After a five-year run-up in stock prices, many investment portfolios resemble the Mississippi River after a three-day deluge: they’re swollen and about to crest at the banks.
The problem with a swollen river is where to put the next drop of water. The problem with a swollen investment portfolio is where to put the next investment dollar. Stock prices are up, yields are down. Value is in short supply.
One solution is to venture off the beaten path of stocks and dividend income.
Bond funds are an obvious option, but these come tethered with annual fees. What’s more, yields tend to be lower than those found on individual bonds.
As for individual bonds, you can find decent yield. But upfront cost is an issue: Most trade in $1,000 increments, if not more. Many are illiquid, so bid-ask spreads can be onerous.
U.S. Treasury notes and bonds are another option. They can be bought for as little as $100. But do you really want a five-year note that yields only 1.5%?
There is a better alternative – exchange-traded debt (ETD).
ETDs are notes and bonds issued by some of America’s largest corporations. ETDs trade just like shares of common stock on the major exchanges. And they’re priced right: ETDs are issued in $25 increments, so they’re affordable to any individual investor.
Yield is the obvious attraction. Many ETDs offer two-to-three times the yield of the issuing company’s common stock. Yields in the 6%-to-7% range are the norm.
Because ETDs are debt instruments, interest payments are contractual. You know exactly what month and on what date you’ll receive your income. (Most ETDs pay quarterly like common stocks.)
ETDs also have a higher claim to the company’s earnings and assets than the common stock. Most are investment grade (rated BBB or higher). Therefore, you’re not venturing out on the risk curve to capture more yield.
Most ETDs trade within a narrower range compared to the issuing company’s common stock. For conservative income investors, low volatility is a plus.
But with any investment, there is a caveat or two.
For one, ETDs pay interest, not dividends. So they’re ineligible for the qualified dividend tax rate. The good news is that superior yield mitigates this disadvantage. If the common stock pays a $1.00 annual dividend and the ETD pays $2.00 in annual interest, an income investor is still ahead after taxes. (Then again, the tax disadvantage can be eliminated altogether if the ETD is held in a tax-deferred retirement account, such as an 401(k) or an IRA. )
Investors must also be cognizant of call dates – the option for the issuing company to repurchase the ETD. Most ETDs mature 10-to-30 years after issuance, but they can be called sooner. A called ETD can ding total return if it’s bought at a premium and then repurchased by the issuing company at par value.
That said, I like ETDs. Next week, I’ll introduce three that I believe are the “Goldilocks” of the sector. That is, they are just right for investors seeking high-yield income from a safe, liquid investment.
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