These Overlooked Securities Yield Up to 16%
They’ve become wildly popular.
Their assets grew more than 30% a year during the past decade. For comparison, mutual funds saw their assets rise just 5-6% per year, according to McKinsey & Co.
And there are no signs of that growth slowing down. McKinsey & Co. projects assets in these securities will more than double in the next five years to at least $3.1 trillion, from a little more than $1.5 trillion today.
I’m talking about exchange-traded products. Most of that growth is in exchange-traded funds (ETFs), but a handful of overlooked exchange-traded notes (ETNs), yielding up to 16%, also are included in this market.
And while there are ETFs for everything from copper to cocoa, ETNs a unique type of exposure to mainly two high-yield groups: master-limited partnerships (MLPs) and business-development companies (BDCs).
For example, there is the JPMorgan Alerian MLP Index ETN (NYSE: AMJ), which yields 5% and tracks the performance of a basket of 50 master limited partnerships. And the UBS ETRACS 2x Wells Fargo BDC (NYSE: BDCL) pays a yield of 16% and tracks 26 BDCs.
ETNs are an entirely different beast from ETFs. Both track the performance of an index and offer a simple way to move in and out of a sector. Both may pay dividends thrown off by the securities in the index they track. And both can be bought or sold during the day, just like a stock.
But that’s where their similarities end.
Unlike ETFs, ETNs do not represent a claim on shares of stock, bonds or commodities. The ETN issuer — usually an investment bank such as Morgan Stanley (NYSE: MS) or JPMorgan Chase (NYSE: JPM) — may invest in the index companies to collect returns, but ETN holders like you and me don’t have a claim on those assets.
Instead, ETNs are promissory notes. They are senior unsecured debt that promises to match the return of a specific benchmark.
Like bonds, ETNs have a maturity date. At maturity, generally 15 to 30 years from the issue date, the ETN is redeemed. Unlike bonds, however, you don’t receive the face value in cash. Instead, the amount you receive is based on the performance of the index. What you get at maturity depends on how well the index has performed.
But one of the features that may be attractive to many investors is that ETNs can help you avoid some potentially hairy tax issues.
As debt, ETNs distribute interest income that’s taxable at your marginal income tax rate. Although the income doesn’t qualify for the reduced dividend tax rate, you do receive a simple 1099-DIV form for the income you receive. That’s especially helpful when investing in an ETN tracking master limited partnerships, where investors are subject to the more complex K-1s when investing in individual MLPs.
Also, you can hold these ETNs in a tax-sheltered IRA or 401(k) account without fear of throwing off more than $1,000 in unrelated business taxable income (UBTI) that can come from investing directly in master limited partnerships.
Combine that with their high yields and you can see why exchange-traded notes have become a favorite of income investors.
But are these the perfect income securities? They definitely provide a good to look into in your search for income, but you should be aware that most ETNs trade very few shares a day. For example, the Morgan Stanley Cushing MLP High Income ETN (NYSE: MLPY) trades fewer than 3,000 shares a day, meaning it can be difficult to buy or sell large lots without moving the price.
Action to Take –> Despite that, any income investor looking for a class of securities “overlooked” by most investors would do well to spend some time researching more about exchange-traded notes.
P.S. — If you haven’t already seen it, don’t miss StreetAuthority’s report — “Top 5 Income Stocks for 2012.” These five select investments pay dividend yields of 7.5%… 8.8%… even 11.5%. For more details on these investments, you can visit this link.