Inverted Yield On Cost Curve

A yield curve is the relationship between yield and maturity. In a "normal" yield curve yields rise as maturity lengthens. When yields drop as the term lengthens, it is referred to as an inverted yield curve. A Yield On Cost (current dividend/basis) curve, like a yield curve, should increase as you move forward in time.

Normally, as dividend stocks' share price and dividends rise over time, the yield on their initial cost should also rise. However, when there are declines in share price, dividends or both, the yield on cost will also decline creating an inverted yield on cost.

Unfortunately, for my most of my income holdings and my income portfolio as a whole, yield on cost is inverted. Of the 35 securities currently in my income portfolio, only 11 of them are not inverted. Since my core rule is to sell a stock when it drops its dividend, all the inversion is coming from declining price. Stocks with an inverted yield resulting from a price decline would include these:

• Bank of America (BAC) - Current Yield: 8.22% - Yield On Cost: 5.39%
• American Capital (ACAS) - Current Yield: 19.00% - Yield On Cost: 10.45%

Of the 11 equities that are not inverted, some of this is due to a long holding period. Put another way, I bought them so long ago that the combination of share price appreciation and increased dividends more than offsets the recent downturn. Two in this category would be (current yields as of 8/29/08):

• Health Care Property Investors Inc. (HCP) - Current Yield: 5.02% - Yield On Cost: 5.71%
• Commercial Net Lease Realty, Inc. (NNN) - Current Yield: 6.61% - Yield On Cost: 7.00%

Securities held for a short period of time easily swing into and out of an inverted position. I don't put too much emphasis on a security's yield on cost until it has been in my portfolio for a minimum of one year and has at least one dividend increase. Two in this category would be (current yields as of 8/29/08):

• Procter & Gamble Co. (PG) - Current Yield: 2.29% - Yield On Cost: 2.48%
• PepsiCo, Inc. (PEP) - Current Yield: 2.48% - Yield On Cost: 2.51%

An inverted yield on cost is not always bad thing. It can sometimes indicate a bargain price, but it can also indicate a company with some serious problems. As always, a detailed analysis needs to be performed before you decide the reason for the inversion.

All current yields listed above are as of 8/29/08.

Disclosure: Long in BAC, ACAS, HCP, NNN, PG and PEP.


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