Over the weekend, I read with great interest an article purportedly tailor made for retirees searching for yield. The article suggested that Tekla Healthcare Investors (NYSE:HQH), with its roughly 8.5% current yield, was a fantastic closed end fund (CEF) and well suited for retirees. Although I don’t have any objections or strong opinions per se regarding the quality of the underlying stocks contained within this closed end fund, I just want to provide some additional clarity on the mechanics of how this 8.5% yield is achieved.
Incidentally, as of September 30, 2021, if you take a look at HQH’s top ten holdings, only Amgen, Inc. (AMGN) and Gilead Sciences, Inc. (GILD) pay a dividend. As of January 14, 2022, Amgen pays a 3.36% dividend yield and Gilead pays a 3.95% dividend. The other eight stocks do not pay a dividend. Since we have top ten holders list, which represent 41.3% of this closed end fund, as of September 30, 2021, and only two out of those ten stocks pay a dividend, you might be wondering how this CEF could have an 8.5% yield. In other words, where is the yield coming from, it isn’t in the form of dividend payouts by the underlying companies contained within this CEF?
If you visit Tekla Healthcare’s website, you just need to spend a little time browsing as all of the information is readily available.
Lo and behold, if you click on the Distribution tab you will quickly learn that the Fund is able to make quarterly distributions at a rate of 2% of the Fund’s net assets.
If you do a little more digging, there is a section ’19(a) Notices’ that contains the source of the distributions.
For example, for the quarter ending December 31, 2021, the source of the $0.51 per share quarterly dividend was 23% net realized short-term capital gains and the remaining 77% consisted of return of capital or other sources. In other words, during Q4 FY 2021, this CEF paid the dividend by returning shareholders’ principal back.
Now one quarter is way too short a period of time to measure anything, so let’s zoom out and take a look at how this fund has performed over the past five years.
Enclosed below, is the underlying net asset value per share, which has declined by 4% from October 1, 2016 – September 30, 2021 ($24.99 per share to $24.04). During that five year stretch, cumulatively, this CEF paid $9.56 in dividends. So an investor’s total return can be calculated as follows: (-$0.95 capital appreciation +$9.56 in cumulative dividends / $24.99 = 34.5% total return).
Also, please note this CEF’s average expense ratio of about 1.1% per year.
As a proxy for relative value, let’s take a look at iShares U.S. Healthcare ETF (IYH). This is a $3.3 billion Healthcare ETF with a less than 50bps net annual expense ratio, per Yahoo Finance. On September 30, 2016, IYH shares closed at $150.21 per share. On September 30, 2021, IYH closed at $275.92. Also, over that time, IYH investors collected $12.88 of cumulative dividends. So the five year total return of IYH was 92.3%. And again, we are talking apples to apples and the same five year time period.
I think it is pretty clear that IYH’s five year total returns of 92.3% is vastly superior to HQH’s 34.5%. And I am not cherry picking the data here as this is measuring five years of total return and not simply isolating a favorable/ unfavorable one quarter period of time.
Putting It All Together
I understand why retirees are so focused on yield. People work their entire lives to accumulate a nest egg and they need that money to last them and carry them through their retirement years. For many retirees, the fear of outliving your money in retirement is a big one. And the Federal Reserve’s policies have been very bad for savers and retirees. Moreover, many retirees simply want to earn a very safe, predictable, and real return on their principal, perhaps 5%. Given the Fed’s policies, keeping interest rates pinned at or near zero for an extended period of time has meant that high quality and traditional fixed income vehicles, such as investment grade bonds, offer very low yields.
Making matter more complicated, throughout 2021 and continuing into 2022, retirees (and most people living in the real world) have to contend with inflation as the Fed’s policies combined with extraordinary fiscal stimulus in the form of three rounds of stimulus checks have meant that everyone’s purchasing power has diminished.
That said, there are no magic bullets or easy answers here. Reaching for yield sounds great, but how do it hold up when the market has a bad year. Simply owning the S&P 500 has been a great way to generate real returns. In fact, did you know that over the past three years, the S&P 500 is up over 100%, including dividends? However, given how much the S&P 500 has moved up, I understand that many retirees don’t feel comfortable being fully invested in the broader stock market, using the S&P 500 as a proxy.
Before retirees dive head first into a closed end fund, like HQH, just make sure you understand the mechanics of how that 8.5% current yield is derived. It is paid out via long-term and short-term capital gains (think the underlying performance of the stocks contained within the fund and to a much lesser extent from dividends paid out by the companies). Moreover, in down periods, like during October 1, 2018 – September 30, 2019, the net asset value of HQH declined by $3.53 per share, yet this CEF paid out $1.82 per share in dividends. This was simply a return of your principal and not real free cash flow that a business paid out to its shareholders in the form of a dividend, at least not in the traditional sense of the word dividend.
For example, in FY 2020 and FY 2021 (ending June 30th), respectively, Procter & Gamble Company (PG) generated $17.4 billion and $18.4 billion in operating cash flow. Capital expenditures were $3.1 billion in FY 2020 and $2.8 billion in FY 2021. So this left $15.6 billion (FY 2021) and $14.3 billion (FY 2020) in free cash flow. P&G used that free cash flow to pay out $7.8 billion (FY 2020) and $8.3 billion (FY 2021) in dividends. They also bought back a lot of stock, but we are only focusing on dividends portion in this article. Now I am not recommending readers go rush out and buy P&G shares, recently trading at $160 per share and sporting a 2.2% yield. Incidentally, I did write up and recommend SA readers buy PG shares on July 3, 2018, back when P&G shares were then trading at $78.54.
In closing, I am not arguing that the underlying stocks contained with HQH aren’t good companies per se. I am simply saying that a 1.1% annual expense ratio is on the higher side and that from a total return perspective, the S&P 500 and IYH has dramatically outperformed HQH over a five year stretch. Technically, this closed end fund has an 8.5% yield but this is achieved via short-term and long-term capital gains and in down period the dividend is maintained by returning principal (and not free cash flow) back to shareholders.