Summary
Investments which produce high current income are a reasonable diversification from stocks. There are reasons to believe the pace of gains in the stock market will decline in coming years, and there can be advantages to receiving a cash income from investments instead of relying on increases in share prices.
Several classes of income-producing securities are described, including:
Current (May, 2018) Typical Yields
Investment-grade bonds 2.5-4 %
High-yield (“junk”) bonds 4.5-6 %
Senior bank loans 4 %
Fixed-rate preferred stocks 5.5 %
Floating-rate preferred stocks 4.5%
Real Estate Investment Trusts (REITs):
Equity REITS 4-6%
Mortgage REITs 8-12%
Business Development Companies 8-10 %
Master Limited Partnerships 6-9 %
Option-Writing Funds 8-9 %
Various funds are available which hold collections of these types of securities. Some closed end funds employ leverage, which increases both yield and volatility. For instance, there are leveraged closed end funds yielding about 8% with preferred stocks and with equity REITs, and yielding around 12% with master limited partnerships. In the current environment with rising interest rates and an expanding economy, commercial mortgage REITs, business development companies, and option-writing funds are likely to continue to deliver equity-like returns of 8-10 % per year, whereas the price of long-term bonds will likely decline.
[Update December, 2021: this article was written a few years back, when overall interest rates were higher. I have not updated the yields cited for the various stocks and funds mentioned here, but the reader should mentally subtract around 1% from many of the yields stated here. In the wake of COVID, the Fed lowered interest rates, and the federal government engaged in massive deficit spending. These factors boosted the prices in the general stock market (e.g. S&P 500) enormously, due to both increases in earnings, and in price/earnings. Growth stocks like the internet titans were favored over income stocks like those described here. We suspect there will be some reversion to the mean going forward].
[Update July 2023: The burst of deficit spending (stimulus money plus enhanced unemployment benefits) put trillions of extra dollars into Americans’ pockets in 2020-2021, even as a huge cohort of 57-65 year-olds permanently left the workforce, which led to an explosion in inflation (more money chasing similar goods and services). In response, the Fed has jacked short term interest rates from near zero to about 5%. Thus, you should mentally add about 2% to the yields discusses in this article for products such as bank loans, floating rate stocks, business development companies, and most mREITs. And add about 1% to most other products, as order of magnitude. Now is a great time to buy fixed income securities like bonds to lock in high interest rates.]
A Case for High-Yield Investments
The data I have seen indicates that if you don’t need to draw down your investment for twenty years or more, you may do well to put it all in stock funds and just leave it alone. For reasons discussed here the average investor will likely do better to buy an index fund like the S&P 500 rather than trying to pick individual stocks. The long term average return (including reinvested dividends) in the U.S. stock market has been about 10 % before adjusting for the effects of inflation. (All my remarks here pertain to U.S. investments; hopefully some aspects may be applicable to other countries [1]).
However, for later phases of life, financial advisors typically counsel investors to allocate some portion of their portfolio to more-stable fixed-income securities that generate cash to spend and keep you from having to sell stocks during a market downturn. Historically, long-term investment grade bonds have been used to provide steady cash, and to serve as an asset which often went up if stock went down. Thus, a 60/40 stock/bond portfolio was considered prudent. That model has been less useful in recent years, since bond yields are so low, and since long-term bonds sometimes fall along with stocks, e.g. if long-term interest rates rise.
Another driver now for allocating some savings into non-stock investments is that after the large run-up in stocks last few years, which has far exceeded gains in actual earnings, the market may well muddle along flatter in the coming decade. According to Vanguard’s 2018 market outlook, the price/earnings ratios for U.S. stocks suggest that they are overvalued, even factoring in the relatively low current interest rate environment [2]. Here we identify some securities which generate stock-like returns (around 10% returns, if the dividends are continually reinvested) via dividend distributions rather than through share price appreciation. These securities often have volatility similar to stocks, so they should be treated in the portfolio as stock-substitutes rather than as substitutes for stable high-quality bonds.
Bonds
A key fixed-income security is the bond. Bonds are issued by corporations and by various government entities. As a simple example, the U.S. government may issue a 10-year bond with face value of $1000 and a stated interest rate of 3%. If you buy this bond, you give the government $1000, and in turn it promises to pay you a series of payments totaling around $30 (3.0% of $1000) per year, and when the bond matures at the end of ten years it will pay you back the $1000.
It is important to note that the market value of an earlier-issued bond will decline if interest rates later rise, and bond values likewise increase if interest rates fall. This effect is more pronounced for long-term bonds. For instance, if interest rates for a 10-year bond suddenly rise from 3% to 4% right after you buy it, customers could then purchase from the government new bonds which pay them $40/year instead of $30/year for the next ten years. Thus, no one will buy your old 3% bond for the full $1000 anymore. Rather, you might get around $900 for it. On the other hand, if you hold a bond that is only a few months away from its maturity, people will pay you roughly its face value since that is what the bond issuer will pay for it very soon. If interest rates rise by 1%, a bond will lose x % of its current value, where x = the “duration” of the bond. The duration is quoted in years, and is typically something like 0.8-0.9 times the number of the years till the bond matures (the exact calculation is somewhat involved).
Chart of U.S. Treasury bond yields for April 2016-early March 2018. Taken from “Investing for Income” page by Bruce Saunders, http://home.earthlink.net/~saundershsd/market/income.html
The chart above shows the yields on U.S. Treasury bonds over the past two years. A two-year certificate of deposit (CD) may pay about what two-year T-bond does. This chart also shows the spread between the ten-year and the two-year bonds. The longer-maturity bonds typically command higher interest rates, to compensate the bondholder for the risk of interest rates rising some years down the road. The two-year bond pays about 2.2%, and the ten-year bond is currently offering about 2.8% interest, which is barely keeping up with inflation. For some years prior to 2017, short-term money market funds yielded essentially zero, but the Fed has started aggressively raising short-term interest rates. Currently a one-year certificate of deposit (CD) yields a little over 1%, and a five-year CD about 2%.
