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31 Flavors of Yield

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Publication Type: Investment Cases
31 Flavors of Yield

 

2019 has introduced myriad new varieties of yield to investors, including familiar fan-favorites such as flat and declining yields.  For investors seeking a more exotic flare, markets have debuted negative and even inverted yields. However, only true aficionados will be able to savor the ultimate pairing of yield flavors, such as negative speculative yields, a true Italian masterpiece. Ciao Bella!

Searching for sustainable yield is never easy, but over the last decade, income investing has been a most unpalatable cocktail — one part frustration and two parts despair (add bitters to taste).  With 10-year treasuries near all-time lows and the Federal Reserve embarking on a fresh easing cycle, the hunt for yield willhttps://bkgstestweb01.azurewebsites.net/institutional/us/en-us/research/help-what-happened-to-my-income/ only intensify. What is a saver to do, and are alternative solutions available? Alternative yield may present a solution to what may be a confounding dilemma of our time.

Necessity Is the Mother of Invention

The unfortunate reality is that a deep chasm stands between investor income requirements and what conventional strategies can now yield.  Even a quick examination of bond markets uncovers intractable difficulties.  Not only has the 10-year treasury yield declined by 150 basis points in the past year, as depicted it the left-hand chart, but it has approached less than 13 basis points from its all time low. Moreover, the chart to the right illustrates the 2 year-10 year spread has steadily contracted, and even outright inverted; not even duration risk may generate yield.

Source: Bloomberg

In a market where every basis point of income counts, many yield-focused strategies simply do not generate as much income mileage as may be imagined. For instance, high-yield dividend strategies generally managed a low 3-handle yield, and real estate achieved a somewhat higher 3-handle distribution. This prompts the obvious question: How is a saver supposed to retire on a 3-handle income stream? Even junk bonds, with all their attendant credit risks, have only delivered in the low 5-handle range.[1]

Learn More: How Much of Your Income is Mental?

Strikingly, this threshold is the upper limit for mainstream income strategies, and yet these yields may still be insufficient for many investors.  This dearth of income has refocused the paradigm on retirement, forcing advisors and clients to reevaluate lifestyle goals within the context of the possible, hemmed in by low yields. But what if there were strategies that could potentially seek four times the yield of the S&P 500, while aiming for less volatility?

“The fact is many investors may be underexposed to alternative income solutions, simply because they fall outside the framework of common market indexes.”

Welcome to the world of alternative income and pass-through securities. Perhaps the problem hasn’t been that income doesn’t exist in this market, but simply that we have been conditioned to look for income in all the wrong places.

The Unusual Suspects

The solution to this income stream problem may lie in an ecosystem of alternative investment beyond the frontier of conventional options. The three prominent contenders in this high-yield arena are Closed-End Funds (CEFs), Business Development Companies (BDCs) and Master Limited Partnerships (MLPs).  These alternative structures achieved yields of 7.49%, 9.52% and 8.84%, respectively, as of 8/31/19.[2] How did they do it?

What these assets have in common is they may exploit unique fund structures or target specific risk profiles to hit income in excess of traditional methods. Their pass-through structures tend to avoid the double-taxation phenomenon, enabling unique yield opportunities for the end investor.

Foremost, closed-end funds can use the gambit of their own internal leverage — they are able to issue their own debt and preferred shares up to 50% and 100% of net assets, respectively — to augment their exposure to high-yield debt. In exchange for increased volatility, the CEF structure enables investors to figuratively “double-down” on speculative-grade yields, while the potential to purchase CEFs below net asset value can further enhance this effect.

Next in line, business development companies are investment firms that specialize in funding small, distressed or emerging ventures in either the public or private investment ecosystem. Based on a fund structure created in 1980, BDCs operate in a fashion not dissimilar to private equity or venture capital, leveraging their internal capital structure for the potential to distribute sizable yields to their equity stakeholders.

Related: Are You Actually Set Up For Income?

The final heavy-yield contender is master limited partnerships, which were created in 1981 but restricted to only the energy and real estate sectors in 1987, as Congress thought the structure was too tax-advantaged. MLPs are a unique cross between a partnership and a corporation that can be publicly traded and employ a pass-through structure to avoid double taxation. Not only do most distributions constitute return on capital, but depreciation and losses can even be passed on to investors as well.

What Does Income Mean to You?

As may be surmised through their descriptions, these alternatives are willing to make unorthodox tradeoffs to earn their high-income status. For instance, CEFs concentrate heavily on interest rate and credit risk, and BDCs by nature focus on at-risk or immature companies. The point is, each of these categories alone may be susceptible to specific shocks, whether in terms of overall market risk or even structure-specific risk.

Two key points follow from this discussion. Foremost, a diversified approach that combines these varying asset classes may be less volatile overall and reduce exposure to any single type of risk. The second point is slightly more nuanced — by seeking out different exposures, these pass-through securities have historically maintained low correlations with standard fixed income risks. Consequently, these new risk profiles can add diversifying value as part of a broader portfolio while also augmenting yields.

The fact is many investors may be underexposed to alternative income solutions, simply because they fall outside the framework of common market indexes.  The GraniteShares HIPS High Income ETF (HIPS) screens these three asset categories, along with Real Estate Investment Trusts, for assets that are both the highest yielding and least volatile. Comprising up to 60 holdings, the fund tracks TFMS HIPS Index which yielded 9.08% as of 8/31/19.

As interest rate cuts start hitting the tape in the coming months, the search for sustainable, yet meaningful, income is only going to become more challenging. A diversified, strategic blend of alternative income structures may present investors with an attractive solution.  

