Managing Risk in the Hunt for High Yield

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.