U.S. Treasury bonds and federally-insured CDs are viewed as essentially risk-free yields – – you can pretty much count on getting your promised interest and principal back, but in return you have to accept low yields. This article will describe a number of alternative investment vehicles, which pay higher interest but which carry higher risk.
Investment-Grade Corporate Bonds
High-quality bonds issued by corporations are called investment grade. They carry credit ratings from Standard & Poor’s or Fitch Ratings of AAA, AA, A or BBB and ratings from a third agency, Moody’s, of Aaa, Aa, A or Baa. The highest rated (AAA) corporate bonds, which are deemed to be very low-risk, have been paying around 1-1.5% higher interest than ten-year Treasury bonds, with lower-rated BBB (Baa) investment-grade corporate bonds paying about 2% more than the Treasuries during the past year.
It is possible to buy individual bonds, as discussed in the Appendix. However, instead of researching and buying individual bonds, many investors prefer to buy a fund which holds many bonds. Funds exist which are tailored to various bond types. For instance, the iShares iBoxx Investment Grade Corporate Bond fund (trading symbol LQD) holds a wide spectrum of mainly investment-grade corporate bonds, and currently yields 3.4%. Its average effective duration is fairly long (8.5 years), and so its value can drop precipitously if interest rates rise.
Since it seems that interest rates will be rising for at least the next year or so, investors may want to use shorter-duration bond funds instead, even though the current yield may be slightly lower. The Vanguard Short-Term Investment Grade Investor mutual fund (VFSTX), which holds very high quality bonds, yields 2.4 %, and has an average duration of 2.7 years. This means that if interest rates increase another 1%, this fund might lose 2.7% in value, or about one year’s worth of interest. The Thompson Bond fund (THOPX) uses some clever management to achieve a yield (2.8%) slightly higher than VFSTX but with only 1 year duration. This mitigates the effects of interest rate changes, but THOPX holds some lower-quality bonds, so it would suffer more than VFSTX in a financial crisis. As a temporary holding bucket for cash, the PIMCO Enhanced Short Maturity Active Fund (MINT) yields about 1.8% and has a share price that is extremely steady.
High Yield (“Junk”) Bonds
Bonds rated BB, B, CCC and lower are deemed speculative grade, also called high-yield or junk bonds. These bonds command higher interest rates, to compensate for the risk that some of them may not pay what they promise if the issuing company or municipality falls into difficulty. Also, if there is a general financial crisis, junk bonds and loans tend to drop in price in concert with stocks.
Two of the largest junk bond funds are iShares iBoxx High Yield Corporate Bond ETF (HYG) and SPDR Barclays High Yield Bond ETF (JNK). These index exchange-traded funds tailor their holdings to match some defined high yield bond indices, but don’t otherwise employ active management. These funds are paying a little over 5% interest. The management team at Vanguard High-Yield Corporate bond fund (VWEHX) selects high yield bonds with higher average quality than HYG or JNK, giving a fund with slightly lower yield but which performs appreciably better in downturns. These three funds have average maturities of about 4 years. The PIMCO 0-5 Year High Yield Corporate Bond Index Fund (HYS) has an average maturity of 2 years, and a yield of about 4.5%.
The VanEck Vectors Fallen Angel High Yield Bond Fund (ANGL) holds funds which were originally issued as investment grade, but were subsequently downgraded to non-investment grade. The current yield (about 5%) is a little lower than most junk bond funds, but the value of the fund tends to rise with time as some of the “fallen angels” get restored to investment grade, so the overall total return of this fund over time has been higher than for most high yield funds.
Some Tax Considerations (U.S. federal; details omitted)
“Qualified” dividends from regular companies, and capital gains on assets held more than a year, are taxed at a special low rate of 15%. Short-term capital gains, interest, and most dividends from real estate investment trusts (REITs) and business development companies (BDCs) are taxed as ordinary income, at marginal tax rates which will be 22-24% for joint incomes of $77,401 to $315,000 under the new tax law [3]. Many investors therefore choose to hold high-yielding REITs and BDCs in tax-sheltered accounts like IRAs, and hold shares of regular companies like AT&T or Southern which pay qualified dividends in non-sheltered accounts, along with funds issued by municipalities (states/counties/towns). The interest from most municipal bonds is not taxed, so for someone in a 22% tax bracket, a 5% yield on a muni is like getting 6.4 % interest from a regular bond.
Some funds pay dividends which are classified as “Return of Capital” (ROC). That is real cash in your account, which you can spend or use to buy further shares, but you are not taxed on it immediately. It shows up in taxes when you sell your fund shares, where you will pay (typically) long term capital gains tax on all that ROC which you have received over the years you held those shares.
Types of Funds: Exchange-Traded, Open End, and Closed End
A straightforward type of fund is the exchange-traded fund (ETF). This holds a basket of securities such as stocks or bonds, and its price is constantly updated to reflect the price of the underlying securities. You can trade an ETF throughout trading hours, just like a stock. If you simply hold it, there will be no taxable capital gains events. Many ETFs passively track some index (e.g. the S&P 500 index of large company stocks) and have low management fees.
An open end mutual fund also trades close to the value of the baskets of securities it holds, but not as tightly as with an ETF. You can place an order to buy or sell an open end fund throughout the day, but it will only actually trade at the end of the day, when the share price of the fund is updated to the most recent value of the net asset value. This means that if the market is dropping precipitously, you cannot sell out in the middle of the day – your order will transact at end-of-day prices. Another quirk of open end funds is that buying and selling by other customers can generate capital gains for the fund, which get distributed to all shareholders. Thus, even if you are simply holding fund shares without selling any, you may still get credited with, and taxed on, capital gains. Also, if a lot of shareholders sell their shares at the bottom of a big dip in prices, the fund must sell the underlying securities at a low price to redeem those shares. This hurts the overall value of the fund, even for customers who held on to their shares through the panic. Some mutual funds have minimum purchase amounts, higher annual expenses, and features like sales charges and restrictions on holding periods which are designed to discourage rapid trading.
