While fixed-income investors may be predisposed to thinking about junk bonds when it comes to high yielding securities, for added diversification and perhaps better long-term total return upside, sights should also be set on options in the equity market. For purposes of this article, we’ll think of high-yield as anything in excess of 7 percent.
Some high-yield securities, like closed-end funds, commonly referred to as CEFs, and business development companies, commonly known as BDCs, hold underlying junk bond or junk-bond-like assets. They are managed to generate high income with capital upside as a subservient goal. Most CEFs and BDCs utilize leverage, which helps to magnify yield and returns, but may also seek to hamper things when underlying assets are underperforming or non-performing. Further, expenses can prove to be quite steep with leveraged CEFs and potentially even higher with regard to externally managed BDCs.
Though an elevated level of risk is generally assumed when we think of high-yield, there are some high-yield products, like option-income CEFs, that can produce double digit income with essentially the same level of capital risk as a diversified stock ETF. Further, a majority of the income generated from one of these funds is usually, but not always, categorized as return of capital, which defers tax consequence and may be highly appropriate for tax sensitive investors.
On the flip side, mortgage REITs, otherwise known as mREITs, which generally yield double-digits, possess substantially higher risks due largely to their highly levered portfolios, dependence on credit spreads, and interest rate sensitive underlying asset valuations. During the “taper tantrum” of 2013, these securities, along with other rate sensitive fare, lost a tremendous amount of their value.
Thus, for those that have the need and/or the stomach for high-yield securities, a diversified, and/or pooled approach is warranted to sidestep the elevated chance of a security specific payout disruption, elimination, or fundamental breakdown.
The following five securities represent a cross section of the high-yield universe.
1) Eaton Vance Tax Managed Global Diversified Equity-Income Fund (EXG) – This is one of the option income funds mentioned above. Trading at a discount to net asset value of nearly 8% and a distribution rate of nearly 10%, EXG is just one of several dozen choices in this category. While the upside to its strategy is increased cash flow to investors, in bull markets the capital upside is generally limited, as positions may be forced to be sold at below market prices.
2) iShares Mortgage Real Estate ETF (REM): This 37-position fund that yielded 12.5% on a TTM (trailing twelve month) basis owns a large swath of leveraged mortgage REITs, with its top three positions Annaly (NLY), American Capital Agency (AGNC), and Starwood Property (STWD) accounting for about 40% of assets. Annaly is a diversified player, AGNC focuses solely on government-agency-backed assets, and
Starwood invests in commercial paper. Due to its potential for rampant volatility, I would advise generally minimal exposure to this fund and its underlying constituents. For those that want to get even more aggressive there is MORL – a 2X leveraged ETN from UBS that yields in excess of 20% at current pricing.
3) UBS ETRACS Linked to the Wells Fargo Business Development Company Index ETN (BDCS) – This is one of the few securities that tracks a basket of BDCs and currently yields a bit above 8 percent. An ETN is substantially different than an ETF in that it does not actually hold the underlying assets, seeming to be more like a fixed-income security underwritten by an institution, in this case, UBS. Therefore you not only assume the risks of the underlying assets, but also the credit worthiness of UBS. Some of its larger tracked constituents include American Capital (ACAS), Prospect Capital (PSEC), and Ares Capital (ARCC).
4) Prudential Global Short Duration High Yield (GHY) – This is a plain vanilla leveraged junk bond CEF that currently trades at a discount and yields right around 9 percent. Though there is obviously credit risk here, the fund limits duration, which means investors won’t see tremendous price dilution when and if interest rates start to scale higher. The fund also has very little exposure to energy, which has been a concern of high-yield investors given the pressures of a lower price per barrel petroleum situation.
5) ClearBridge American Energy MLP (CBA) – Here’s another leveraged CEF that invests mostly in mid-stream (energy transportation, typically pipeline) energy assets. The fund is trading at an 8% discount to NAV and boasts a better than 7% distribution rate. While as mentioned above oil companies have been under the gun given the drop in the price of crude, the long-term outlook for movers of natural gas is quite positive in my view. The fund owns a compendium of partnerships and the distributions here are generally return of capital, which is a tax advantaged proposition for investors.
While the risks of high-yield are elevated compared to other security types, I think if you take a blended, measured approach and don’t over-expose, there may value for some investors. One must consider their own tolerance for price volatility and income disruption however, and allocate accordingly. While economic or interest rate upheavel tends to play havoc with just about all equities, the impact is generally more profound when it comes to the high-yield space.
Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.
Disclosure: Mr. Aloisi was long EXG, STWD, MORL, PSEC, GHY, and CBA at time of writing, but positions may change at any time.
About the author: Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.