Investors Are Looking for Yield in All the Wrong Places

Animated image of a businessman walking a tightrope.

Searching for sustainable yield is never easy, but over the last decade, income investing has been a most unpalatable cocktail — one part frustration and two parts despair (add bitters to taste). With 10-year treasuries near all-time lows and the Federal Reserve embarking on a fresh easing cycle, the hunt for yield will only intensify.

Necessity Is the Mother of Invention

The unfortunate reality is that a deep chasm stands between investor income requirements and what conventional strategies can now yield.

In a market where every basis point of income counts, many yield-focused strategies simply do not generate as much income mileage as may be imagined. For instance, high-yield dividend strategies generally manage a low 3-handle yield, and real estate achieves a somewhat higher 3-handle distribution. This prompts the obvious question: How is a saver supposed to retire on a 3-handle income stream? Even junk bonds, with all their attendant credit risks, may only deliver in the low 5-handle range. Strikingly, this threshold is the upper limit for mainstream income strategies, and yet these yields may still be insufficient for many investors.

This dearth of income has refocused the paradigm on retirement, forcing advisors and clients to reevaluate lifestyle goals within the context of the possible, hemmed in by low yields. But what if there were strategies that could achieve four times the yield of the S&P 500, with less volatility?

Welcome to the world of alternative income and pass-through securities. Perhaps the problem hasn't been that income doesn't exist in this market, but simply that we have been conditioned to look for income in all the wrong places.

The Unusual Suspects

The solution to this income stream problem may lie in an ecosystem of alternative investment beyond the frontier of conventional options. The three prominent contenders in this high-yield arena are closed-end funds (CEFs), business development companies (BDCs) and master limited partnerships (MLPs), achieving yields of 7.55%, 9.54% and 8.17%, respectively. How do they do it?

What these assets have in common is they may exploit unique fund structures or target specific risk profiles to hit income in excess of traditional methods. Their pass-through structures avoid the double-taxation phenomenon, enabling higher yields for the end investor.

Foremost, closed-end funds can use the gambit of their own internal leverage — they are able to issue their own debt and preferred shares up to 50% and 100% of net assets, respectively — to augment their exposure to high-yield debt. In exchange for increased volatility, the CEF structure enables investors to figuratively "double-down" on speculative-grade yields, while the potential to purchase CEFs below net asset value can further enhance this effect.

Next in line, business development companies are investment firms that specialize in funding small, distressed or emerging ventures in either the public or private investment ecosystem. Based on a fund structure created in 1980, BDCs operate in a fashion not dissimilar to private equity or venture capital, leveraging their internal capital structure for the potential to distribute sizable yields to their equity stakeholders.

The final heavy-yield contender is master limited partnerships, which were created in 1981 but restricted to only the energy and real estate sectors in 1987, as Congress thought the structure was too tax-advantaged. MLPs are a unique cross between a partnership and a corporation that can be publicly traded and employ a pass-through structure to avoid double taxation. Not only do most distributions constitute return on capital, but depreciation and losses can even be passed on to investors as well.

What Does Income Mean to You?

As may be surmised through their descriptions, these alternatives are willing to make unorthodox tradeoffs to earn their high-income status. For instance, CEFs concentrate heavily on interest rate and credit risk, and BDCs by nature focus on at-risk or immature companies. The point is, each of these categories alone may be susceptible to specific shocks, whether in terms of overall market risk or even structure-specific risk.

Two key points follow from this discussion. Foremost, a diversified approach that combines these varying asset classes may be less volatile overall and reduce exposure to any single type of risk. The second point is slightly more nuanced — by seeking out different exposures, these pass-through securities have historically maintained low correlations with standard fixed income risks. Consequently, these new risk profiles can add diversifying value as part of a broader portfolio while also augmenting yields. The fact is many investors may be underexposed to alternative income solutions, simply because they fall outside the framework of common market indexes.

As interest rate cuts start hitting the tape in the coming months, the search for sustainable, yet meaningful, income is only going to become more challenging. A diversified, strategic blend of alternative income structures may present investors with an attractive solution. Ultimately, the opportunity for high income streams through retirement may afford greater financial freedom, both in the present and future.

For full disclosure: GraniteShares manages the GraniteShares HIPS US High Income ETF (HIPS).

Ryan Giannotto, CFA, is the director of research at GraniteShares, a New York-based independent exchange-traded fund issuer that seeks to launch innovative and disruptive ETF investments. At GraniteShares, Ryan focuses on portfolio construction, indexing strategies and the use of non-correlating assets. He graduated from the Honors Program at Boston College with a B.A. in economics and philosophy.