There are some advantages for open end mutual funds. First, some of them offer skilled active management which may meet your needs better than an index fund. For instance, the actively-managed Vanguard VWEHX fund seems to give a better risk/reward balance than the indexed junk bond funds. Also, open end funds may offer automatic dividend reinvestment, which keeps your money always working for you rather than having your dividends sitting around in cash until you get around to reinvesting them yourself. This is advantageous for a buy-and-hold investor. [4]
Closed-end funds (CEFs) are more complicated. A closed-end fund has typically has a fixed number of shares outstanding. When you sell your shares, the fund does not sell securities to redeem the shares. Rather, you sell to someone else in the market who is willing to buy them from you. Thus, the fund is protected from having to sell stocks or bonds at low prices. The fund’s share price is determined by what other people are currently willing to pay for it, not by the value of its holdings. Shares typically trade at some discount or premium to the net asset value (NAV). The astute investor can take advantage of temporary fluctuations in share prices, in order to buy the underlying assets at a discount and then sell them at a premium. CEFs are typically actively managed, and employ a wider range of investment strategies than open-end funds or ETFs do. CEFs can raise extra money for buying securities, by borrowing money or issuing preferred shares. This leverage enhances returns when market conditions are favorable, but can also enhance losses. Some further aspects of CEFs are discussed below.
Bank Loan Funds
Another type of debt security is a loan. Banks can make loans to businesses, with various conditions (“covenants”) associated with the loans. Banks can then sell these loans out into the general investment market.
Most commercial loans are floating-rate, so the interest received by the loan holder will increase if the general short-term commercial interest rate (usually keyed to the London Interbank Overnight Rate, or LIBOR) increases. Thus, the loan holder is largely protected against inflation. Loans typically rank higher than bonds in order of payment in case the company goes bankrupt, and some loans are secured by liens on particular company-owned assets like vehicles or oil wells. For these reasons, in the event of bankruptcy, the recovery on loans is higher (around 70%) than for bonds (average around 40%). This all sounds good, but it should be noted that the underlying assets, the loans themselves, are very illiquid. If shareholders sell in a market downturn, they will get a poor price for their shares, since the fund will have difficulty finding someone (usually a private dealer) to buy the loans it is trying to unload. Junk bonds face the same liquidity crunch in the event of a market panic.
Various funds are available which hold baskets of these bank loans, also called senior loans or leveraged loans. One of the largest loan funds is the PowerShares Senior Loan ETF (BKLN), which currently yields about 4%. Most of its loans are rated BB and B, i.e. just below investment grade. Week to week, this fund’s value fluctuates less than most high yield bond funds. However, it lost more long-term share value than VWEHX or HYS over the past five years, while also paying less interest. The American Beacon floating rate fund SPFPX has done much better over time- – a conservative policy on choice of loan holdings in the fund has kept share value relatively stable. A bank loan fund may be a reasonable place to park money for a few months, but a better longer-term play (more volatility but much higher yields) in the loan space might be a high quality business development company, as discussed below.
High-Dividend Common Stocks
Most company common stocks are valued for their potential to grow in share price or to steadily keep increasing the size of their dividend. The average dividend yield for the S&P 500 stocks is about 1.8%, which is lower than the current yield of the (risk-free) 2-year Treasury bond.
There are some regular (C-corporation) stocks which are not expected to grow much, but which pay relatively high, stable dividends. These include some telecommunication companies like AT&T (T; 5.5%) and Verizon (VZ; 4.9%), electric utilities like Southern (SO; 5.3%) and Duke (DUK; 4.6%), and petroleum companies like ExxonMobil (XOM; 4.1%) or Royal Dutch Shell (RDS.B; 5.8%). Investors might want to buy and hold some of these individual stocks, since these are among the highest yielding, high quality stocks. Broader funds which focus on large high-quality, high-yielding stocks tend to have lower average yields than the stocks mentioned above. For instance the Vanguard High Dividend Yield Index Fund (VHDYX) currently yields only about 2.7%. The Global X SuperDividend U.S. ETF (DIV; 6.2% yield) holds shares of mainly mid-sized companies with high dividends and relatively stable stock prices. SCHD holds stock that pay a moderate, but growing, dividend.
Preferred Stocks
Companies, including many banks, issue preferred stocks, which often yield more than either bonds or common stock. Like bonds, most preferreds have a fixed yield; some convert from fixed to floating rate after a certain number of years. Unlike bonds, most preferreds have no fixed redemption date. Fixed-rate preferreds are vulnerable to a large loss in value if interest rates rise, since the shareholder is stuck essentially forever with the original, low rate. On the other hand, if interest rates drop, a company typically can, after a few years, redeem (“call”) the preferred for its face value (typically $25) and then issue a new, lower-yielding preferred stock.
Preferred shares sit above common stock but below bonds in the capital structure. Companies have the option of suspending payment of the dividends on preferred stock if financial trouble strikes. However, a company is typically not permitted to pay dividends on the common stock if it does not pay all the dividends on the preferred stock. For preferred shares where the dividend is “cumulative”, if the preferred dividend is suspended for some period of time, the company must then pay preferred shareholders back for all the missed dividends before it can pay anything to the common shareholders.
The largest preferred ETF is iShares US Preferred Stock (PFF). It yields about 5.6%, but holds mainly fixed-rate shares. The PowerShares Variable Rate Preferred ETF (VRP; 4.7% yield) holds variable or floating rate shares, which helps insulate investors from the effects of interest rate raises. The First Trust Intermediate Duration Preferred & Income Fund (FPF) is a closed end fund with more than half its holdings as floating rate. It uses leverage to boost the fund yield to 7.9%, though this also makes it more volatile.
