The 10% Yielder You’ve Likely Never Heard of

In case you didn’t already know… it’s a tough time to be an income investor.

Ten-year treasuries yield 2%, the average dividend stock in the S&P pays slightly more at 2.1%, and a savings account earns next to nothing.

But if you think that means that high-yield opportunities are in short supply, think again.

There are dozens, if not hundreds, of high-yield plays hiding in the market that most investors simply don’t know about. You just have to know where to look.

Take the energy sector for example.

When most people think of energy stocks, integrated oil and gas behemoths like Chevron (NYSE: CVX) usually come to mind.

But while Chevron’s 3% yield is nothing to laugh at, don’t think for a second that’s the best you can do. In some industries, 3% might be the ceiling, but it’s often just the floor in certain subsectors of the energy space.

The recent shale boom in the U.S., expanding economic output in the emerging markets, and fears over oil security in the Middle East have all stoked demand for everything from fracking fluids to LNG tankers.

Consequently, energy companies across the board are raking in record amounts of cash… and paying it back to investors in the form of dividends.

But look closely, and you’ll notice its not major players like Chevron and Exxon (NYSE: XOM) offering investors these healthy distributions. Rather, these robust yields are coming from non-traditional energy investments like MLPs and royalty trusts.

I won’t talk much about MLPs. I’ve already covered them extensively here. Instead, I’d like to introduce you to another class of high-yielding securities the energy sector has to offer — royalty trusts.

Royalty trusts boast some of the highest yields on the market — typically 6% to 8%, but payouts north of 10% aren’t uncommon. And aside from writing generous paychecks every quarter, many of these securities have also delivered triple-digit share price appreciation. I’ve found several with returns in excess of 300% over the past 10 years.

Yet despite their double-digit yields, and solid industry fundamentals to boot, many retail investors are generally unaware these securities even exist. Most can’t name even two royalty trusts — let alone know enough about them to consider buying into one.

In the simplest of explanations, they work like this. When an energy company wants to raise money, it can sell a “stake” or interest in certain properties in the form of a trust. Most commonly, these properties are oil and gas wells, but sometimes they’re built around other resources like coal or iron ore.

The trust’s parent company takes care of the drilling, production, marketing, and selling of the oil and gas produced from those wells.

The royalty trust is passive in the relationship. It doesn’t have to do a thing. In return for the initial investment when it went public, its investors get a cut of all the oil and natural gas sold from the wells.

Now, you might be wondering why any energy company would voluntarily give up a percentage of the income from its wells. The answer here is simple.

Developing wells requires a lot of capital. Increasingly, the financial whizzes at these firms are finding that selling royalty interests is a much better way to raise cash than borrowing from a bank, issuing bonds or printing new shares.

This financing arrangement is a win-win. From an investor’s perspective, these trusts exist for just one purpose: to collect ongoing royalty payments and distribute them to unitholders. (Shares of trusts are called “units” instead of shares.)

One such trust is Chesapeake Granite Wash Trust (NYSE: CHKR), an offspring of energy giant Chesapeake Energy (NYSE: CHK).

CHKR is a brand new trust with royalty rights to 69 of Chesapeake’s existing wells in the Granite Wash, an oil producing region that spreads from the Texas panhandle all the way to western Oklahoma. According to the geologists, these wells will be drawing from a reserve base of 18.6 million barrels of oil equivalent (approximately half gas, the rest crude and natural-gas liquids (NGLs).

But it doesn’t stop there. Unitholders will also be entitled to 50% of the proceeds from another 118 development wells that will be drilled over the next few years.

The development wells, which will be located on 45,000 acres in the Anadarko Basin of western Oklahoma, will more than double today’s production as they come online. There are another 25.7 million barrels of oil below the development wells, for a grand total of 44.3 million barrels attributable to the trust.

I think the added output makes CHKR an attractive investment. Though it’s a new trust, it’s backed by Chesapeake, a veteran oil and gas producer. And the initial distribution bodes well. Thanks to higher-than-expected sales volume, CHKR was able to pay investors $0.58 a unit, versus a target of $0.54.

As production increases, those distributions should only grow larger. Right now, CHKR is targeting a $3.13 dividend for all of 2012. But it expects that number to grow to $3.48 by 2013 as more wells come on-line.

If you’re an income investor starved for higher yields, I think CHKR could be a good buy. Its 10% yield is one of the highest you’ll see in this low interest rate environment.

Let me warn you though. Like any natural resource investment, royalty trusts carry commodity risk. Energy prices could remain volatile as signs of economic deceleration in developed economies continue to hang over financial markets.

Action to Take –> But, that said, the long term fundamentals look bullish for energy investments. Dwindling reserves and rising global demand will inexorably lead to higher oil prices. And judging by the last ten years of stock market data, one thing seems certain — the energy space looks like one of the best hunting grounds for income investors looking for higher returns.

[Note: I’ve barely scratched the surface on the unique benefits royalty trusts have to offer. If you want to learn more about how you can earn double-digit yields in this lucrative sector, I invite you to watch this presentation. In it, I’ll highlight everything you need to know about royalty trusts, and give you the ticker symbol for one of my favorite trusts yielding 17.1% right now. For more information, click here.]