Buying For A Risky Yield

05/19/09 09:52:26 AM

by Koos van der Merwe

The market is due for a correction. The maxim "Sell in May and go away" is on everyone's mind. So what do you buy?

Security: RBS.PR.M
Position: Accumulate

The market is due for a correction, so what will you buy? Am I crazy? Should my question not have been, "So, what will you sell?" Probably, but short-selling is risky, especially now that new regulations on short-selling are on the cards, which means that unless you are a professional who is an expert in short-selling, don't even look at it. However, if you insist on playing the short side of the market, buying a put option is a lot less risky than selling short simply because you know that your loss is the cost of the option.

So what should you buy? The answer was suggested by Suze Orman on a CNBC interview when the market started collapsing. "Buy ETFs that pay a good yield," she said, "and don't look at the price for at least a year." Her argument was that as an exchange traded fund, an ETF is a copy of an index. As you know, an index is made up of a number of companies, not a single company that has numerous risks ahead of it, and the yield paid is a risk spread of the dividends paid by each company, with the hope that at least 80% of the companies that make up the index will not cut their dividend. The risk, however, is still there, but greatly diluted.

So you then buy a portfolio of those ETFs that pay a good yield, setting your yield limit at, let us say, 6%. But what about being a little greedy? What if a 6% yield is not enough for you and for the risk you are taking, you would like a greater reward?

There are shares out there that pay an enormous yield in the region of 17%. Admittedly, we all know that the higher the yield, the greater the risk, especially when the yield paid is from a foreign bank that has been 70% nationalized. I am referring to Royal Bank of Scotland preferred shares. Figure 1 is a weekly chart of Royal Bank of Scotland Preferred M shares, listed as an ADR on the New York Stock Exchange.

FIGURE 1: ROYAL BANK OF SCOTLAND PREFERRED M ADR, WEEKLY

Graphic provided by: AdvancedGET.

Note how the price has fallen sporadically from a previously stable high of $26.13 to a low of $1.95. This was the result of the British government buying 70% of the bank and firing its head, Sir Fred Goodwin, and other prominent managers in the bank, replacing them with government-appointed managers. The bank has effectively been nationalized. At $1.95 the yield of the preferreds was in the region of 76%, and only a brave man would have been prepared to take the risk of buying at this level — but many did. They did on the argument that the bank would want to regain its independence from the British government. One of the ways they could raise capital, other than selling highly profitable sections of the company, is to issue preferred shares. If they therefore defaulted on the ADRs, no US investor would buy the preferreds. The argument was sound, and the share price rose to its present level of $10.22, offering a yield of 15.6%.

Do note on the chart the ineffectiveness of the relative strength index (RSI), and how volume since October 2008 has been remarkably constant with the exception of the large volume as the price fell on a gap in the week of January 23, 2009.

FIGURE 2: ROYAL BANK OF SCOTLAND PREFERRED M ADR, DAILY

Graphic provided by: AdvancedGET.

Figure 2 shows how the price has recovered from the low of $2.00 ($1.95) to its present high of $10.65. The RSI is in overbought territory and we could now expect a retracement, a buying opportunity, at any one of the Fibonacci levels shown.

If you are an investor looking for yield, here is a share you should consider, but do be aware of the risk. Be aware also that as the date approaches the dividend declaration cutoff date, the share price could rise and then fall after that date by the dollar amount of the dividend paid. Traders could take advantage of this strategy, investors should hold, and they should say thank you for a comfortable dividend.

Koos van der Merwe

Has been a technical analyst since 1969, and has worked as a futures and options trader with First Financial Futures in Johannesburg, South Africa.

Address:	3256 West 24th Ave
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Buying For A Risky Yield

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