In Search of Higher Yields

As interest rates have fallen to record lows and
stayed there in recent years, the yield on your
savings may be stuck in neutral. If you’ve
focused on capital preservation and kept your
assets in U.S. Treasuries, a money market
account, or certificates of deposit, you may
have minimized the chance of the financial
equivalent of a car crash. However, you also
may not be happy letting your portfolio’s engine
idle forever.
Dividend-paying stocks are one solution, but
last year’s volatility has made many investors
wary of committing more money to equities.
Though past performance is no guarantee of
future results, for those who need something
more than 2% 10-year (US) Treasury yields and who
can handle the additional risks involved, there
are other alternatives that could potentially
boost overall yield.
Corporate bonds
Many corporations have taken the opportunity
presented by low rates to refinance their
corporate debt and lower borrowing costs.
Though any company could still default on its
obligations, of course, and all bonds face
market risk, stronger balance sheets have
helped lower the overall risk of corporates as a
whole. The spread between the yield on
Moody’s Aaa-rated industrial bonds and
10-year (US) Treasuries at the end of 2012 was
roughly 1.7 percentage points. For a Baa bond
(one notch above noninvestment-grade), the
difference was over 3 percentage points. Yields
on noninvestment-grade bonds (so-called
high-yield or “junk” bonds) were higher still,
roughly 5% above 10-year (US) Treasuries.
Bank loans
Floating-rate bank loans (also known as senior
loans, leveraged loans, or senior secured
loans) are a form of short-term financing for
companies that usually do not rate an
investment-grade credit rating. The rate is
typically tied to the London Interbank Offered
Rate (LIBOR) and adjusts with it, generally
quarterly. As with high-yield bonds, the lack of
an investment-grade credit rating means bank
loans must offer a higher yield.
As with all debt, investors still run the risk of
default. However, bank loans also have
benefitted from the favorable corporate finance
picture noted above. And because bank loans
typically are a company’s most senior debt
obligation and are secured by some form of
collateral, investors have typically recovered a
higher percentage of their investment in the
event of default than with high-yield bonds
secured only by a company’s promise to pay.
Finally, as with all bonds, as bond yields rise,
the price falls, which could cut overall return
enough to offset any yield advantage. For the
majority of investors, the most accessible way
to invest in floating-rate bank loans is through a
mutual fund or exchange-traded fund.
Master limited partnerships
Master limited partnerships (MLPs) can not only
offer an income stream in the form of quarterly
cash distributions; they also may offer tax
benefits. An MLP that receives 90% of its
income from qualified passive sources such as
oil, natural gas, real estate, or commodities
may qualify for tax treatment as a partnership
rather than a corporation. If it does so, the MLP
is not taxed at the partnership level, and may
pass on a greater share of its earnings to the
limited partners (i.e., individual investors), who
also receive a proportionate share of any
depreciation, depletion allowances, tax credits,
and other tax deductions.
Many MLPs are managed so as to ensure that
those tax benefits offset or eliminate any
current tax liability on the cash distributions,
which are considered a return of capital and
used to adjust the individual partner’s cost basis
upon sale of the MLP units. An MLP that
pursues this strategy successfully can in effect
provide a tax-deferred ongoing income stream,
which can be particularly appealing to investors
in a high income tax bracket. Yields on MLPs
vary greatly, depending on the particular MLP’s
assets and the way in which the general partner
manages the business.
MLPs have risks. Because they can be
relatively illiquid, an investor should plan to stay
invested for a number of years, and individual
investors’ collective share of cash distributions
may decrease over time. Also, the tax issues
involved can be complex; for example, MLPs
can create problems if held in a tax-deferred
retirement account. Finally, commissions and
other front-end costs can reduce the amount
available for investment.