Be Careful Dealing with Creative Sources of Yield
by Ron Muhlenkamp, Originally published in the Pittsburgh Business Times, February 15, 2013
A broker friend of mine told me recently that his clients are looking for “creative sources of yield.” The phrase set off alarm bells in my head! Let me tell you why.
Investment securities have different characteristics. At the simplest level, cash and cash equivalents (short-term Treasuries, bank CDs, money market funds) are a parking place to protect investors’ assets when markets go down, or to have the money available when it is needed.
Debt instruments are designed to protect capital over a period of time and to provide interest payments in the interim. Equity securities represent ownership in a company. A focus on yield or income normally focuses on debt securities. Since 1957, the interest yield on corporate bonds has exceeded the dividend yield on corporate stocks.
Key point: “yield” is generally understood (and I define it) as the interest payment earned on a security over and above the promised return of the principal.
I just returned from attending a large “Money Show” in Florida. The topic that generated the most interest was: “How can I generate more income from my investments?” One speaker spoke in favor of “royalty trusts,” but he used the words “yield” and “payout” interchangeably, as if they were the same thing. They are not—particularly in a royalty trust. A royalty trust is a trust (a pool of investors) which owns the royalty rights on a group of oil or gas wells. As the oil from the wells is produced and sold, the investors in the royalty trust receive their pro-rata shares of the proceeds. When the oil is gone, so are the assets. I think of the oil as being in a warehouse; once you have sold the contents, the warehouse is empty.
But nearly all oil fields produce at a declining rate, with higher rates at the beginning. Let’s assume we sell the contents of the warehouse over 20 years, but sell 10% in the first year, declining to 1% in the 20th year. Your proceeds from the first year sales would not be representative of the later years. The speaker’s recommendation on the royalty trust (buying the warehouse contents), however, was based largely on the expected “payout” (proceeds) in the first year, which he expected to be over 10 percent. He also stated that most of the payout (which he often spoke of as yield) was “tax sheltered.” Folks, the reason it is expected to be tax sheltered is that most of the payment is a return of capital—and we are not required to pay taxes on a return of our capital. We are only required to pay taxes on the money earned in excess of our investment.
Another speaker at the Money Show recommended a Mortgage Participation Fund currently yielding 5¼ percent. It wasn’t clear whether the 5¼% was “yield” or “payout.” Think of your own experience with paying a mortgage: unless you have an interest-only mortgage, each payment is part interest and part principal. The payments are calculated to amortize the principal balance to zero at the end of the period, typically 30 years. So your payments each year (“pay in”) are part interest and part principal. As an investor in a Mortgage Participation Fund, you are on the receiving end of similar payments. The payout is part income (yield), which is taxed—and part return of principal, which is not taxed.
But let’s say the 5¼% promised yield truly represents interest payments of the mortgages. To pay 5¼% to the investors would require a pool of mortgages with 5½% to 5¾% interest rates because the various parties who pool the mortgages (the underwriters), guarantee the mortgages (Fannie Mae?), and manage the funds must all get paid. In today’s market of 30-year fixed-rate mortgages at 3.35%, the mortgages in the pool are likely to be refinanced to a lower rate (and the process gets repeated). So the investors get the money back sooner than desired; the 5¼% return is only temporary.
These are just a couple examples of “creative sources of yield.” Be careful out there.