Recently, I have written quite a bit about finding unconventional yields in low rate environments. Up to this point, I have highlighted preferred shares, junk bonds, and a variety of high yielding dividend funds. Last weekend, I continued my search for yield and stumbled upon a couple of very interesting products sporting dividend yields of 9% and 15%.
You may be wondering how its possible to create such high yielding products?
The driver behind these incredible yields is leverage. Over the last few years, leveraged exchange traded products have taken the financial world by storm. A leveraged product, such as a fund or note, uses financial derivatives and/or debt to amplify returns. For example, a 2:1 leveraged product will match each dollar of investor capital with an additional dollar in debt.
As a result, the returns of the underlying index will be multiplied by a ratio of 2. If the underlying index were to rise 1% for example, the leveraged product would rise 2%. If the underlying index were to fall 1%, the leveraged product would fall 2%. While the returns may be exceptionally high, these funds carry high risks and may not be suitable for all investors. The risks include correlation risk, compounding risk, high tracking fees, and credit risk associated with the issuing firms. If you’re looking to spice up a diversified income portfolio, check out these high yielding products.
Leveraging Master Limited Partnerships
The UBS E-TRACS 2x Leveraged Long Alerian MLP Infrastructure Index (NYSEMKT: MLPL) was designed to offer investors 2:1 exposure to the Alerian MLP Infrastructure Index. This index is composed of 25 liquid companies who generally earn the majority of their cash flow from the transportation and storage of energy commodities. Investors have been drawn to MLPs as these companies tend to be correlated with the demand for energy commodities, which are often less volatile than energy commodity prices. As a result, these companies have very predictable cash flows, low costs, and strong dividends.
The fund’s largest holding, Kinder Morgan Energy Partners LP (NYSE:KMP), is a dominant player in the natural gas transportation industry. Kinder Morgan is the largest player with over 46,000 miles of pipeline designed for the constant transportation of gasoline, carbon dioxide, natural gas, and crude oil. The company has placed great importance on rewarding shareholders via dividends.
Over the last 10 years, the company has maintained an average dividend growth rate over 7%. As energy output from the U.S. rises, Kinder Morgan Energy Partners LP (NYSE:KMP) stands in the best position to transport the additional liquids. Just last week, the company canceled its plans to build a $2 billion pipeline along the west coast as opportunity costs proved too great. It’s possible that the company will look to return some of these savings to shareholders in the near future.
Year to date, this fund has return over 40% while maintaining strong dividends. Distributions are paid four times per year after the 0.85% expense rate and tracking fees are applied. As of today, the annual dividend yield of this fund sits at an attractive 9%. Going forward, the dividend payout should remain stable even among great fluctuations in the underlying index. This industry should continue to perform well as the United States energy industry grows to meet global energy demand.
Leveraging business development companies
If you are not yet familiar with the relatively new business development industry, you are not alone. Business development companies are created to invest in and help grow small companies in the initial stages of their development. Similar to venture capital firms, these firms have been popular with investors as typically these companies generate high payouts for shareholders.
The UBS ETRACS 2xLeveraged Long Wells Fargo Business Development Company Index ETN (NYSEMKT: BDCL) was designed to provide investors 2:1 exposure to the Wells Fargo Business Development Company Index. The fund’s top holdings include Ares Capital, Prospect Capital, American Capital, Apollo Investment, and Fifth Street Finance. Year to date, this fund has returned 14.80%, while in addition, offering investors a dividend yield close to 15% before associated fees. As the economic recovery continues, business development firms stand to benefit from low interest rates and higher company valuations.
Wrap up
While the risk associated with these investments may be high, the high dividend yields can lure any income driven investor. Both of the above leveraged products carry high risk, but in combination with a diversified income portfolio, could spice up returns for years to come. Please discuss your investment objectives and risk tolerance with an investment adviser before investing in any leveraged exchange traded product.
Nathaniel Matherson has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
The article Leveraged Funds With Exceptional Yields originally appeared on Fool.com.
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