These Widely Overlooked Securities Yield Up To 16%
StreetAuthority | Apr 27, 2012 06:10AM ET
Exchange-traded products (ETPs) are wildly popular. Their assets grew more than 30% a year during the past decade, compared to just 5% to 6% for mutual funds, according to McKinsey & Co. The management consultancy projects ETP assets will more than double over the next five years to $3.1-$4.7 trillion, from a little over $1.5 trillion today.
Most of the growth is in exchange-traded funds (ETFs), a subclass of the exchange-traded product family. But a handful of exchange-traded notes (ETNs) are also a small part of this market.
And while there are ETFs for everything from copper to cocoa, ETNs offer a unique type of exposure to mainly two high-yield groups: master limited partnerships (MLPs) and business development companies (BDCs).
Readers of my newsletter know that I'm a big fan of MLPs and BDCs. These unique businesses allow investors to capture higher yields than many blue chip stocks and bonds.
MLPs are in the pipeline business, transporting oil and natural gas from the drilling site to the "downstream" facilities such as refineries and storage facilities. They earn a fee based on the volume transported, and in turn are not as sensitive to energy prices as drilling companies, for example. This provides a reliable stream of income, much of which is passed right on to investors in the form of sizeable dividends.
BDCs, on the other hand, provide financing to smaller companies seeking to grow their business. In return, many BDCs not only get interest payments on the money they loan (which is why BDCs pay hefty dividends), but also secure an equity stake in the business as well.
So if, like me, you're a fan of these dividend juggernauts, then ETNs are definitely worth a look. In some cases, I've found these overlooked securities yielding as high as 16%.
ETNs are an entirely different beast from ETFs. Both track the performance of an index and offer a simple way to move in and out of a sector. Both may pay dividends thrown off by the securities in the index they track.
But that's where their similarities end. Unlike ETFs, ETNs do not represent a claim on shares of stock, bonds, or commodities. The ETN issuer may invest in the index companies to collect returns, but ETN holders like you and me don't have a claim on those assets.
Instead, ETNs are promissory notes. They are senior unsecured debt that promises to match the return of a specific benchmark. Interest payments on the note are generally made quarterly and reflect the quarterly payments made by the MLPs in the index.
Like bonds, ETNs have a maturity date. At maturity, generally 15 to 30 years from the issue date, the ETN is redeemed. Unlike bonds, however, you don't receive the face value in cash. Instead, the amount you receive is based on the performance of the index. [Note: There's a little more to how ETNs work, but this is just to get you going. If you're interested in learning more details about these securities, I encourage you to read the latest issue of High-Yield Investing.]
Of the 10 high-yield ETNs listed below, seven track the performance of MLPs, two follow BDCs, while one tracks a diverse portfolio of stocks and bonds.
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How to choose the best ETNs
To help you make an informed decision, I've given you key data points on each ETN in the list above. The specific index it tracks is given in the name, but I've also noted daily trading volumes, initial and recent index VWAP levels, the principal value and the maturity date.
Besides index size and liquidity, the biggest question that needs to be asked when picking an ETN is how well the index is performing. You can follow the indices and even the VWAP level of some of them on free financial websites like Marketwatch or Bloomberg. But to estimate your potential capital gains, you also want to know the principal amount and the starting level of the index, and for these I've gone directly to the prospectus.
You also want to note the maturity date. If the index is doing well right now, the sooner the ETN matures the better. These are long-term bonds, however, and the earliest maturity date of the listed ETNs is the Alerian MLP Index (NYSE: AMJ) at 2024. You can, of course, buy and sell ETNs during the day just like stock. You can also redeem them at your option, but generally you must proffer a minimum required amount of around 50,000 notes to do so.
Risks to Consider: Besides fees, much has been made of the credit risk of ETNs. That was particularly a problem when the first ETNs came out during the financial crisis of 2008. But most of the popular ETNs issued by investment banks such as Morgan Stanley or JP Morgan Chase don't carry the same credit risk today.
It's also worth noting that as debt, ETNs distribute interest income that's taxable at your marginal income tax rate. Also, you can hold these ETNs in a tax-sheltered IRA or 401(k) account without fear of throwing off more than $1,000 in unrelated business taxable income (UBTI).
Of the 10 high-yield ETNs on the list, only those tracking MLP indices are showing positive returns from their initial index level. And of the seven MLP ETNs on this list, AMJ shows the best returns, has the largest daily trading volume, and the soonest maturity date. While all of them bear a closer look, at first blush, I view AMJ as my top pick, although you should certainly do more research before purchasing these securities.
by Carla Pasternak
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