In Seach Of Yield And A Note Of Caution

 |  Includes: PAA, PNG, UAN
by: wjexchange

I think we can all agree that during the past five years we have endured the worst economic downturn since the great depression. While unemployment peaked nationally at around 10 percent, many parts of the country blew right through that number into mid double digit figures. Homeowners have seen the values of their houses decimated, while the prices for food and fuel have skyrocketed well beyond the inflation rates that our government cares to admit to.

Ok, no more gloom and doom - we all hear enough of that. But, a note of caution is in order for those with any money left over for investment. The search for yields above the one-half of one percent levels offered by our friendly banks has been difficult to say the least. Many have sought refuge in Treasuries or bond mutual funds where yields of 2 to 5 percent were and still are available. But look out below! Your principal is now at great risk as interest rates look like they are poised to begin rising. A one percent increase in the prevailing rate will wreak havoc on your principal. Here is an example of how this works.

Suppose you recently invested $10,000 in a ten-year Treasury note with a coupon yield of 2.5%. If you hold the note until maturity, you will receive annual interest payments of $250 and you will eventually get your $10,000 back when the note matures in ten years. But meanwhile, if the going rate for ten-year Treasuries increases to 3.5% within the next year or so, the face value of that note will decline to around $7,000. The reason is that the note will still only pay interest at the original rate of 2.5%, or $250 per year. So if you sell the note in the open market before its maturity in a 3.5% rate environment, any prospective purchaser will demand a competitive yield, ergo, 3.5%, and will therefore only offer $7,142 for the note. That will leave you with a principal loss of $2,858, or a 29% capital loss on your original investment.

Ok, you have been warned - now some alternatives to consider. Regular readers will recognize that this writer favors stable income producing instruments, while eschewing the latest high flying rockets. The WJ Exchange Income Buy List can be viewed here. It is heavily laden with boring quality dividend paying common stocks, preferreds, master limited partnerships, and a few closed end funds. But as rates rise, the face value of these instruments will likewise feel the pressure of rising rates, although not as much as bonds.

I have recently uncovered two attractive high yield investments yielding in the 8 percent range, whose dividends look pretty solid. The first one is CVR Partners (NYSE:UAN). It is a Master Limited Partnership currently yielding 8.8%. This Sugarland Texas based company produces nitrogen based fertilizers and enjoys a distinct cost advantage over its competitors due in part to its strategic production locations and proprietary processes. Further, natural gas, at currently record low prices, is a major input in the fertilizer production process.

The second one is a company yielding 7.4% called PAA Natural Gas Storage LP (NYSE:PNG). Like UAN, it is also a Master Limited Partnership. The company's principal business is the storage of natural gas which, by the way, the country is swimming in at the moment. In listening to their recent conference call, it was revealed that 90% of their storage capacity is currently contracted through the end of the year, which should make the dividend relatively safe. 57% of the common units are owned by Plains All American Pipeline LP (NYSE:PAA), another master limited partnership. PAA is engaged in the transportation, storage, terminaling and marketing of crude oil, refined products and liquefied petroleum gas and other natural gas-related petroleum products.

It should be noted that master limited partnerships are not suited for frequent trading in that their distributions typically include return of capital that could materially affect your cost basis when selling. Further, because of their tax advantage characteristics, they are a better fit for taxable accounts rather than IRA's or 401K's. Distributions are reported on a K-1 directly from the company as opposed to the 1098 forms from your broker, which will somewhat complicate preparation of income taxes. For those not familiar with master limited partnerships, a great source for information and education is The National Association of Publicly Traded Partnerships which can be viewed here.

Disclosure: I am long UAN, PNG.