High Yield Investing, 2: Types of Funds; Loan Funds; Preferred Stocks

Types of Funds: Exchange-Traded, Open End, and Closed End

Some investors like to pick individual stocks, while others would rather own funds that own many stocks.  For bonds, investors usually own funds of bonds rather than taking possession of individual bonds.

A straightforward type of fund is the exchange-traded fund (ETF). This holds a basket of securities such as stocks or bonds, and its price is constantly updated to reflect the price of the underlying securities. You can trade an ETF throughout trading hours, just like a stock. If you simply hold it, there will be no taxable capital gains events. Many ETFs passively track some index (e.g. the S&P 500 index of large company stocks) and have low management fees.

An open end mutual fund also trades close to the value of the baskets of securities it holds, but not as tightly as with an ETF. You can place an order to buy or sell an open end fund throughout the day, but it will only actually trade at the end of the day, when the share price of the fund is updated to the most recent value of the net asset value. A quirk of open end funds is that buying and selling by other customers can generate capital gains for the fund, which get distributed to all shareholders. Thus, even if you are simply holding fund shares without selling any, you may still get credited with, and taxed on, capital gains. Also, if a lot of shareholders sell their shares at the bottom of a big dip in prices, the fund must sell the underlying securities at a low price to redeem those shares. This hurts the overall value of the fund, even for customers who held on to their shares through the panic.

Some open end mutual funds offer skilled active management which may meet your needs better than an index fund. For instance, the actively-managed Vanguard VWEHX fund seems to give a better risk/reward balance than the indexed junk bond funds.

Closed-end funds (CEFs) are more complicated. A closed-end fund has typically has a fixed number of shares outstanding. When you sell your shares, the fund does not sell securities to redeem the shares. Rather, you sell to someone else in the market who is willing to buy them from you. Thus, the fund is protected from having to sell stocks or bonds at low prices. The fund’s share price is determined by what other people are currently willing to pay for it, not by the value of its holdings. Shares typically trade at some discount or premium to the net asset value (NAV). The astute investor can take advantage of temporary fluctuations in share prices, in order to buy the underlying assets at a discount and then sell them at a premium. CEFs are typically actively managed, and employ a wider range of investment strategies than open-end funds or ETFs do. CEFs can raise extra money for buying interest-yielding securities by borrowing money. This leverage enhances returns when market conditions are favorable, but can also enhance losses.

Bank Loan Funds

One type of debt security is a loan. Banks can make loans to businesses, with various conditions (“covenants”) associated with the loans. Banks can then sell these loans out into the general investment market.

Most commercial loans are floating-rate, so the interest received by the loan holder will increase if the general short-term commercial interest rate increases. Thus, the loan holder is largely protected against inflation. Loans typically rank higher than bonds in order of payment in case the company goes bankrupt, and some loans are secured by liens on particular company-owned assets like vehicles or oil wells. For these reasons, in the event of bankruptcy, the recovery on loans is higher (around 70%) than for bonds (average around 40%).

Various funds are available which hold baskets of these bank loans, also called senior loans or leveraged loans. One of the largest loan funds is the PowerShares Senior Loan ETF (BKLN), which currently yields about 4.5%. Most of its loans are rated BB and B, i.e. just below investment grade.   There are also closed end funds which hold bank loans, which yield nearly twice as much as the plain vanilla BKLN ETF, by virtue of employing leverage, selling at a discount to the actual asset value of the fund, and expertly selecting higher yielding loans.  For instance,  the Invesco Senior Income Trust (VVR), which I hold,  currently yields 8% , which is enough to keep up with inflation.      

High-Dividend Common Stocks

Most “stocks” you read about are so-called  common stocks. Most company common stocks are valued for their potential to grow in share price or to steadily keep increasing the size of their dividend. The average dividend yield for the S&P 500 stocks is about 1.6%, which is lower than the current yield of the (risk-free) 2-year Treasury bond.

There are some regular (C-corporation) stocks which are not expected to grow much, but which pay relatively high, stable dividends. These include some telecommunication companies like AT&T (T; 6.5%) and Verizon (VZ; 5.9%), electric utilities like Southern (SO; 3.5%) and Duke (DUK; 3.7%), and petroleum companies like ExxonMobil (XOM; 3.6%). Investors might want to buy and hold some of these individual stocks, since these are among the highest yielding, high quality stocks. Broader funds which focus on large high-quality, high-yielding stocks tend to have lower average yields than the stocks mentioned above. For instance the Vanguard High Dividend Yield Index Fund (VHYAX) currently yields only about 3.2 % .  

Preferred Stocks

Companies, including many banks, issue preferred stocks, which behave more like bonds. They  often yield more than either bonds or common stock. Like bonds, most preferreds have a fixed yield; some convert from fixed to floating rate after a certain number of years. Unlike bonds, most preferreds have no fixed redemption date. Fixed-rate preferreds are vulnerable to a large loss in value if interest rates rise, since the shareholder is stuck essentially forever with the original, low rate. On the other hand, if interest rates drop, a company typically can, after a few years, redeem (“call”) the preferred for its face value (typically $25) and then issue a new, lower-yielding preferred stock.

Preferred shares sit above common stock but below bonds in the capital structure. Companies have the option of suspending payment of the dividends on preferred stock if financial trouble strikes. However, a company is typically not permitted to pay dividends on the common stock if it does not pay all the dividends on the preferred stock.

The largest preferred ETF is iShares US Preferred Stock (PFF). It yields about 5.8%, but holds mainly fixed-rate shares. The PowerShares Variable Rate Preferred ETF (VRP; 5.9%  yield) holds variable or floating rate shares, which helps insulate investors from the effects of interest rate raises. The First Trust Intermediate Duration Preferred & Income Fund (FPF) is a closed end fund with more than half its holdings as floating rate. Due to use of leverage and selling at a discount, the fund yield is a juicy 7.9%.

Happy investing…

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