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Generating meaningful passive income through traditional approaches has posed a challenge in today's investing environment. Following the emergence of the pandemic, interest rates plummeted and bond yields continue to remain very low by historical standards, with the U.S. 10-Year Treasury Bond yield hovering around 1.3%. Additionally, during the pandemic, many companies or funds that typically pay dividends had to cut or pause due to the economic conditions. Rising inflation adds yet another obstacle in the search for yield leaving most income investments firmly in negative interest rate territory once inflation has been accounted for. It's enough to leave many investors, particularly retirees and near-retirees, at a loss for what to do.
One potential solution to consider is pass-through securities, which offer investors access to groups of specialized assets that are traded on the public market and are corporate tax-exempt. Because these securities are not taxed, nearly all their earnings must be paid out to investors, which is why they are called "pass-through" securities. Earnings are passed on to investors without taxation to avoid being taxed twice. This mechanism allows investors to benefit from income streams that may be higher than if they were subject to taxes.
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There are four types of pass-through securities, each providing exposure to different market sectors:
1. Real estate investment trusts (REITs). REITs are probably the most well-known pass-through security. These provide investors access to the real estate market without having to own or manage an actual property. REITs typically invest in either funding mortgages or owning physical properties (such as commercial buildings). In a REIT, 75% of the investments must be in real estate and 90% of earnings must be issued to investors to qualify for corporate tax exemption.
2. Master limited partnerships (MLPs). MLPs are mostly companies structured as publicly traded partnerships, where investors serve as limited partners. To qualify as an MLP, 90% of the company's revenue must come from the energy or natural resources sectors. The benefit of being an MLP instead of a traditional company? MLPs don't have to pay income taxes. The general partner will manage the day-to-day operations, while the limited partners (investors) provide the funding and therefore receive a portion of the earnings.
3. Business development companies (BDCs). BDCs are publicly traded companies that invest in small to medium-sized businesses to help them grow, normally through money lending. Created by Congress in 1980, their purpose is to spur job growth and provide support to new businesses. BDCs must invest at least 70% of their assets into private or public U.S. firms that have less than $250 million in market capitalization. They are the smallest group of pass-through securities, with 48 listed on the public market.
4. Closed-end funds (CEFs). CEFs are listed with an initial public offering (IPO) and structured similarly to a mutual fund, except that a CEF has a fixed amount of share capital, whereas a mutual fund can have unlimited investors and capital. For a CEF, the amount of capital raised for the IPO is how much the fund manager has to invest. Investors then buy and sell the set amount of shares on the stock market, with the price fluctuations based on the value of the fund, as well as the supply of and demand for the shares.
Because pass-through securities are traded on the public market, adding them to a portfolio is as easy as buying a traditional stock. One way to manage risks related to picking or selecting which individual pass-through securities to own is through a diversified investment in all four categories.
Currently, the traditional investment market is too unreliable to depend solely on it for steady returns. Anyone who invests to produce livable income may find a solution in pass-through securities.
Will Rhind is the Founder and CEO of GraniteShares, an ETF investment firm focused on providing investors with innovative, cutting-edge investment solutions. The GraniteShares HIPS U.S. High-Income ETF (HIPS) is an exchange-traded fund that provides exposure to REITs, MLPs, BDCs and CEFs. The HIPS ETF seeks to pay a monthly distribution. The fund has a current distribution rate of 8.34% (as of 9/24/2021; distributions are not guaranteed) per annum. Investors should consider the investment objectives, risks, charges and expenses carefully before investing. For a prospectus or summary prospectus with this and other information about the GraniteShares ETF HIPS, please call (844) 476-8747 or visit www.graniteshares.com/etfs. Read the prospectus or summary prospectus carefully before investing.
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