In my latest article about the ETF retirement portfolio I discussed two means of boosting the yield of the portfolio without substantial risk of losing one's principal: exchange-traded debt (ETD) and preferred shares. In this installment, I want to discuss a means of providing substantial yield (often more than 10%, and up to as much as 30% or more), although it comes at the possible risk of losing one's invested capital.
The Royalty Trust
A royalty trust (or simply "trust") is an investment structure through which a company distributes (a portion of) its profits to the trust's participants. Most trusts seem to be established by oil and gas companies, although some mining companies use them - and there is even one funded by a company in the music industry.
The trust is formed through a prospectus (filed with the SEC)1, in which the company specifies the details of the trust. Some of the more salient features of a trust include the following:
- Rather than issuing shares representing ownership, a trust issues units which entitle one to a portion of the funds distributed by the trust. Units are initially made available via IPO, and are subject to pricing the same as shares in a company, shares of an ETF, and so forth.
- The amount to be distributed is a portion of the establishing company's profits, the portion being defined by the company in its SEC filings. The company also determines the duration of the trust and any conditions or milestones that may affect distributions.
- Depending on the nature of the company and terms established for the trust, unitholders' income may not be qualified for reduced tax rates; income may be reported on a 1099 or on a K-1.2
- Unitholders acquire no rights with respect to the company that establishes the trust; rights extend only to the trust, and only so long as the trust exists. When the trust terminates, one may receive a final payment, but after termination one's units have no value.
- Conditions for the trust's termination are determined by the establishing company: a specific date may be indicated; the level of trust revenues may be the determining characteristic; unitholders may be able to decide to terminate the trust by majority vote.
- The trust is administered by a trustee, usually a bank, although it may be an individual or group of people. The trustee handles distributing the trust's revenues to its unitholders as well as matters involved in the maintenance and termination of the trust. The trustee is paid, and the trustee's pay, as well as any administrative costs encountered by the trust, are paid from the trust's revenues before distribution to unitholders.
Funds raised in the trust's IPO are typically used by the founding company to pay off liabilities, after commissions and other expenses incurred in establishing the trust are paid.
There is basically only one benefit to a trust, but it is a big one: a potentially significant income over a usually generous period of time for a fairly reasonable price. A recent list of royalty trusts shows a unit price range from $2.50 to $89.47. The same list shows dividend yields from 7.13% to 33.71%. The time frame for the trusts on the list range from a few years from now to 2031, and a few with no determinate termination point.
While the upside to trusts may seem very attractive, one should keep in mind that "every silver lining has a cloud."3
It is important to keep in mind that a unit is not like a share that gives one ownership interest in a company; the unit only gives one a share of the funds distributed by the trust (along with whatever voting rights are granted by the establishing company).
It is typically stated in a trust's prospectus that unitholders have no shareholder rights with respect to the establishing company. This is an important stipulation to keep in mind as one considers investing in a royalty trust, since once the trust ceases to exist, so too do its units. Once the trust's final payment is made, unitholders have no further prospects - even if they have not recovered all of their invested capital.
Of primary importance, then, is determining the minimum expected value of the trust; that is, if one were to buy a certain number of units, what is the least one could expect to receive for the remaining life of the trust? Further, supposing one is able to recover one's initial investment, is the total return from the investment worth it - could one have done better elsewhere?
Consider Whiting USA Trust II (NYSE:WHZ),4 selling at $13.12/unit at close, August 14, 2014. Over the past twelve months, Whiting II has paid $2.69/unit in dividends, ostensibly giving it a dividend yield of 20.5%. At that rate, it would take five years to make back one's invested capital, taking us to 2019.
Established in 2011, Whiting II is scheduled to terminate in 2021 or when it has produced 11.79 million barrels of oil equivalent ("MMBOE"), whichever is later. Whiting Petroleum Corporation (NYSE:WLL) has produced ~ 5.3 MMBOE thus far (through 2013). The company further projects a decrease of roughly 8.4% per year in production (the trust receives 90% of the company's profits).5
At its current rate of production, the company looks to exceed the trust's production limit, with the trust likely staying in operation until its scheduled termination date of December 31, 2021, albeit with gradually declining distributions.
Assuming that the last two years see dividends comparable to those at present, each unit purchased now would receive approximately $5.40 over the invested capital, or a total of roughly $18.52 - a return of about 41% for a seven-year investment, which averages to an approximate yield of 6% per year.6 Keeping in mind the projected decrease in production, the figure could be significantly less.
VOC Energy Trust (NYSE:VOC) was established in 2010 by VOC Brazos Energy Partners, L.P. This trust is scheduled to terminate in 2030 (or once 10.6 MMBOE have been produced). On August 14, 2014, VOC units sold at $14.91, and had paid $2.01 in dividends, ttm - a dividend yield of ~ 13.48%.
It would take until early 2022 to earn back one's invested principal, leaving a little more than eight years to realize yield. Again assuming payments remain the same, that would give one a little more than $18.00 beyond one's cost basis, amounting to an annual yield of approximately 7.5% - not a bad figure, by any means.7
Strategizing the Royalty Trust
The two examples above involve buying units in a trust and holding those units until the trust terminates. While that may be the easiest strategy to use with trusts, it may not be the most optimal.