Ultimately, the opportunity for high income streams through retirement may afford greater financial freedom, both in the present and future.  The latest flavor of yield may soon be alternative yield.


Important Information

This material must be preceded or accompanied by a prospectus https://www.graniteshares.com/Documents/130/GraniteShares-ETF-TrustForm-485POS-Prospectus.pdf. Carefully consider the Fund’s investment objectives risk factors, charges and expenses before investing. Please read the prospectus before investing.

Investing involves risk; Principal loss is possible. Investments in debt securities typically decrease when interest rates rise. This risk is usually greater for longer term debt securities. Investments in lower rated and non-rated securities present a greater risk of loss to principal and interest than higher rated securities. Investments in foreign securities involves greater volatility and political, economic, and currency risks and differences in accounting methods. Investments in smaller companies involve additional risks, such as limited liquidity and greater volatility. Master Limited Partnerships (“MLPs”) are subject to certain risks inherent in the structure of MLPs, including complex tax structure risks, limited ability for election or removal of management, limited voting rights, potential dependence on parent companies or sponsors for revenues to satisfy obligations, and potential conflicts of interest between partners, members and affiliates. Investments in asset-backed and mortgage-backed securities include additional risks including credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. A Real Estate Investment Trusts (“REIT’s”) share price may decline because of adverse developments affecting the real estate industry. REITs may have limited financial resources, may trade less frequently and in limited volume, and may be more volatile than other securities. The risks of investing in REITs include certain risks associated with the direct ownership of real estate and the real estate industry in general. Business Development Companies (“BDCs”) may carry risks similar to a private equity or venture capital fund. BDCs usually trade at a discount to their NAV because they investing unlisted securities and have limited access to capital markets. Closed-end Funds (“CEFs”) may be subject to leverage, liquidity risk, credit risk, and losses may be magnified due to the use of leverage. Leverage may increase the risk of loss and cause fluctuations in the market value of the Fund’s portfolio to have disproportionately large effects or cause the NAV of the Fund generally to decline faster than it would otherwise. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value. Shares of any ETF are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Brokerage commissions will reduce returns. An investment in the Fund does not receive the same tax advantages as a direct investment in a Pass-Thru Security. Funds accrue deferred income taxes for future tax liabilities associated with the portion of Pass-Thru Security distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments. This deferred tax liability is reflected in the daily NAV and as a result the Fund’s after-tax performance could differ significantly from the underlying assets even if the pre-tax performance is closely tracked. The potential tax benefits from investing in Pass-Thru Securities depend on them being treated as partnerships for federal income tax purposes.

The TFMS HIPS Index is constructed to capture high income securities, typically with pass-through structures, across the following sectors: (i) CEFs, (ii) mortgage REITs, (iii) commercial equity REITs, (iv) residential/diversified REITs, (v) asset management and BDCs, and (vi) energy production and energy transportation & processing companies. Energy-related companies included in the Index are expected to primarily be structured as MLPs. CEFs included in the Index are limited to taxable, debt-based funds and may include CEFs that invest primarily in bank loans, high-yield securities (also known as “junk bonds”), foreign securities (including those in emerging markets), and mortgage- or asset-backed securities. You may not directly invest in an index.

Distribution Rate represents a single distribution from the fund and does not represent total return to the fund. The distribution rate is calculated by annualizing the most recent distribution and dividing it by the most recent NAV.

30-Day SEC Yield is a standard yield calculation developed by the Securities and Exchange Commission that allows for fairer comparisons among bond funds. It is based on the most recent month end. This figure reflects the interest earned during the period after deducting the Fund’s expenses for the period.

This information is not an offer to sell or a solicitation of an offer to buy shares of any Funds to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. Please consult your tax advisor about the tax consequences of an investment in Fund shares, including the possible application of foreign, state, and local tax laws.

You could lose money by investing in the ETFs. There can be no assurance that the investment objective of the Funds will be achieved. None of the Funds should be relied upon as a complete investment program. The investment program of the funds are speculative, entails substantial risks and include asset classes and investment techniques not employed by more traditional mutual funds. Investments in the ETFs are not bank deposits and are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.

The Fund is distributed by Foreside Fund Services, LLC, which is not affiliated with GraniteShares or any of its affiliates.

©2019 GraniteShares Inc. All rights reserved. GraniteShares, GraniteShares Trusts, and the GraniteShares logo are registered and unregistered trademarks of GraniteShares Inc., in the United States and elsewhere. All other marks are the property of their respective owners.

       [1].  All yields are as of 8/31/19.  High Dividend strategies are represented by the FTSE High Dividend Yield Index, Real Estate strategies by the Dow Jones Equity REIT Index, and High Yield or junk bond strategies by the iBoxx USD Liquid High Yield Index. One cannot directly invest in an index. Past performance does not guarantee future returns.

       [2]. MLPs are represented by the Alerian MLP Index, BDCs by the S&P BDC Index and CEF’s by the S-Network Composite Closed-End Fund Index.  One cannot directly invest in an index.

Ryan is Director of Research at GraniteShares, and has focused his career on spanning the divide between traditional active management and indexed strategies. He has worked as an analyst at a number of hedge funds, including Tudor Investment Corporation, before developing first to market, scalable strategies utilizing the ETF wrapper. He graduated from Boston College in the Honors Program with a Bachelor of Arts degree in Economics and Philosophy. He earned his CFA charter in 2019.

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