3 Types of Unique Investments with Massive Yields

By understanding how these three types of investments work, you can enjoy huge yields and major tax benefits.

Jun 30, 2014 at 6:00AM

The current average dividend yield of the Dow Jones 30 is about 2.7%. While a 2-3% yield can certainly be a nice profit-generator for your portfolio, it pales in comparison to the yields of business development companies, such as Prospect Capital Corporation (NASDAQ:PSEC), master limited partnerships, such as Ellington Financial LLC (NYSE:EFC), and real estate investment trusts like Annaly Capital Management (NYSE:NLY).

If you've ever run a stock screen looking for stocks with high dividend yields, you've probably had some of these companies turn up in your results.

Reityield

Those yields almost seem too good to be true! In fact, as I have discussed before, one important way to assess the ability of a company to pay (or continue to pay) its dividend is by looking at a number called the payout ratio. The payout ratio is simply the dividend per share divided by the earnings per share. This number gives a quick indication of how much of a company's profits are being immediately paid out to shareholders. Payout ratios for healthy companies usually do not exceed 50%.

Reitpayout

All three of these companies' payout ratios are well over 50%, and two of them are over 100%! So what the heck is going on here?

Each of these three entities is a special type of company with special rules about how it distributes cash to its shareholders.

The Business Development Company
Prospect Capital, with its 12.8% yield and 104% payout ratio, is a type of company called a business development company (BDC). BDCs are essentially venture capital funds that trade on a public exchange. BDCs provide loans to smaller businesses, often in exchange for equity positions in the companies.

For example, Prospect Capital recently announced that it invested $92 million into aircraft leasing company Echelon Aviation, a company in which Prospect is the controlling shareholder. BDCs hope that investments in smaller companies in need of capital will eventually pay off in the form of capital gains.

By law, BDCs must distribute 90% of their taxable income to shareholders, which is the reason Prospect's payout ratio is so high. The downside to these huge payouts is that BDCs cannot rely on earnings to fund their investments and must instead turn to stock offerings or borrowing.

Any savvy investor knows that stock offerings and debt are not good for share price, but share price growth is not what interests many BDC investors. All they care about is that gorgeous yield, which itself is not exactly a pure "dividend," but rather a "distribution."

The distinction between a typical dividend and a BDC distribution is the tax that shareholders pay. Typical dividends are taxed at capital gains tax rates, but BDC distributions may be subject to either capital gains rates or ordinary income tax rates depending on the source of the BDC's income.

The Master Limited Partnership
Ellington Financial is a type of company called a master limited partnership (MLP). By law, an MLP must generate at least 90% of its income from "qualifying sources," such as oil and natural gas exploration or real estate. Ellington Financial, for example, invests in residential mortgage-backed securities.

Like BDCs, MLPs do not pay typical corporate tax on their income. In that sense, "unitholders" (the MLP's version of shareholders) are responsible for paying income or capital gains tax on their distributions.

A large percentage of each distribution can be tax-differed and is simply subtracted from the cost basis of your "units" (shares). Again, since a great portion of the partnership's income is distributed to shareholders, additional asset purchase are typically funded by issuing more units.

Real Estate Investment Trusts
Finally, Annalay Capital is a type of company called a real estate investment trust (REIT). REITs invest only in real estate. By paying out 90% or more of their earnings to shareholders, REITs are exempt from U.S. Federal income tax. Much like BDCs allow small individual investors access to the venture capital business, REITs allow access to real estate investment.

Equity REITs own physical properties such as apartments or shopping centers, while mortgage REITs simply own mortgages. For example, as a mortgage REIT, 94% of Annalay's portfolio consists of government-backed collateralized mortgage obligations. 

As was the case with MLPs and BDCs, most of a REITs distributions are taxed as income rather than capital gains. In addition, asset purchases are often funded by share offerings.

Are these high yielders right for you?
The tickers of these three types of unique entities might scroll across your screen disguised as typical stocks, but they are entirely different beasts. The huge yields of these companies are certainly appealing. In addition, under the right circumstances ownership can provide valuable tax benefits. However, before you buy any of these companies for yourself, make sure you fully understand exactly what you are buying and the nuanced tax provisions associated with owning it in your portfolio.

Top dividend stocks for the next decade
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

Wayne Duggan is the author of Beating Wall Street with Common Sense and the developer of tradingcommonsense.com. Wayne Duggan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Money to your ears - A great FREE investing resource for you

The best way to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as “binge-worthy finance.”

Feb 1, 2016 at 5:03PM

Whether we're in the midst of earnings season or riding out the market's lulls, you want to know the best strategies for your money.

And you'll want to go beyond the hype of screaming TV personalities, fear-mongering ads, and "analysis" from people who might have your email address ... but no track record of success.

In short, you want a voice of reason you can count on.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich," rated The Motley Fool as the #1 place online to get smarter about investing.

And one of the easiest, most enjoyable, most valuable ways to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as "binge-worthy finance."

Whether you make it part of your daily commute or you save up and listen to a handful of episodes for your 50-mile bike rides or long soaks in a bubble bath (or both!), the podcasts make sense of your money.

And unlike so many who want to make the subjects of personal finance and investing complicated and scary, our podcasts are clear, insightful, and (yes, it's true) fun.

Our free suite of podcasts

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. The show is also heard weekly on dozens of radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable. Rule Breaker Investing and Answers are timeless, so it's worth going back to and listening from the very start; the other three are focused more on today's events, so listen to the most recent first.

All are available for free at www.fool.com/podcasts.

If you're looking for a friendly voice ... with great advice on how to make the most of your money ... from a business with a lengthy track record of success ... in clear, compelling language ... I encourage you to give a listen to our free podcasts.

Head to www.fool.com/podcasts, give them a spin, and you can subscribe there (at iTunes, Stitcher, or our other partners) if you want to receive them regularly.

It's money to your ears.

 


Compare Brokers