A more effective strategy would seem to be one which looked at the trust as a short-term investment where one would plan to sell one's units at an appropriate time, collecting dividends in the meantime. The only question is determining when to sell one's shares.
In principle, there would seem to be two conditions that would determine whether a particular trust holding would be worth maintaining in one's portfolio:
- Is the yield one is receiving at least as good as the yield one could expect to get from another holding? A trust that is earning one 20% - 30% is likely paying its way, and would normally be a nice holding for the portfolio. A trust that is earning 7% - 10% might be acceptable as long as the unit price stays in the general range that one originally paid, but one could get comparable yield elsewhere.
- Is the unit price holding up? While yield is based on the purchase price of the units, the total return is going to factor in the price at which the units are sold, as well. If the unit price begins to drop precipitously, it may indicate that the useful life of the trust has gone by, whether because the termination date is drawing near, or because production is down and - consequently - royalties are decreasing. The investor should approach the trust with the expectation of selling if the price goes below a certain level.8
Once the trust investor has decided to sell, it becomes a matter of timing the sale. As the following chart indicates, it seems that unit prices tend to peak just before the ex-dividend date, which would be one to two weeks before the payout date (although that is also not always the case).
VOC pays its dividends near the last day of January, April, July and October.9 Note that, except for a few times, unit prices peaked anywhere from seven to fourteen days prior to the distribution date. Conversely, the best time to buy units would seem to be about two months after the distribution (again, not always the case).
Keep in mind the apparent truism that you cannot time the market.
A Cautionary Tale
More than 18 months ago, I wrote an article about the Great Northern Iron Ore Properties (NYSE:GNI), a royalty trust that is scheduled to cease operation in April, 2015. At the time of writing, GNI was paying a quarterly dividend of somewhat less than $5.00, and its shares were priced in the vicinity of $78.00.
After analysis, I presented the case that GNI was worth - at best - $35.00 per unit, given that (1) its dividends were decreasing due to a poor market for iron ore, (2) it looked at best to pay approximately $40.00 - $45.00 before termination, and (3) the final payment was not shaping up to be worth very much.
Since my article appeared, GNI has paid roughly $20.00 in dividends, and does not seem likely to reach my $40.00 low estimate (shortly after my article, the dividends dropped to an average of $2.50 per quarter). Given its $21.47 unit price (as of closing, August 15, 2014), the trust looks to be paying a yield of over 45%, although the trust ceases to exist less than a year from now - that is, it is possible that unitholders will not see much more than $10.00 in income from this point on.
What is interesting to note is that GNI commanded a unit price in excess of $70.00 as recently as December 27, 2013, with the prospect of receiving at best less than $20.00 in dividends total. Further, the price dropped by nearly half between December 27 and January 6, 2014, when it closed at $35.70; by the end of the month it had gravitated to its current level, a drop of approximately 70%.
A person who purchases GNI now may see $15.00 in distributions between now and GNI's termination date - including the final payment. On paper, that would look like a nearly 70% yield. However, because the units are worthless after the final payment is made, units purchased today would have a total return of -30%, a loss of $6.47 per unit.
Approached as a short-term investment, a royalty trust can provide one with several years' worth of handsome yield. As a long-term prospect, however, they require serious planning and careful attention. The dividend yields associated with royalty trusts can be alluring, but they have to be balanced against the inevitable loss of invested capital. The best approach is to be satisfied with several years of high dividends, then selling one's units while the units still have value.
In a way, a retirement portfolio may be the ideal place for a royalty-trust holding, provided one limits one's investment to a small portion of non-core, discretionary capital.
This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein.
All data contained herein is accurate to the best of my ability to ascertain, and is drawn from the Company's SEC filings to the extent possible. All tables, charts and graphs are produced by me using data acquired from pertinent SEC filings; historical price data from Yahoo! Finance. Data from any other sources (if used) are cited as such.
All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views.
Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully.
1The terms of the trust will also be reiterated in the trust's 10-K filings with the SEC.
2 Tax implications may vary from trust to trust. Trusts are not recommended for investment in tax- deferred or tax-free accounts such as IRAs because of the vagaries surrounding the taxability of their distributions. However, I am not a lawyer, nor am I a tax specialist; consult with your financial specialists as part of your due diligence.
3Yes, I know this is the reverse of the real saying.
4 Data used in this example taken from Whiting USA Trust II 10-K, 2013.
5 Whiting Petroleum Corporation website.
6 The figures presented do not include any final payment. Such a payment would include any unpaid profits and liquidated assets of the trust, minus any liabilities the trust may have.
7 Again, this is assuming the dividend payments remain roughly the same throughout. It is more likely that they will decrease over time, as the wells dry up.
8 A couple of notes: unit price is going to fluctuate (sometimes by quite a bit) between payout dates - do not confuse this normal fluctuation with a more general downward trend (one where the price goes down with very little uptick prior to payouts); also, finding and setting a selling price is a matter of projecting dividends over a period of time, and seeing how much of a price drop one could accept and still see a reasonable return.
9 Technically, "on or about 45 days following the completion of each quarter" according to SEC filings. Companies typically announce a few weeks in advance when the next distribution is to be paid, how much the distribution will be, and what the date of record must be.
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