Alternative Investment Vehicles
Various pieces of legislation in the past decades have defined several alternative vehicles for investment. They typically involve passing most of the earnings directly to the shareholders, which avoids taxation at the corporate level. Thus, the distributions from these companies or funds, including dividends from their preferred stocks, are typically taxed as regular income.
Real Estate Investment Trusts
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate properties, and meets a set of statutory requirements. There are three main types of REITs. Most REITs are equity REITs (eREITs). Equity REITs invest in and own income-producing real estate properties, such as offices, apartments, hotels, cell towers, shopping centers, nursing homes, etc. Buying shares in an eREIT is like owning a portion of the properties. Instead of you financing and buying and managing a rental property, the equity REIT does all that for you, and (after extracting some management fees) lets you collect the net income. Over long periods the dollar amounts of their distributions rise (since rents keep increasing with time) and so their share prices likewise rise. Thus, although the current yields of eREITs are not very high, their total return can be more like a high-dividend stock than a fixed-income bond.
Most eREITs trade like long-term bonds, because the rents are generally fairly stable, often not readjusting quickly with interest rates. Thus, their share prices have dropped in recent months with the rise in interest rates. We might expect this drop in share prices to continue as long as interest rates are increasing, but after rates stabilize, we expect the values of eREITs to largely recover. The values of the properties and of the rents extracted from these properties should eventually rise, providing a hedge against inflation. Mortgage REITs (mREITs) invest in and own property mortgages. These REITs loan money to real estate owners and operators not only for mortgages but also for different types of real estate loans or through purchasing mortgage-backed securities. Hybrid REITs invest in both properties and mortgages.
It is hard to generalize about equity REITs, since the different classes of property (cell towers, shopping centers, medical, etc.) behave differently. Very safe, stable plays like apartment buildings pay commensurately low dividends (e.g. 3.7 % for Avalon Bay Communities, AVB). The share price for Omega Healthcare Investors (OHI) has dropped due to its exposure to the overbuilt skilled nursing facility sector, so it currently yields 9.5%.
A plain vanilla way to participate in eREITs is through the Vanguard Real Estate ETF (VNQ). This is a low-fee fund which tracks a diverse U.S. eREIT index, and currently yields around 4.8%. The international counterpart, Vanguard Global ex-U.S. Real Estate Index Fund ETF (VNGI; yielding 3.9%) may provide some diversification. The Cohen & Steers Quality Income Realty Fund (RQI), a leveraged closed end fund, yields 8.4%.
Investors may also wish to purchase some individual eREITs which have demonstrated growing earnings [5]. Some popular choices are:
Realty Income, which owns many small retail properties which often house convenience stores (O; 5.1% yield)
Ventas, which owns various health care properties (VTR; 6.3%)
Iron Mountain, which provides off-site storage of company records (IRM; 7.1%)
Stag Industrials, holds various industrial buildings (STAG; 6.1%)
Mortgage REITs (e.g. NLY, AGNC) own pools of mortgage-backed securities. These companies use the leverage of borrowed money to boost the return from the securities they own. “Agency” mREITs hold residential mortgages whose principal is guaranteed by quasi-governmental agencies like GNMA. The mREITs holding these mortgages thus have little credit risk, but their payouts and share prices can change dramatically if interest rates change.
As a simplified example with residential mortgages, consider the purchase of $1 million of mortgage securities yielding 4%, producing $40,000 per year in interest. The REIT finances the purchase by borrowing $800,000 of short-term money at 2% and using $200,000 of company capital. The result is $24,000 of net interest earnings on $200,000 of invested capital for a 12% annual return. This high degree of leveraging enables mREITs to pay very high dividends on shareholder capital. However, it makes them extremely sensitive to changes to the spread between short and long term interest rates, since the mREIT must keep renewing the short-term financing. For instance, if the short-term rates in this example rise from 2% to 3% while the mortgage rates stay at 4%, the spread would shrink from 2% to 1% (i.e. 4% – 3%), and thus the ability of the mREIT to pay dividends would drop nearly in half. Mortgage REITs buy hedges to give some protection against such interest rate movements, but these hedges are only cost-effective for a limited time.
Although the expected increases in short term interest rates will likely hurt the earnings of residential mortgage REITs, this may already be reflected in their share prices, which have dropped significantly in the past three months. Two Harbors (TWO; 13% yield) may be especially worth considering, since it is less rate-sensitive than most of its peers.
Commercial mREITs are quite different from residential mREITs. The mortgage loans they hold are typically floating rate (i.e. they get readjusted if rates change), so these mREITs are less sensitive to what the Fed does with rates. On the other hand, since these commercial mortgages are not backstopped by quasi-government agencies, the credit risk is higher than with residential mortgages. They would be more strongly affected if business conditions deteriorate, affecting the ability of the borrowers to repay their loans. Apollo Commercial Real Estate Finance Inc (ARI; 10% yield) and Blackstone Mortgage Trust (BXMT; 8% yield) and Arbor (ABR) are a couple of names here.
REM (11% yield) is an ETF holding a broad range of mREIT stocks. Neuberger Berman Real Estate Securities Income Fund (NRO; 11.5% yield) gives a highly diversified exposure to the REIT space. This is a leveraged closed end fund which holds a variety of REIT securities, including eREITs, mREITs, and preferred stocks issued by REITs.
Business Development Companies
A Business Development Company (BDC) is a kind of closed end fund which invests in small and mid-sized companies which would typically not qualify for a loan from a regular bank. BDC investments mainly take the form of loans, but may include taking an equity position in a start-up company. Most BDCs are structured such that they are managed by an external management which does not answer directly to the shareholders. The more loans the BDC makes, the more fees the management company takes in. Thus, the external management company is incentivized to keep endlessly expanding assets under management, whether or not the added investments turn out well in the end. From the shareholder perspective, there are (to oversimplify) bad BDCs which succumb to this temptation, and there are good BDCs which maintain financial discipline.
