From the November 2013 issue of Investment Advisor • Subscribe!

Managing Risk in the Hunt for High Yield

As opportunities increase, advisors need to educate themselves on the risks

More high yield, more MLPs, more super dividends, more yield, more, more, more. In this environment of historic low yields and baby boomers entering or fast approaching retirement, financial advisors can provide their clients a reasonable level of income along with some amount of principal preservation. Based on asset growth numbers, advisors are increasingly turning to high yield, master limited partnership (MLP) and senior loan ETFs for their clients.

While these types of ETFs have clear benefits, their strategies also present new and different risks to investors that are important to understand. MLPs have witnessed almost $10 billion in asset growth this year alone. In addition to the higher yields MLPs have offered, their principal value has maintained a solid total return for investors. MLPs present two important risk factors to consider. First, MLP volatility is not driven by traditional bond factors such as duration and creditworthiness. MLPs invest in energy and natural resources and are instead driven by commodity markets and the individual investing success of the MLP manager. Additionally, MLPs are offered in a variety of legal structures including exchange-traded notes (ETNs) that offer extra counter-party credit risks and a less tax-efficient structure, as well as exchange-traded products (ETPs) that have better tax benefits but provide tax-unfriendly K-1s to the newer registered investment company (RIC) structures. RICs are limited from owning more than 25% of an MLP to maintain its tax-advantaged “pass-through” status.

Therefore, MLP ETFs bear a heavy tax burden of approximately 30% on gains in the ETF. To offset such tax burdens, sponsors of MLP ETFs using RICs utilize leverage to provide the same level of income as other ETP versions with K-1s. If the MLP market experiences a jolt, a bumpy ride could be ahead for its investors.

Senior loan ETFs certainly have been recent hot sellers in the market. Senior loans historically have maintained the ability to weather a rising rate environment due to their underlying loans’ adjustable interest rates, usually based on Libor. Senior loans are often collateralized and typically provided to below-investment-grade borrowers. Their higher risk provides higher yields with the ability to adjust rates in an escalating interest rate environment. Consequently, this asset class can achieve higher income needs and serve as a hedge against rising rates. An additional risk senior loans face is the absence of an electronic clearing mechanism—meaning settlement for underlying loans in an ETF can take anywhere from seven to 21 days, and in some cases longer. In a normally functioning market, these ETFs will trade very efficiently, but if a Lehman-like event occurs, trading could run into pricing challenges that would factor in not the illiquidity of the underlying loans, but the perceived cost of a delayed redemption that effectively challenges hedging the underlying loans.

To be clear, both MLP and senior loan ETF strategies present great tools to manage income needs for clients. Historically, advisors have used lower duration, higher credit quality and bond diversification to manage interest risk. With more innovative options for income available today, advisors need to be fully aware of increased risk they may take on and how to appropriately manage that risk. Expect to see more innovation in products in the ETF space that navigate interest rate risks, including those that utilize interest-only strips that can provide income with a negative duration. More choices require more education as advisors effectively implement appropriate income investment solutions for clients.

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