16% Yield In An ETN - What Could Go Wrong?

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Leveraged ETNs that invest in closed-end funds offer high yields with a higher degree of risk.

The current low volatility environment has been supportive of these products to date, however that may change in the near future.

Investors should carefully research and consider the risks of leveraged products before they decide to invest.

Last week I wrote an article about generating yield using ETFs that invest in closed-end funds. My goal was to point out innovative ways to increase the income stream in your portfolio outside of traditional high yield asset classes.

I was initially concerned that many investors would view this strategy as fraught with risk at a time when everyone is overextending themselves in the search for yield. However, the feedback that I received was shockingly in favor of taking more risk to generate an even greater yield.

Many readers pointed out that I failed to mention the ETRACS Monthly Pay 2x Leveraged Closed-End Fund ETN (NYSEARCA:CEFL) as a suitable alternative for aggressive income seekers. This exchange-traded note is designed to provide two times exposure to the ISE High Income Index. This is in fact the same index of 30 closed-end funds that the Yield Shares High Income ETF (NYSEARCA:YYY) tracks, just without the leverage component.

CEFL is not the same as a traditional ETF that holds a basket of underlying securities. An exchange-traded note is a debt instrument issued by a bank (in this case UBS) with the promise to track a specific index over a predetermined length of time. There is technically credit risk associated with investing in ETNs; however I rate that risk very low in this case because of the high credit rating of the issuer.

CEFL was initially launched in December 2013 which happened to coincide quite nicely with a six month period of discount narrowing and premium expansion. Many of the underlying closed-end funds were in the middle stages of emerging from correction territory in the wake of the Federal Reserve's tapering announcement in May of 2013. As a result, the year-to-date returns have been fantastic. CEFL has gained 19.15% in 2014 and more than 28% in the last 6 months.

In addition, the current annualized yield on CEFL is listed at 16.53% according to the fund company website. For perspective, the current yield on a 10-Year Treasury Note is hovering right around 2.6%. So CEFL is offering 6 times the yield of a credit risk-free Treasury asset based on its current distribution rate.

While the initial results have been successful and on the surface CEFL appears to be a perfect vehicle for high income seekers, I would caution the majority of investors from stepping into this fund without considering a number of risks.

A good rule of thumb for income investors is that high yield = high risk. It's really that simple. Every incremental step in the reach for yield will come with the higher risk of principal draw down as a result of credit exposure, portfolio leverage, and structural makeup.

Remember that the majority of closed-end funds by their nature are already using leverage as a component of their existing strategy. They often deploy anywhere from 15-50% of the fund in leverage to enhance their yields or total return. That's how they are able to produce steady income in the 6-10% range.

In the case of CEFL, you are then adding additional leverage on top of the existing portfolio which significantly magnifies the yield and also price fluctuations. So far this ETN has existed during a period of low volatility that has benefited its strategy. However, there will come a time when discounts widen and net sellers of closed-end funds introduce you to a whole different world of price instability that can have adverse consequences.

While I am far from a "doom and gloom" investment adviser, I get concerned with the level of risk taking and lack of due diligence that many investors take with these leveraged products. They can experience periods of high growth and might appeal to a short-term trader, however I would be hesitant to recommend their use by the majority of retirees and conservative income investors.

I have seen many people get lured by yield statistics or recent performance numbers into areas that they don't fully understand. A few sectors that come to mind are other leveraged income wrappers such as mortgage REITs or business development companies. This can often lead to loss of capital in a very swift period of time due to a lack of knowledge and individual investor due-diligence.

My advice is that if you do decide to invest in a fund like CEFL is that you do so with a stop loss or other sell discipline to define your total risk. That way you have a plan in place if things do head south. In addition, it's worth comparing the use of a leveraged product versus a larger allocation to a non-leveraged peer (such as YYY) in order to achieve similar results.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.