Investors be like looking for yield in all the wrong places.
In a low-interest-rate environment, finding high-yielding investments is hard, and 2020 has been a horrible year for income investors. The yield on the 10-year Treasury note has been below 1% since March, when the pandemic lockdown started. The iShares Core U.S. Aggregate Bond ETF (AGG) AGG , which tracks the investment-grade bond benchmark, yields 2.23%. And the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) HYG , which holds junk bonds, posts a yield of 4.89%.
It has also been a dismal year for equity income as many companies facing a cash crunch this year either cut or eliminated their dividends. The stock market’s 905 dividend suspensions year to date topped the 783 in 2009, said Howard Silverblatt, senior index analyst at S&P DowJones Indices.
Currently, the yield on the S&P 500 Index hovers around 1.57% and the Vanguard High Dividend Yield ETF (VYM) VYM pays just 3.22%. All yields according to Morningstar.
There are a significant amount of exchange traded funds (ETFs) that seek to provide a high yield for investors, but only one does it using a blend of alternative income sources, specifically pass-through securities. The GraniteShares HIPS US High Income ETF (HIPS) HIPS holds a unique portfolio of real estate investment trusts, master limited partnerships, business development companies, and closed-end funds.
For most of 2019, the HIPS (for High Income Pass-through Securities) ETF traded between $17 and $18, for an average yield of 7.4%, not too shabby. However, like most of the stock market, the fund experience a big drop as some of its underlying securities were in the worst-hit sectors this year, real estate and energy.
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In 2019, the fund posted a 23.72% return, according to Morningstar. This year, the fund is off 11.5% through Dec. 9, according to Morningstar. But the fund has done well the last few months, recovering about 60% of its losses from March. Still, real estate and energy remain week.
“That’s the 1-2 punch. It’s not just a yield story,” said William Rhind, the founder and chief executive of GraniteShares. “There are funds in the market that have a high yield, but the trade off is that you may not get any growth in the underlying portfolio. But if you believe that the market is going to improve from here, then it’s an opportunity to lock in a near 10% yield with the prospect for capital growth.”
The fund pays a monthly distribution of 10.75 cents a share, or $1.29 annually. Thursday, it closed at $13.63 a share, giving it a yield of 9.5%.
HIPS manages to achieve such a high yield by holding only pass-through securities. This means they don’t pay corporate taxes and pass along most of their income to their investors. By avoiding the double-taxation phenomenon where companies and investors pay taxes on the same money, investors receive more income.
Closed-end funds (CEFs) are funds trade their shares on the stock market like ETFs and are able to use leverage to increase their yield. Of the 15 closed-end funds held by HIPS, 60% are equity and 40% are fixed-income funds. Among the fixed-income funds, three are high-yield-bond funds, two are senior-loan strategies and one holds convertible securities.
Business development companies (BDCs) are investment firms that specialize in funding distressed or emerging companies and operate similar to private equity or venture capital. These companies leverage their internal capital structure to create high-income payouts to their investors.
Master-limited partnerships (MLPs) are publicly traded firms somewhere between a partnership and a corporation. Most of these companies provide pipelines and other services for the transportation and storage of oil and natural gas. These companies are required to pay out all their cash flow to investors.
Real Estate Investment Trusts (REITS) are a way to receive capital appreciation and income without holding real estate. REITS buy, manage, and develop commercial or residential properties. They must return 90% of their annual profit to shareholders.
The fund screens for the 15 highest-yielding securities with the least volatility in each sector. It then gives each company an equal weighting in their category. It then weights each sector based on volatility. As of Sept. 30, the portfolio held 41.5% in CEFs, 29.1% in BDCs, 17.8% in REITs, and 10.6% in MLPs. The fund says the portfolio is not correlated to the conventional fixed-income market. Another benefit to buying this fund is that unlike a fund focused on MLPs, there are no K-1 forms to file with your income taxes, because they keep the portfolio weighting below 25%.
Rhind said there are two reasons the fund is gaining traction. The obvious reason is the fund pays yield during an income crisis. The second is that it took the Federal Reserve seven years to raise rates after the Fiscal Crisis of 2008.
One point of confusion is the fund’s expense ratio, the fees investors pay to run the fund. The fund’s management fee is 0.70%, which is subtracted from the NAV each year. Then there are acquired fees and expenses of 0.60% paid to the closed-end funds, which charge their own expense ratios, for a total of 1.3%. But, the total expense ratio is listed at 3.19% per year.
Rhind said investors don’t pay this high rate directly because it’s not accrued by the fund as management fees. Most BDCs choose to be treated as regulated investment companies for tax purposes, meaning that they must distribute at least 90% of their taxable income to shareholders. The consequence of this is that they must report their expenses like a mutual fund, not a corporation.
“BDCs are more akin to traditional companies as they have operating expenses such as payroll and real estate expenses, which is quite different from mutual funds that only support management fees. As a result, BDCs report expense ratios of around 10% when mutual funds report much lower levels,” said Rhind.
So, on the accounting documents they need to report 1.89% of BDC expenses, but this is not what investors pay. They do pay the 1.3%, though.
However, the HIPS tracking error, the difference between the fund’s return and that of its index, is only 16 basis points, according to Bloomberg.
Finally, the fund helps lower investors’ tax bill by making part of the distribution a return on capital. This lowers the amount of income taxed as ordinary income, and lowers the investor’s cost basis for the investment. This means this part is taxed at the lower capital gains rate only when the investor sells the shares.