February 27, 2014 in Investing

4 investments with higher yields and risk

Money market accounts are eking out abysmally low yields and even 10-year Treasuries won’t get you more than 3 percent, so where can a retiree find a higher return in a fixed-income product?

While none of the high-yield options out there are risk-free, and many are considered high risk, some alternatives exist that can help retirees reach their income goals. Following are four popular investments with higher yields.

Caution: None of these is low risk, but they offer returns well above those of U.S. Treasuries and government bonds to retirees willing to face possible loss of capital and diminishing returns. OK, so they’re not for everybody.

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A master limited partnership, or MLP, is a publicly traded corporate structure operating in the energy sector, typically natural gas pipelines. MLPs pass on the vast majority of their income to investors, meaning that these companies usually offer huge dividend yields.

MLPs are designed as tax pass-through entities so that dividends are not taxed at the corporate level, and they must provide a quarterly distribution. They offer tax savings to individual investors, says Sanjoy Ghosh, chief investment officer of Covestor.com. “The MLP itself is not getting taxed, but the owners of the partnership are. This includes common stockholders, who are taxed when they get the distribution,” he says.

Only a portion of each distribution is taxed at ordinary income rates while the rest is considered a return of capital. However, tax record-keeping is essential since the investment’s cost basis changes with each distribution.

When searching for an MLP in a portfolio, Ghosh says that most investors look for more than high dividends — they usually want to see a long history of having sufficient cash on hand. “This doesn’t mean cash-rich MLPs are risk-free, though. They are sensitive to interest rates, and a lot of these assets become overpriced when a lot of investors are desperately looking for passive income,” Ghosh says.

Real estate investment trusts

Real estate investment trusts, or REITs, are required to distribute at least 90 percent of their taxable income to unit holders. As with MLPs, a portion of the dividends may be a return of capital.

Also like MLPs, REITs borrow money to invest. But REITs invest in real estate instead of energy. This means they are sensitive to declines in the real estate market as well as rising interest rates.

“In 2013, a number of REITs, especially those focused on mortgages, fell in value as the 10-year Treasury rose,” says Ben Marks, chief investment officer of Marks Group Wealth Management.

REITs fall broadly into two categories: Some buy, hold and manage a portfolio of properties, such as shopping malls or apartment complexes. Others focus on buying and selling mortgages in the secondary mortgage market. “We avoid the mortgage REITs altogether and look for those that own higher-quality properties, because they are less correlated to interest rates,” says Marks.

A number of REITs offer dividends in excess of 6 percent, and some dividend yields go as high as 15 percent. However, the highest dividend yields may be due for a fall. “A number of REITs have lowered their dividends over the past couple of years, because their net investment income has fallen radically as their borrowing costs have gone up,” says Ghosh. “Again, dividend payout history is important.”

For those with a bigger appetite for risk, business development companies, or BDCs, allow retail investors the ability to invest like a venture capitalist. This is because BDCs invest in small, emerging companies, usually offering them loans that larger banks will not.

Like MLPs and REITs, these companies pass along the vast majority of their earnings to shareholders in the form of dividends, which allows the companies higher margins and lower tax burdens. “The good news is that BDCs are required to pass along their earnings to you, the shareholder. The bad news is this means that BDCs can only grow by borrowing more money or issuing stock,” says Duane Batcheler, who writes as “BDC Buzz” for Seeking Alpha. “This makes BDCs risky, which justifies their average dividend yield of about 9 percent,” Batcheler says.

While BDCs have been around since the early 1980s, they’ve remained relatively unpopular among retirees looking for a source of passive income despite their relatively generous dividend yields because of their risk.

“The BDC industry is worth about $30 billion and they’ve been growing since 2008, and some are well-diversified across several sectors,” Batcheler says. “Although they’re classified as financial companies, really the BDCs expose you to small and mid-sized businesses throughout America in many different industries. I consider buying BDCs investing in America.”

A small group of high-yield bond funds have caught the attention of investors since 2008. Hungry for higher yields, investors have paid closer attention to bond funds that offer high-dividend yields by specializing in municipal or corporate debt.

These high-yield bond funds are available as mutual funds, closed-end funds and exchange-traded funds. “Funds are usually better than buying bonds themselves because, when it comes to investing, there’s safety in numbers,” says Marks, referring to the number and variety of bonds in a typical portfolio. “Still, in this environment we remain cautious and defensive when it comes to investing in bond funds.”

As rates rose in 2013, many bond funds fell in value on the fear that higher rates will cause the bonds to fall even further in the future. “We have warned investors for a long time that chasing yield is dangerous and usually ends badly,” says Marks, who adds that the recent decline “has been evidence of the risks in chasing yield.”

This doesn’t mean that Marks sees no place for high-yield bond funds in a well-diversified portfolio. “In moderation, a small amount of high-yield funds operating in municipal or corporate debts will suit many investors,” Marks says.

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