“Boy, that double-digit yield looks pretty juicy…”

Slow down, big fella.

Often, double-digit yields indicate that the market doesn’t believe the current distribution is sustainable.

Usually, yields move higher as investors perceive more risk. In this way, a higher current return is delivered as a way of responding to those concerns and encouraging ultimate investment. A higher current return, at least in part, protects the investor from a total return perspective, if the price of the stock should decline.

Double-digit yields can certainly mean opportunity, given the right circumstances.

For instance, if a security has just come public, early investors may seek liquidity for reasons specific to their own needs/situation. On the other side, buyers may not be familiar enough with the security to be willing to step up and buy in a significant way. This can create a short-term disconnect between the market price and underlying fundamental value that can be exploited by investors who are willing to be patient for an efficient liquid market to develop.

How can an investor tell the difference? Details matter – details such as:

What business is the company in? And do the characteristics of that business impact the returns investors demand? For instance, mid-cap BDCs tend to have a higher yield than large cap consumer staples stocks.
What is the asset class?  For instance, investors in corporate junk debt demand a higher current return than investors in investment-grade corporate debt.
Where has the security or asset class traded historically?  If the yield has never been in this range before, something could be seriously wrong. Or maybe the entire business-type or asset class has been re-priced in the market.

We believe there are multiple potential resolutions to atypical yields:

Price moves higher to reflect a market mispricing of risk and/or opportunity. The stock moves higher, and the current distribution generates a lower current yield.
Dividend/distribution is cut to reflect more realistic underlying fundamentals and the current yield moves lower.
A combination of price movement and reduction in dividend/distribution noted in each of the above scenarios.
Current yield moves higher as the price declines further placing even more pressure on management to cut the distribution. The classic “value trap” – just because something is “cheap”, doesn’t mean it can’t get cheaper.
The thing to remember is “quality” usually demands a premium and rarely trades at a double-digit yield. However, rolling up your sleeves and carefully taking a good look under the hood can also lead to significant opportunities.

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