009 to around C$5 by early 2010.

But Paramount faced one huge problem: natural gas prices.

The trust's heavy focus on producing natural gas from fields in Alberta was a tailwind as gas prices climbed steadily for much of the period from 2003 to 2008. But unlike crude oil prices, gas prices in North America never regained their footing after the 2008 financial crisis.

The culprit: a jump in low-cost gas production from North America's vast shale plays such as the Marcellus Shale in Pennsylvania and the Haynesville shale in Louisiana. A rush of gas from these fields pushed prices so low that production from Canada's shallow gas fields was no longer competitive.

Two years later, Paramount, now renamed Perpetual Energy (Toronto: PMT), is trading below C$1 per share and hasn't paid a distribution since October 2011. The company is taking steps to improve its fate, including adding exposure to oil, but even under a best-case scenario it's likely to be a long while before this company pays a dividend again.

Paramount is only one example of the perils of blindly chasing high-yield investments. While there are some quality companies yielding north of 10% in the current low interest rate environment, the double-digit yield universe is replete with income traps -- companies that face fundamental headwinds that may soon force them to slash payouts to investors.

A better bargain for investors: stocks yielding 7% to 9% that have the potential to grow their payouts steadily over time.

Consider the case of two companies offering sizeable dividends at the end of 2009, offshore drilling contractor Seadrill (NYSE: SDRL) and U.S. mortgage real estate investment trust (REIT) Hatteras Financial (NYSE: HTS).

At the end of 2009, Seadrill was yielding roughly 7.5% and paying $0.50 per quarter, while Hatteras offered a yield of more than 17% and was paying out $1.20 per quarter.

 The chart above shows the value of $10,000 invested in each stock at the end of 2009. Both companies have performed well, besting the S&P 500 and most other developed-world market stock indexes over an equivalent holding period.

While Hatteras now pays $0.90 per quarter (good for a yield of nearly 13%) instead of $1.20, the drop is mainly a function of the decline in yields for the government-backed mortgage securities that the REIT buys rather than any management missteps. Still, I'm glad I steered clear of Hatteras.

Investors solely looking for dividend yields at the end of 2009 might well have chosen that 17% yield over Seadrill's high single-digit payout. But Seadrill has been the better performer by far. A $10,000 stake in Hatteras is now worth about $13,600 including dividends, while a similar investment in Seadrill is worth more than $18,000. And if you purchased $10,000 in Seadrill at the end of 2009 and reinvested your dividends every quarter, you'd now be earning more than $1,500 per year in dividends -- a 15% yield on your initial stake.

That's because Seadrill is now paying a quarterly dividend of $0.80 per share, up 60% since the end of 2009. And with Hatteras now cutting its distributions, Seadrill is also on track to pay more in total dividends this year than you're likely to earn out of the mortgage REIT if you purchased the same $10,000 stake two years ago.

Risks to Consider: Just as with the double-digit yielders, you can't automatically assume a company's dividend is sustainable just because it yields 7% or 8%. Look at metrics like cash flow and payout ratio, along with company and analyst projections, to determine if you think the payments are likely to remain safe and grow over time.

Action to Take --> In my High-Yield International portfolios, I recommend several companies offering high single-digit yields and the potential to grow their payouts by 7% to 9% annualized over the next few years, including Seadrill. And while the yields on these securities may not be as exciting as a stock offering a 12% or 13% payout, their history of steady dividend increases over time makes the total return potential compelling.

-- Paul Tracy

Paul Tracy does not personally hold positions in any securities mentioned in this article. 
StreetAuthority LLC does not hold positions in any securities mentioned in this article. 

This article originally appeared at www.streetauthority.com.

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