The bad BDCs like Prospect Capital (PSEC; 13% yield) and FSK often have high current yields, but these may be “sucker yields”, which lure investors into buying more shares so the BDC can expand its inferior portfolio. Such BDCs may artificially inflate yields by paying more dividends than are really earned by their investments; but then the net asset value (NAV) per share declines, and eventually the dividend per share has to be cut. Thus, the total long-term return to the shareholder is much lower than promised by the initial high yields. These BDCs have a higher cost of capital, and so they need to make higher-interest, more-risky loans in order to generate income. Paradoxically, buying BDC shares priced at a premium over NAV is typically a good thing, while shares selling at a big discount to NAV is a sign of a troubled fund. [6]
It may be possible to make more than 10% return by closely monitoring their financial data and actively trading in (after a dividend cut) and out (before a dividend cut is announced) of these lower-tier BDCs. However, the investor who wants a more dependable return may prefer to hold shares of “good” BDCs, which have steady or rising long-term net asset values and share prices, and moderate but stable yields (e.g. 7-9%). They typically have a high percentage of highly-secured, variable-rate loans in their portfolio. These BDCs include MAIN and HTGC and CSWC (all internally managed), ARCC (huge),GBDC, TSLX, and FDUS.
There are several ETFs/ETNs (e.g. BIZD, BDCS, BDCZ, and the 2X BDCL) that hold or track broad indices of BDCs. These include the bad along with the good BCDs, and so the long-term performance of these instruments has been appalling. FGB is a fund which chooses and holds the better sorts of BCDs, but as with any fund you pay fees which eat into your take-home. The investor will probably do better to buy a couple of the individual good BDCs listed above than to buy any of these funds. A list of BDCs with current prices and yields may be found here .
Master Limited Partnerships
A master limited partnership (MLP) is a publically traded limited partnership. It is not taxed at the corporate level. Rather, it passes its income, gains, losses, and deductions directly to the unitholder (shareholder). This allows for relatively high yields for unitholders. However, unitholders receive a K-1 tax form (rather than the usual 1099), which makes tax filing somewhat more complicated, and makes holding an MLP in an IRA inadvisable.
Most MLPs operate in petroleum production and processing, especially in the “midstream” area, e.g. owning and running gas/oil/gasoline pipelines. Revenues are affected by oil prices, but not as much as for oil producing companies. Prices of midstream MLP shares have been declining steadily for the last year, even though earnings seem to be holding up fine. [2023 note: MLP prices seem to have finally stabilized] Alerian MLP ETF (AMLP) is a large index fund of MLPs. Its yield varies between about 6 and 8%. I prefer that one for stability. InfraCap MLP ETF (AMZA) holds a similar basket of MLPs. It uses leverage and options to boost distributions, which also increases volatility. It currently yields about 16%. EMO is a leveraged closed end fund with less volatility than AMZA, yielding 12%. Participating in MLPs via funds like these avoids having to receive and deal with the K-1 tax forms which usually go with MLPs.
More on Closed End Funds
Closed end funds can hold most of the investment vehicles described above, e.g. stocks, bonds, loans, REITs, etc. For instance, Barings Participation Investments (MVP; 7.5% yield) holds loans similar to those in BDCs. Here are two further alternative strategies which are implemented by closed end funds:
( a ) Covered Call (Buy/Write) Funds
These funds hold a basket of stocks, and sell (“write”) call options on these stocks. Doing this harvests significant steady income, but it prevents the fund from taking advantage of large rises in stock prices. Under most market conditions, the share price stays fairly flat, but the fund regularly yields 8-9% per year. The share price would drop along with the broad stock market in a prolonged correction. So I suggest not making this a big fraction of your portfolio. With a “tax-advantaged” fund like Eaton-Vance Tax-Managed Buy-Write (ETV), the distribution is mainly in the form of return-of-capital, which are taxed at lower rates than regular income. The Global X S&P 500® Covered Call ETF (XYLD) implements a similar covered call strategy with similar results, except the distributions are nearly all regularly taxed income.
( b ) Collateralized Loan Obligations (CLOs)
To oversimplify, collateralized loan obligations (CLO) are like highly leveraged pools of bank loans, with a certain set of rules for managing them. They are capable of producing very high yields for the so-called equity tranche, as long as not many of the loans in the pool default. Defaults are currently very low, though that could change in a recession. Eagle Point Credit (ECC) is a closed end fund which invests in CLO equity slices (tranches). Its share price can move around, but it pays a fairly regular distribution, currently yielding 13%. Oxford Lane Capital (OXLC; 16% yield) is similar.
A sweet spot, I think, is the lower-rated debt tranches from CLOs, giving a nice blend of high yield and low default risk. CLOZ holds the lower end (mainly rated BB) of these CLO debt instruments, and JBBB middle grade (BBB). EIC is a closed end fund (with the usual leverage, high fees, and opaque accounting) that holds mainly BB CLO debt. See here for more on CLOs.
( c ) Funds of Funds
As noted earlier, it can be advantageous to buy into a closed end fund when the fund’s discount is steeper than usual, and trade out (and into some other fund) after the discount turns to a premium. Here is an article on the Seeking Alpha investment discussion site where a retired financial professional, Steven Bavaria, lists and explains his selection of about 30 diverse closed end funds. He regularly obtains a portfolio income yield of at least 10%, by periodically adjusting his holdings based in part on current discount/premium. He is not troubled if the prices of his fund shares go down, since that allows him to reinvest the dividends at more favorable prices.
