Glossary: Understanding High-Yield Investments

To get high yields today, you may need to invest in products that aren't household words. We describe some of them below:

Floating-rate bank loans. Banks typically extend these loans to companies with subpar credit ratings. Interest rates normally reset every 60 or 90 days at a few percentage points above a benchmark of short-term rates, such as LIBOR. So if LIBOR is yielding 0.5%, a floating-rate loan may pay 3.5%. Because of the periodic adjustments, these securities hold up well when interest rates are rising. But they do come with credit risk. The complexity of these securities makes them ideal for mutual funds.

Preferred stocks. Part bond, part stock, preferreds pay a fixed dividend at regular intervals. As a result, they often trade like bonds, rising in value when interest rates fall and losing value when rates rise. When it comes to dividend payments, preferred holders get preference over common-stock holders. Moreover, if a company goes bankrupt, owners of preferred shares stand ahead of common-stock holders (but behind bond holders) in collecting any remaining assets. Most preferred shares are issued by banks and other financial firms.

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Closed-end funds. Unlike mutual funds, which issue new shares to meet demand and redeem shares based on the value of their assets at the end of each day, closed-end funds generally issue new shares just once -- when they're formed. After that, investors buy shares from each other, not the fund. As a result, a closed-end’s share price fluctuates with supply and demand, and that price may not precisely track the value of the fund's holdings. So it's common to see a closed-end trading at a wide discount from or premium to its net asset value per share. Ideally, you want to buy at a big discount and avoid funds selling at stiff premiums. Because closed-ends don't experience big cash inflows or outflows, they can do things, such as invest in illiquid assets or borrow to boost returns, that most mutual funds are barred from doing.

Master limited partnerships. MLPs are limited partnerships that trade like stocks. They usually invest in energy-producing assets, such as oil refineries and shale mines, or in facilities that transport or store oil and gas. Yields tend to be high because MLPs do not pay income taxes; instead, they pass all their income straight to investors, who are responsible for paying tax on their share of the partnership's profits. Volatile energy prices can lead to wild swings in MLP share prices, so look for firms with a steady payout history. One downside of MLPs is that you have to contend with K-1 partnership forms when filling out your tax returns.

Mortgage REITs. These real estate investment trusts do not own property. Instead, mortgage REITs borrow at short-term interest rates to buy higher-yielding mortgages. They may invest in securities backed by Uncle Sam, or they may own non-agency securities, which means the REITs face not only interest-rate risk but also the risk that borrower defaults will diminish the value of their portfolios. For that and other reasons, the financial markets price mortgage REIT shares to yield much more than property-owning REITs.

Business development companies. BDCs function almost like venture capitalists, investing in small start-up businesses that can't go to major banks for capital. A BDC typically lends money at high rates of interest, although borrowers may sometimes offer BDCs rights to buy stock in the company as a way of reducing their financing costs. Like REITs, BDCs pay little or no corporate income taxes and must distribute substantially all of their profits to shareholders. Even a whiff of a recession can slam shares of BDCs because the small companies they finance don't have the staying power of giant firms.