The Search For Yield

Risk free yield is shrinking, as many investors have been finding out when recently logging into their on-line bank accounts. The interest rate on many “high yield” bank accounts has shrunk to near 4%. Leaders such ING Direct (4.10%), EmigrantDirect (4.65%), and HSBC (HBC) Direct (4.25%) have reduced rates over the past months. While these rates are not dreadful for FDIC insured deposits, the yields are significantly down from the 5% region before the Fed started to drop the short term rates.

The situation at your neighborhood brick & mortar bank is even bleaker, many money market funds are back to yielding below 1%. Heaping further injury on banking customers, most local corner institutions have been busy increasing fees for every imaginable service. This combination has left many investors seeking opportunities for better yield.

The current environment is a challenging time for income seekers to be focused on yield, investors must navigate the turmoil of bond downgrades, shrinking dividends, falling interest rates, falling real estate, and a financial sector immersed in the subprime fallout. Fortunately a few solid income opportunities are available in less utilized instruments such as Master Limited Partnerships (MLPs), Trust Preferred Securities (TruPS), and Canadian Royalty Trusts. Many of these opportunities are directly associated with the natural resources sector which is hot. Energy and commodities are likely to see growth over the upcoming years.

As always there is no such thing as a free lunch, attempting to increase yield will amplify your portfolio risk. The theory is to select high-grade investments that have minimal risk relative to the generated income. The best policy to decrease overall risk is to select different instruments across various sectors. This minimizes the risk relative to sector performance, individual company credit rating, and taxation changes.

Another key consideration is taxation. Most of these yield focused investments are taxed as your standard tax rate rather then the 15% dividend rate. If possible it is usually preferred to place income generating securities in a tax sheltered account such as an IRA.

Many of MLP and TruPS securities are unloved on Wall Street and out of the mainstream. The majority are under-valued relative to their yield. These securities trade like stocks so as the price goes down the effective yield increases. Most are currently trading below their issue value as most investors are not informed about their income potential.

Master Limited Partnerships (MLPs)

Master Limited Partnerships (MLPs) offer investors yields up to 9%. MLPs, which are primarily focused in the oil and gas sector, must pay out most or all of their cash flow in distributions. Typically MLP investors pay regular income tax rates on 20% of their cash distributions; for many partnership products taxes on the remaining 80% or so are usually deferred until the investor sells.

Many income-oriented investment advisors recommend energy-focused MLPs such as Enterprise Products Partners (EPD) (6.1% Yield) and Kinder Morgan Energy Partners (KMP) (6.5% Yield). These instruments offer solid yields with possible share appreciation. Additionally both have demonstrated strong insider buying.

One excellent resource for researching income focused investments is quantumonline.com (QOL). The site is free to those that register. QOL is “unbiased information on preferred stocks and other exchange-traded income investments.” The site allows you to research MLPs, TruPS, Royal Income Trusts, and many other instruments. Solid information is provided about taxation, distributions, and limitations of the various yield-focused securities.

Trust Preferred Securities (TruPS)

Trust Preferred Securities (TruPS) are sometimes called “bonds for the masses” These instruments normally trade at a face value of around $25 instead of the $1,000 price tag needed to purchase a bond. TruPS come from many different issuers; most are originated from well-know companies such as General Motors (GM), Citi Corp (C), and American Airlines. Most TruPS are taxable at your standard income rate, a number are only taxed at the 15% dividend yield rate. A list of the TruPS taxed at the 15% dividend rate can be found at the QOL site.

Some investment advisors consider these preferred securities to be the worst of both worlds. From an equity perspective they do not rise as quickly as the common stocks of the companies, and from a debt-market angle TruPS are considered riskier than bonds. Other advisors view TruPS as a valuable addition to an income-oriented portfolio.

The majority of available TruPS are from financial sector firms. Naturally with the current sector turmoil investors should avoid this sector except for banks that have limited sub-prime exposure such as US Bancorp (USB). US Bancorp offers a preferred security yielding 6.9% and listed under USBH (or USB-PH in Yahoo).

With many sectors beaten down in the last months, many industries are offering excellent yields on preferred stock. It is best to avoid the financials and focus on preferred securities from major manufacturers (GM, Ford (F), etc), utilities (DTE (DTE), Duke (DUK)), and conglomerates (General Electric (GE)). These are all companies that will likely survive any recession and continue paying their preferred payments for many years into the future.

General Motors (GM) has a good number of preferred offerings that are now yielding over 11%. These can be found listed as (BGM), (RGM), (GMW), (XGM), (GMS) and (HGM) on the NYSE. While the auto industry certainly has faced challenges which have battered the credit ratings of most manufacturers over the past years, it is unlikely that GM will stop paying dividends on these preferred securities.

A comprehensive table of preferred securities can be found at the WSJ online site.

Canadian Royalty Trusts

Another income investment to consider is Canadian Royalty Trusts. Most of these instruments are focused on the natural resource industry. The yield on many is above 9%. However the taxation situation is difficult to sort out; investors must deal with a tax withholding situation in Canada and unclear requirements about the U.S. taxation rate. Due to the taxation situation, it is best to avoid putting Canadian Royalty Trusts in an IRA or other qualified plan. Investors should see their tax advisor before diving into these instruments.

One leading Canadian Royalty Trust is Canadian Oil Sands Trust Units [COS-UN.TO] which recently raised its quarterly distribution by 38% at the end of October. Another prominent trust is Provident Energy Trust (PVX) which is listed on the NYSE and is yielding 14.4%.

One summary of leading Canadian Royalty Trusts can be found at DividendDetective. QOL also provides a solid summary of the Canadian Royalty Trusts listed in the U.S. market.

Summary – Understand the Risks before jumping in

Keep in mind that income-focused securities are only appropriate for a portion of most investors’ portfolios. The key focus is normally to replace the income-oriented component of the portfolio with higher yielding instruments. Recognize that a capital depreciation risk exists when buying preferred equities; their price can go down just like common stock.

Certainly these investments offer better yields than CDs and money market funds. Interest rates on most traded equity-based instruments are above 6%, some have eye-popping yields of over 14%. An investor should evaluate the credit rating of the issuers prior to jumping in, while diversifying across multiple vehicles to control risk. When utilized properly MLPs, TruPS, and Canadian Royalty Trusts can boost income yields within a portfolio significantly above standard bank interest rates – without causing a loss of sleep over the safety of the principle.

Disclosure: The author does not have a position in any of the income equities mentioned in this article. The information provided does not constitute a solicitation to buy, or an offer to sell securities.