Chasing Yield Off the Beaten Path

 | Mar 31, 2014 | 10:50 AM EDT
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The chase for yield in a ZIRP environment is one of the most difficult risk-reward scenarios for the moderate risk tolerant or income seeking investor. I tend to stray from the beaten path in this endeavor, investments targeted for yield.

Buying long date exposure comes with the uncertainty of the taper. Will it continue? Will it accelerate? Could it even be reversed? Any of these three will have an impact on the value of interest sensitive instruments.

I know I've railed against holding leveraged ETFs and ETNs for the longer term, especially for those without a complete understanding of how the products work. How the daily reset and the volatility of the underlying components, or volatility decay as I refer to it, impact these products is paramount in the application. Don't get me wrong. I believe many of these vehicles offer tactical trading opportunities, but for the buy-and-hold investor, most of these are portfolio kryptonite.

Why am I considering one or more as an income/yield component in my long-term portfolio? Is my return to RealMoney the result of me losing my mind? Of course not. That's as crazy as saying Blue Steel should be retired.

There are three Etracs ETNs which have my interest: Etracs Monthly Pay 2x Leveraged Closed End Fund (CEFL), Etracs Monthly Pay 2x Leveraged Diversified High Income ETN (DVHL) and the Etracs Monthly Pay 2x Mortgage REIT ETN (MORL) all offered by UBS.

Let me address the leverage issue first on these 2x products. The answer is in the name: Monthly. These notes only reset once per month. While these ETNs can suffer some volatility decay, with only 12 resets per year the impact is minimal compared to the products which reset each day.

Leveraged products also actually outperform in trending markets, up or down. So it only takes one or two longer trends during the year to offset any decay or even enhance return vs. the traditional unleveraged approach. I've used the monthly leverage MLP products with great success in the past.

First, there is CEFL with a current annualized yield of 16.09%. CEFL is make up of 30 closed-end funds (CEF) with no single fund making up over 5% of the fund. Eaton Vance CEFs holds four of the five top spots in the ETN while Blackrock holds four of the five spots in the next five spots. These two management companies make up the majority of the fund, so be certain to have some comfort in their portfolio selections before considering this trade.

MORL is the only ETN focused on individual stocks. The top five holdings of Annaly (NLY), American Agency (AGNC), Starwood Property (STWD), Chimera (CIM) and MFA Financial (MFA) make up approximate 44.5%. At 16.22%, this is top the yielding ETN of the group, but it is likely to be the most interest rate sensitive. It is also the only one subject to a single stock risk given the previous information plus the fact that NLY alone is 15% of the ETN and AGNC is 12.8%. Comfort with both of these names is an absolute must to own this fund.

DVHL is the most diverse ETN in the group, but also the lowest yielding at 12.6%. Rather than trying to describe the 138 holdings of this ETN, a pictures paints, well, a better picture. On the surface, this is far and away my favorite given the 60/40 stock/bond split.

The facthold there are some master limited partnerships, mortgage REITS, REITS, preferred stock, preferred stock, high-yield bonds and municipal bonds among other holdings. Quite a bit of the underlying holdings of the ETN are ETFs. In the end, a buyer of DVHL is sacrificing some yield to obtain a large diversification pool.

When examining these three together one must consider the short lifespan all three currently have. In terms of the markets, these three are newborns,

I've plotted all three together to get a feel for how they move and a quick glance at their volatility. I also added some correlations on here. A quick glance shows me DVHL and CEFL have been the strongest. They appear to move together although the correlation between the 20-day moving averages of each shows an ebb and flow between the correlations. At times it is high while other times it is simply spurious. During this same period, the correlation between DVHL and CEFL has remained relatively high often trading near one, but the performance of CEFL has significantly trailed that of DVHL.

In the end, I like the combination of DVHL and MORL with a heavier weighting on DVHL. Ironically, MORL looks like the name which is the least volatile of the group, but I also see it as the least diverse. CEFL is just as diverse as DVHL, but closed end funds often trade at a discount to their net asset value (NAV). If one is willing to watch the top 10 holdings to monitor whether the underlying are trading at a larger than a three-or five-year average to NAV, then I think there is a little extra risk in the entry and volatility component. If one has time for the leg work, then an entry when the CEFs are trading at a wider than average discount to NAV could produce a very attractive-risk reward.

In the end though, I am willing to sacrifice some yield to get the wide diversification offered by DVHL as the biggest new purchase. I am not interesting in watching these day to day, so I not too terribly concerned with the technical picture. The buy of DVHL and MORL are for my long term portfolio.

 One consideration I will keep in my mind here is what to do with the distribution. My initial inclination is to buy CEFL with the distributions. If I were to scale into that name, then I know I would be likely to sometimes catch the wider than average discount entry while others times I would not.

Also, just using the distributions for my CEFL's buys would allow me time to set up an easy system to monitor how the CEFs are trading compared to their underlying NAV. It would be a way for me to add all three into my portfolio which I would feel comfortable owning to generate some attractive yield with an acceptable level of risk and reward.



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