A long time ago, in a financial world very unlike today's, investors could earn decent returns with just a savings account and certificates of deposit issued by the local bank.
In contrast, today's easy-money policies and near-zero interest rates have made things much easier for borrowers. However, the flip side is that decent yields have all but vanished from the risk-free landscape, forcing investors to look to unusual and often high-risk instruments.
One such instrument has been known to provide yields in excess of 50% -- yet owns no assets, has no employees and doesn't pay any federal income taxes. In fact, yields on these investments are tax-advantaged and may offer unique tax credits.
Called royalty trusts, these instruments are corporate entities that focus on natural resources such as oil, gas or mining. They own the rights to royalties on the production and sale of natural resources rather than the resources or infrastructure. The trusts have no physical operations and no management or employees.
Royalty trusts are financing vehicles that trade like stocks and are operated by banks. They do not produce a steady cash flow and are at the mercy of commodity prices and production levels. This means returns can vary greatly from year to year.
Royalty trusts are required by law to pay out nearly all their cash flow to investors, which is how they're able to offer such high yields. Other upsides include a tax-advantaged status: Due to asset depletion and depreciation, the IRS does not consider trust distributions as income. This allows investors to defer taxes until the royalty trust is sold. In addition, unique tax credits can be available for royalty trust investors due to unconventional fuel production sources.
However, royalty trusts are not without their downside:
Royalty trusts have no intrinsic value: Trusts are valued purely on their production and commodity prices. This means that, over time, the trusts' resources will be depleted, forcing the yield and trust value to zero.
Complex taxation: Although there are many tax advantageous to royalty trusts, trust taxation can be very complex, requiring specialized experts.
Massive volatility: Royalty trusts' returns are tied directly to the price of their underlying commodities. Therefore, investors should expect extreme volatility in the returns.
Yield versus price: As you know, price and yield can be inversely correlated: the lower the asset price, the higher the yield. The price of a royalty trust declines as the yield increases, so beware the trap of a high-yield royalty trust whose price declines more quickly than its yield increases.
Out of the 26 or so royalty trusts available in the U.S., my current favorite is the Enduro Royalty Trust (NYSE: NDRO). The trust has yielded better than 10% since November 2011 and is in a growth phase of production. It controls the rights to oil and natural gas production facilities in Texas, New Mexico and Louisiana.
Enduro has produced substantial yield while recently maintaining a solid uptrend in share price. The trust has no production limit or end date. In the parlance of royalty trusts, it is known as being perpetual. Obviously, this does not mean it will last forever, but based on the projections, there is at least five years' worth of resources remaining.
Risks to Consider: In addition to the risks outlined above, it's critical to note that the highest-yielding royalty trusts are often near depletion or have other issues. It is critical that investors read the trust prospectuses thoroughly before making an investment decision.
Action to Take --> When chosen with care, royalty trusts can be a great way to add high-yielding diversification to your portfolio. I consider NDRO a long-term hold, and buying now in the $13 to $14 range with stops at $9.90 and a price target of $18 makes solid investing sense.