As an alternative to the investor doing a lot of financial analysis in order to choose some individual high-yielding, discounted closed end funds to purchase, there are several funds which make that selection for you. PowerShares CEF Income Composite Portfolio (PCEF; 7.2% yield) and YieldShares High Income ETF (YYY; 8.4% yield) are ETFs which hold sets of closed end funds chosen according to some underlying indices. PCEF is currently paying a somewhat lower yield, but its share price seems to hold up better than YYY long term. Cohen & Steers Closed-End Opportunity Fund (FOF; 8.1% yield) is an actively managed closed end fund which likewise holds a basket of closed end funds, and seems to do slightly better over time than PCEF or YYY.
Some Resources for Buying Stocks and Bonds
Yahoo Finance is a good starting place to check on basic data for a security, and gives links to recent articles. The Morningstar site gives more detailed information on stocks and funds (portfolio holdings, financial statements, etc.) as well as the usual price charts. The Morningstar phone app is convenient to use, but only has basic information.
I have found the Seeking Alpha site to be very educational. Contributors are always posting short articles sharing information and touting some stock or fund; what really adds value is the comments on these articles. If the article’s thesis is bad, usually some knowledgeable reader will point it out. Most articles on Seeking Alpha are available for free (you may have to establish a free account for sign-in) for the first ten days after they are published, then are available only for paid subscribers. Seeking Alpha also is available via a smartphone app.
You need to establish an account with a broker in order to purchase and hold the securities discussed here. Various inexpensive on-line brokerages exist. Charles Schwab is a popular discount broker, with relatively low fees and real people on the phone you can talk with.
The Vanguard Group is structured as a mutual company, and hence is ultimately owned by its customers. This means that the management is incentivized to benefit its customers, not an outside group of profit-seeking shareholders. The company has decades of experience with billions of assets under management, and typically offers funds with the lowest fees available. The company offers honest, low-or-no-cost advice on investment options, since the advisors have no motive to push any particular products. Thus, Vanguard is a sound choice for individual investing, both for its funds (open-end mutual funds and ETFs, which you can purchase through Vanguard or through some other brokerage) and for its own brokerage service, where you can buy other stocks, closed-end funds, BDC’s, etc.
I hope this article provides useful information for some readers. For my description of the overall workings of the modern monetary system (what is money and how it is created in the banking system, effects of government and trade deficits, etc.), see here.
[Boilerplate Disclaimer: This article should not be taken as advice to buy or sell any particular security].
Appendix: Buying Individual Bonds and Preferred Stocks
Although most individual investors may want to hold bonds and preferreds in funds, some may wish to buy some individual securities. If you buy an individual bond and plan to hold it to maturity, you know exactly what your income stream and final pay-back will be, no matter what interest rates or the general market does. (This assumes that the issuing company does not go bankrupt in the meantime). Some investors build up a “ladder” of bonds, which include some that mature sooner (and then get replaced) and some that mature later. Information on individual bonds can be found the FINRA/Morningstar site.
For most corporate and municipal bonds, the usual way to buy or sell them is by calling your broker. U.S. treasury bonds can be bought on line, through TreasuryDirect.
There is a subset of bonds that are traded on exchanges just like stocks. These are called exchange-traded debt (ETD) or baby bonds, since their face value is normally $25, rather than the usual $100 or $1000 for a regular bond. An alphabetical list of baby bonds appears here on the Innovative Income Investor site . Current yields are shown, but as with any bond you should also calculate (on-line tools exist) the yield to maturity (YTM) of the bond.
Impact of Early Calls of Bonds And Preferred Stocks
When bonds or preferreds are issued, the fine print often includes an option for the company to redeem or call the bond or stock at face value (par), after some specified date. This date is often five years after the security is issued. This needs to be taken into account in valuing the security. For instance, in the list of baby bonds, there is a 5.90% note (VZA), from Verizon Communications. This bond matures in 2054, but is callable any time after 2/15/2019, which is less than a year from now. Its current price is $26.12, which is $1.12 over the face value of $25. The elevated price knocks the current yield down from 5.9% to 5.65%. More importantly, if the company exercises its option to buy the bond back at $25 in February, the bondholder would suffer a capital loss of $1.12 or 4.3%. That would largely wipe out the interest income of the bond between now and then. (It may be that “the market” believes that the finances of Verizon are such that they will not call this particular bond, which is why the current bond price is so high).
If the price of a bond or preferred stock is appreciably different from the face value, the investor should calculate or obtain a “yield to worst”. If the market price is above the face value, the yield to worst is usually what the total return would be, including both interest or dividend payments and capital losses, if the bond or preferred stock is called at the earliest possible time. If the market price is below the face value, the yield to worst would be the total return (in this case including a capital gain) if the bond is not redeemed until its maturity date.
Buying Individual Preferred Stocks
Lists of preferred stocks are here . This list includes call dates, and also yield to worst calculations. A wide variety of preferreds are available. For instance, the solid agency mREIT Annaly Capital has issued NLY-D, currently priced just a hair over par ($25.16) and yielding 7.45%. Annaly has also issued NLY-F and NLY-G, which currently yield about 6.8% and which convert to floating rate in a few years, giving the investor some protection against inflation. Full details on any particular preferred stock or baby bond is available at QuantumOnline. Different sites used different notations for preferred stocks, such as NLY_pF or NLY-F or similar.
When closed end funds and business development companies issue preferred stocks, the fund is required to maintain assets in an amount at least double the amount of issued preferred stock or bonds. If net asset value starts for fall below that threshold, the fund must start to sell off assets to raise cash to start to redeem the preferreds at face value ($25). That prevents the CEF or BDC from getting over-leveraged, and serves as fairly strong protection for the preferreds, even if the underlying business is a little shaky.
