Up To 10% Yielding ETFs That Enjoy Structural Tailwinds

The transition from ultra low interest rate environment to a more restrictive setting has changed the ball game across the overall investment landscape. Asset classes and investment strategies, which were unattractive during the accommodative interest rate period, have suddenly become enticing enough to provide optionality and more choices especially for yield-seeking investors.

These asset classes are the ones which embody a meaningful duration factor and emphasize stable cash generation as opposed to a back-end loaded growth profile. In other words, as the interest rates have gone up, the fixed income and bond-like assets have come back fashionable as the more aggressive discount factor leads to lower valuations (asset prices), which, in turn, push the yields higher.

Yet, there are also specific asset classes that have not only benefited (from the dividend investor perspective) on the yield front, but also have been enjoying decent tailwinds that enhance the growth profile.

One such asset class is private credit or BDCs. The way BDCs (which are effectively publicly traded private credit investment vehicles) create value is through spread capture. They assume cheap leverage and utilize these proceeds to fund private credit opportunities at higher yields, thereby profiting from the spread. A large part of the collected spreads are distributed to shareholders (or rather unit holders) with the remaining chunk left at the BDC level to fund new investments.

Now, once the interest rates are high, BDCs benefit from the following:

• Higher portfolio yields since most of the funded loans are based on floating rate component.
• Higher yields lead to juicier spreads because in most cases the external leverage is either cheaper and has not inflated so much as the private credit yields or fixed and locked when the interest rates were much lower.
• Enhanced deal flow as traditional banks have become increasingly regulated and less able to accommodate M&A, LBO and capital markets transactions due to higher interest rates, which at least optically weaken the company financials.

As a result of this, the overall BDC space offers double digit dividend yields (in most cases) in combination with attractive growth prospects.

The second asset class, which has clearly benefited from the prevailing macroeconomic dynamics, is the midstream segment and, more specifically, MLPs. In the midstream space, the companies generate cash flows mostly based on regulated tariffs or long-term offtake agreements, which are subject to specific volumes and CPI escalators. The key growth avenues stem from retained cash generation, bolt-on M&A, and periodic revenue bumps.

The fact that the inflation has surged higher, inflating the commodity (including energy) prices across the board, has introduced very strong tailwinds for MLP top-line levels. This in combination with the system-wide deleveraging and consolidation that started to take place right around the outbreak of COVID-19 have de-risked the underlying cash flows of most MLPs in my view.

Let me now elaborate on two high-yielding ETFs, where one captures the favorable BDC dynamics and the other one offers attractive exposure towards MLP players.

Pick #1: The Alerian MLP ETF (NYSEARCA: AMLP)

AMLP is a pure play ETF, which focuses on MLPs and publicly traded midstream companies. It currently yields ~7.7% and since the moment when MLPs started to optimize their balance sheets (which is around 2020), AMLP’s distributions have consistently ticked higher.

If we look at the sector breakdown, we will notice a rather concentrated exposure towards pipeline transportation and gathering plus processing sectors, which are the most common and heaviest business lines for MLPs.

The fact that there is a significant concentration in just two to four sectors should not come as a surprise, since AMLP is specifically structured to track the MLPs. So, this is really what we want – i.e., have a systematic exposure towards MLPs to avoid the company-specific risks, while pocketing high and growing distributions.

The overall situation is further de-risked by AMLP’s Top 5 allocations, which together account for roughly 60% of the total AuM:

1. Western Midstream Partners, LP (NYSE:WES) – ~13% of total weight.
2. Energy Transfer (NYSE:ET) – ~12% of total weight.
3. MPLX (NYSE:MPLX) – ~12% of total weight.
4. Plains All American Pipeline (NASDAQ:PAA)(NASDAQ:PAGP) – ~12% of total weight.
5. Enterprise Products Partners (NYSE:EPD) – ~12% of total weight.

All of these names carry fortress balance sheets and have the leverage and coverage metrics within the range of investment grade level.

Finally, another component, which makes AMLP a more interesting ETF from the yield-perspective is the embedded tax benefits:

• No K-1s – 1099 tax reporting
• Qualified dividends
• A portion of distributions being tax-deferred
• IRA and 401k eligible

Pick #2: The VanEck BDC Income ETF (NYSEARCA: BIZD)

BIZD is also a pure play investment vehicle, which tracks almost the entire list of publicly traded BDCs, which are domiciled in the U.S. Currently, BIZD yields just over 10.5% and has managed to grow its dividend quite consistently since early 2020.

Just as in AMLP’s case, there is a fair degree of concentration risk involved. Unfortunately, BIZD does not disclose its exposure towards BDC sub-sectors (e.g., CLO-focused, VC-focused or traditional ones), where part of the reason could be that some BDCs embody a mixture of sub-sectors in which they deploy capital.

Yet, again, this should not surprise us or somehow make BIZD less attractive because its strategy is just that – to invest only in the BDC space, which currently is comprised of less than 30 companies.

By looking at Top 10 holdings list below, we will also observe a huge concentration in just three BDCs with the remaining 24 consuming from 2% to just below 5% of BIZD’s AuM base.

Two of the Top 3 names can be easily characterized by stronger defense than on average in BDC sector. For example, Ares Management Corporation (NYSE:ARES) is the largest BDC out there with a greatly diversified portfolio and sufficient cash generation power to support its base dividends, while leaving a decent margin of safety in the system.

Theoretically, one could make an argument that so huge allocation into FS KKR Capital (NYSE:FSK) is suboptimal and injects unnecessary risks into BIZD as FSK has lately struggled a lot due to consistently rising non-accrual positions. As a result of this, FSK has lost a lot of value and lagged behind the overall sector. However, by assessing the most recent quarterly report and really dissecting the key figures, it is evident that the worst scenario is over and from now on, a smooth recovery process can start. For example, there have been positive movements both at the internal risk rating and non-accrual front, which has led to enhanced dividend coverage levels. Here I suggest you to take a look at my recent article on FSK, where the Q1 dynamics are thoroughly assessed.

All in all, BIZD is an excellent and low cost (i.e., management fee of 0.4%) ETF through which to go long the BDC segment in order to pocket the double digit yield, which is connected to secular tailwinds of the overall private credit market.

The bottom line

Higher interest rates have made many asset classes attractive again, especially from the dividend investor perspective. In the case of MLPs and BDCs, there is also an element of structural shift that nicely complements the juicy dividends.

For MLPs, it is about reaping the benefits of higher energy prices and significantly de-risked MLP balance sheets. For BDCs it is about benefiting from more constrained banking activity and higher cost of financing levels, which force many borrowers to tap into the private credit solutions as their credit profiles have become too weak for very conservative banking players.

BIZD, which tracks the BDCs and yields ~10.5%, and AMLP, which invests in MLPs and also offer a decent yield of ~7.7% are great ETFs to consider in this context.