Dividend stocks have been bid up in 2013, and many investors believe the yawn-inducing dividends of 3-4% generally available now aren't worth the risks involved in an overheated income sector.
Many stocks paying higher dividends, in the tantalizing 8-10% range, are paying them out of capital, which is hardly a good thing. A number of companies are paying a fixed dividend where it's mathematically impossible for investors to get their money back just because so many unwary investors are craving big, easy income.
And while there's need to beware, there's also no need to despair.
There's a unique class of dividend paying companies that kick off big dividends but aren't going to sell their investors down the river. And Wall Street doesn't talk about them because they're a bit more complicated than your average income stock because their dividend yields fluctuate.
In some cases, you can get a very good deal in spite of the complexities involved.
What's more, if you're willing to put up with a few peculiarities, this asset class is tax-advantaged, to boot.
Their variable dividends arise directly because these master limited partnerships (MLPs) can avoid paying corporate tax provided more than 90% of their income is distributed to shareholders.
Increasingly, companies have used this provision to spin off parts of their operations to separate entities, relying on the receptive market for dividend stocks to pay an attractive price for them.
Steady but Variable
Most spin-offs of this kind pay fixed dividends. First, the operation concerned may have an income that is effectively fixed; for example the spinoff of a pipeline may ship a fixed amount of product through the pipeline and pay a fixed charge per ton, giving a fixed annual income.
Second, if the income from an operation varies only moderately, and cash flow exceeds income, then dividends can be paid at roughly the highest annual income figure, which then allows the company not to pay tax while still having only a small chance of running out of cash.
But not all MLPs and REITs work the same way.
There are a substantial number of MLPs or equivalent structures that pay out quarterly the actual income earned, and allow that income to fluctuate. That gives investors a fluctuating dividend, which the market generally values lower than a fixed dividend of equal average amount.
And this is where the opportunity arises.
If the market values something lower because it's simply variable, smart investors can buy it cheaper, and earn a superior return.
That's what I'm talking about here.
But not all variable yield MLPs are created equal.
Most MLPs, especially those with fluctuating dividends, rely on a finite pool of assets with a finite lifespan. If an oilfield is expected to last 20 years for example (or if as in some cases only 20 years of the field's production accrues to the MLP), the 5% should be deducted from the yield to reflect that part which is a true return of capital.
In some cases, the calculation is more difficult.