Limit versus Market Orders
Some CEF’s and preferreds are thinly traded issues (relatively few trades per day), which means the spread between the “bid” (the price at which someone is currently offering to buy) and the “ask” (the price that someone on the stock exchange is offering to sell for) can be large. If you place a “market” order, you will end up buying at the higher (ask) price, and selling at the lower (bid) price. Thus, it is recommended to place limit orders, rather than market orders, to buy or sell these securities at reasonable prices.
With a limit order, you specify the maximum price you are willing to buy for, or the minimum price you are willing to sell for. Also, if you are not in a hurry to complete an order, you can look at the price action of the stock over the last few days, and place a limit order to buy at a relatively low price (or sell at a high price). Then you can leave your order open, go away, and wait for the market to come to your specified price during some swing up or down in the coming days, at which point the desired transaction should occur.
Update June, 2020: After the Crash
As any investor knows, the markets took a hit in March, mainly in reaction to the shutdown of large swathes of the economy imposed to slow the spread of the Covid-19 virus. There was swift, massive intervention by the Fed and the federal government in the form of buying bonds and other securities, instituting emergency lending programs for businesses, enhanced unemployment benefits, and giving people free money. Investors believed that this tidal wave of money would support corporate earnings once virus restrictions were eased, and so the broader stock market (e.g. S&P 500), led by internet stocks like Amazon and Google, quickly recovered most of its losses. The lower interest rates engineered by the Fed also tend to inflate stock prices, as alternative investments such as bonds become less attractive. The covered call option CEF ETV has nearly recovered in share price, and continues to pay about 9% yield. (The covered call ETF QYLD yields 11%, but was forced by its mechanical rules to make some transactions which chopped its net asset value). {I’ll add a few further observations as of early Feb, 2021 in curly brackets: Tech stock have continued to relentlessly climb in the second half of 2020 – – the QQQ NASDAQ ETF is nearly 50% higher than a year ago, and ARKK, which focuses on new, innovative technologies has more than doubled. So everyone wants growth, while plain old high yielding cash cows are boring. Gold (GLD steadily losing ground) is also boring, but Bitcoin (GBTC, nearly doubled in past six months) is all the rage.}
Preferred stocks also rebounded, and the Fed’s purchasing program supported bond prices, including junk bonds. Preferred stock funds like PFF (unleveraged ETF, 5.8% yield)), and junk bond funds like JNK (5.8% yield) are only modestly lower compared to February.
On the other hand, several of the categories of high yield securities described here were devastated in March. It seems that the Fed so far is not propping up loans (as opposed to bonds), and there is concern that the virus shutdowns may lead to widespread defaults on loans. Accordingly, the shares of many BDCs (which make loans to non-investment grade companies) remain 20-40% below their previous prices. Some have cut or suspended their dividends, in order to ride out the storm. If their loan portfolios hold up, most of these BDCs have a chance at recovery within a year or so. Share prices of high quality BDCs such as GBDC and ORCC remain at discounts to their book value, making them attractive investments now. The CEFs like OXLC and ECC, which hold the high risk/high yield equity tranches of senior loan CLOs, have lost about half their value. EIC, which holds the less-risky junior debt tranches, is only down by 25%, and provides a relatively stable 7% yield. {Feb. 2021: Most high quality BDCs have nearly recovered their pre-crash stock price, all the while cranking out 8-11% dividends – -feared widespread loan defaults did not materialize.}
A lot of permanent damage was done in the REIT sector, which was unexpected considering how REITs are often touted as being more stable and secure than stocks in general. Equity REITs own and charge rents on commercial property, such as cell phone towers, apartment and office buildings, hospitals and nursing homes, and malls and restaurants and standalone stores. With such “solid” assets, the values of REITs might be expected to be less subject to economic cycles than ordinary stocks. However, the virus-related shutdowns have struck at the usage and value of many classes of commercial real estate. Traffic in hotels and in shopping malls and other stores was essentially shut down for several months, and may be slow to fully recover; many older citizens remain reluctant to expose themselves to the risk of catching the virus. Movie theaters and many restaurants long have been considered recession-proof, but these sectors were hit especially hard. Office buildings may lose long-term occupancy, as companies have realized savings by having employees work from home. Thus, some eREITs have cut dividends and remain depressed. Others REITs, in sectors such as cell towers, apartments, data centers, and industrial warehouses, have done OK. The broad Vanguard REIT ETF VNQ is about 20% lower than in February. {Feb. 2021: VNQ, which is weighted towards cell phone towers and data centers, has nearly recovered in price, but many shopping mall REITS remain depressed}
The most widespread carnage occurred in mortgage REITs. Commercial mREITs borrow money, and make mortgage loans to owners of commercial buildings. These loans are secured by the value of the buildings. Unfortunately, many commercial mREITs also borrowed money from banks to buy other sorts of interest-bearing mortgage securities. When the value of these securities dropped in March, the banks exercised their rights to sell off these securities and essentially call in their loans. These “margin calls” drove the prices of these securities even lower, and forced the mREITs to sell them at much lower prices than they had bought them for. This produced severe, irrecoverable losses for these mREITs. For instance, LADR, which was regarded as a safe, responsible mREIT, slashed its dividend by 41%, and sells for about half of what it did in February. XAN, a shakier commercial mREIT that was in the process of improving, eliminated dividends on both its common and its preferred shares, and has lost 75% of its market value. Some commercial mREITs such as ARI and BXMT seem to have suffered less damage. {Feb. 2021: No way around the permanent hit to value for many of these commercial mREITs and for the residential mREITs below, though there has been some recovery since the lows of mid-2020. For investors who had the courage to wade in over the summer, when it was clear that the worst was over, this has been a bonanza.}
Residential mREITs borrow money to buy residential mortgages. In many cases, these mortgages are guaranteed by agencies such as GNMA, so they are considered to be very safe. Nevertheless, agency mREITs such as NLY, AGNC, and ORC have suffered long-lasting drops in share prices and have had to trim their dividends. The main problem was that they held hedges against a rise in interest rates, but when the Fed suddenly slashed interest rates by a full 1% in March, the value of these hedges cratered, causing a big drop in the net asset value (NAV) of the mREITs. The value of these mREITs seems to have stabilized, and they are paying dividends of around 12%, but the cautious investor might rather buy their preferred shares, which are yielding a fairly safe 7%. Other residential mREITs, such as TWO and NRZ, held more exotic mortgage instruments, which dropped in value and required forced sales at low prices. TWO is now worth only a third of its value in February, but is probably stable from this point on, since it is now essentially a pure agency REIT.
