Investors Are Looking for Yield in All the Wrong Places

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.