As a side note, the popular 2X leveraged ETNs MORL and MRRL, which tracked mREITs and which offered a mouth-watering ~22% yields, lost essentially all of their value (due to their leveraged structure) and were shut down with a near-total loss for investors.
Finally, there was a big drop in oil prices in March because of a price war with Saudi Arabia and Russia, and lower demand due to virus shutdowns. This in turn led to lower oil production and pipeline flow, which dropped the value of the pipeline MLPs. Some MLP’s have cut dividends, while others have maintained their payouts, even though their share prices have dropped. AMLP, a plain unleveraged MLP ETF, has lost about half its market value, but pays 14%, which is not bad. However, the leveraged MLP CEFs, such as TYG and CEN, were forced (by rules on leverage limits) to sell their holdings at low prices. TYG is now worth a quarter of its February value, and CEN is down to 15% of its former value. This again demonstrates the hazards of combining leverage with volatile assets. {Feb. 2021: Most oil/gas pipeline stocks from companies structured as MLP’s have had their value just go down and down for years. AMLP has recovered about halfway from its March lows, but is still down about 50% from five years ago. Companies structured as regular “C” corporations like KMI and WMB (yielding about 7%) have held up better in the past five years, though they all took a big hit in March.}
My overall takeaway from all this is that any investment with a yield over about 8% is highly likely to crater at some point; the reason any yield would be ever that high is because the market believes that it is ultimately unsustainable. Thus, I am now less inclined to chase high yields, and more inclined to value stability. This means holding more preferred and less common shares for REITs and CLO funds, and swearing off 2X ETNs and leveraged MLP funds. {Feb. 2021: Lots of pretty secure mREIT preferred shares still available yielding around 7%}
Of all the authors on Seeking Alpha who write articles on REITs (e.g. Rida Morwa, Jussi Askola, Brad Thomas), I have found that Colorado Wealth Management has given the most realistic, prudent, and profitable recommendations. Some observations from him:
( a ) REITs which are paying low current yields are often the ones that give greater total return long-term due to healthy growth; the lower-quality REITs have higher yields because their share price is low, because the market (usually correctly) believes that they have poor growth prospects. For example, in the area of manufactured housing, UMH pays a higher dividend than SUI (regarded as higher quality), but the cash flow and share price and dividends for SUI have grown much faster.
( b ) The common shares of mortgage REITs in general are not buy-and-hold securities. They are prone to large swings up and down, often with a long-term downward trend. He recommends buying when the shares are priced at a significant discount to the NAV, and then selling as their price rises close to NAV. Preferred shares of mREITs are more viable long-term holdings, with fairly safe yields of 6-7%, though even there one can make money by trading to take advantage of temporary price differentials.
ENDNOTES
[1] Investors in other nations may find similar securities available in their own country’s stock exchange. Alternatively, they could buy some of the American securities described here, and live with the country and currency risk, which can swing either way. Also, there are funds on American exchanges which mimic the strategies of some of the funds described in this article, but hold mainly or all non-U.S. assets. “Non-U.S. developed country assets” usually means “mainly European assets”, so this approach might be good for European investors. For instance, the Vanguard Global ex-US Real Estate ETF ( VNQI; 3.9% yield) is the non-U.S. version of U.S. eREIT fund VNQ. The Eaton Vance Tax-Managed Global Buy-Write Opportunities Fund (ETW; yielding about 9%) is the global version of ETV. About 35% of its holdings are European, and 11% Asia/Pacific.
[2] There may be a bump up in stock prices in 2018 as “repatriated” money is brought back to the U.S. by companies such as Apple. The current administration seems to hope that this money will be put to work in hiring more workers and investing in factories, but the most likely application of these funds will be stock buybacks. Once this effect passes, the impact of rising interest rates will likely act as a drag on stock prices, for several reasons. First, higher interest rates make fixed-income securities like bonds a more attractive alternative to investing in stocks. Second, much of the rise in stock valuations in recent years has been due to stock buybacks, mergers, acquisitions, and other financial engineering which was facilitated by low-interest money. Third, the rise in interest rates may eventually choke off growth in GDP which will limit increases in corporate earnings.
[3] 20% of dividend income from REITs will be excluded from taxation starting in 2018, making them somewhat more attractive to hold in taxable accounts, particularly for high-income investors.
[4] I don’t know if this is a general rule, but it seems a lot of open-end mutual fund trading symbols (like VWEHX) have five letters and end in X, which may help to distinguish them.
[5] In looking at the financial statements of eREITs, the usual “earnings” line in the financials is somewhat meaningless. Analysts focus instead on Funds from Operations (FFO) or (better) Adjusted Funds from Operations (AFFO) as a measure of the dividend-paying power of a REIT.
[6] While BDCs can raise money for investments by issuing bonds and preferred stock, the amount of leverage they can employ is capped by law. Thus, most of the money they raise comes from issuing more shares of regular (common) stock. The good BDCs maintain high share prices per NAV, so when they sell more shares, the value of existing shares is not diluted. The premium over NAV is generally justified and sustainable. Because they make higher-quality loans, their credit rating is higher, so they can borrow money at cheaper rates. This, plus the high share price, gives them a lower cost of capital, so they can (in a virtuous circle) afford to make lower-interest, higher-quality loans. All this is reversed in the bad BDCs.
Letters to Creationists 