Certain types of stocks pay higher yields than your typical dividend stock. These include closed-end funds, real estate investment trusts (REITs), business development companies (BDCs), master limited partnerships (MLPs), and preferred stocks. While these types of stocks are lesser known and can be a little more complicated, they are worthy of your consideration. Additionally, MLPs have unique tax implications.

Let's start with the simplest: closed-end funds.

Buying $1 in Assets for $0.90

You're probably familiar with mutual funds. Those are investments where your funds are pooled with other investors' money and the fund manager buys a portfolio of stocks, bonds, or other assets. The price of the fund is equal to the value of the assets in the fund divided by the number of outstanding shares.

For example, if the Marc Lichtenfeld Dividend and Income fund (which I operate out of Marc Lichtenfeld's Authentic Italian Trattoria's back office) has $10 million under management and there are one million shares outstanding, the fund is worth $10 per share ($10 million/one million shares = $10). If tomorrow the stock market rises, the value of the assets goes up to $10.5 million, and the share count remains the same, the fund will be priced at $10.50 per share ($10.5 million/one million shares = $10.50).

Anyone who wants to own the fund buys it directly from the fund company and pays $10.50 per share. The mutual fund company will create new shares as a result of the purchase. The price per share will not change because the price now reflects the new money that just came into the fund.

For example, a buyer purchases $100,000 worth of fund shares at $10.50 per share. That means the buyer buys 9,523.8 shares ($100,000/$10.50 = 9,523.8). The fund, which had $10.5 million in it, now has $10.6 million because of the $100,000 of new money that the investor gave to the fund.

The Marc Lichtenfeld Dividend and Income fund now has $10.6 million in assets divided by 1,009,523.8 shares (the original 1,000,000 shares plus the newly created 9,523.8 shares). The price per share remains $10.50 ($10.6 million/1,009,523.8 shares = $10.50).

Anyone who wants to sell will also get $10.50 per share from the fund company, and those shares will be removed from the share count as a result. The price of the fund fluctuates exactly with the price of the assets in the fund.

A closed-end fund is a little different. A closed-end fund is essentially a mutual fund with an important difference: It trades like a stock. Its price is determined by supply and demand for the fund itself, not entirely by the price of the assets.

The price of the assets will have an effect on the demand for the fund but is not the sole determining factor in the price, the way it is with mutual funds. Therefore, it's possible (and usual) that the price of the fund will be lower (a discount) or higher (a premium) than the value of the assets rather than equal to the asset value.

Like a stock, when a person buys a closed-end fund, she is buying it from another party, not from the fund company. This contrasts with a mutual fund, where investors can only buy shares newly created by the fund company for purchase.

When researching a closed-end fund, you always want to know whether it is trading at a premium or discount to its net asset value (NAV)—the value of the assets in the fund.

To find the NAV, you usually have to go to a site that focuses on closed-end funds or one that has a section dedicated to them. You won't find NAVs on Yahoo! Finance or in the stock quotes in your newspaper. (See Figure 6.1.)

I usually go to the website of the Closed-End Fund Association (CEFA; www.cefa.com). The CEFA is a trade organization for closed-end funds, and the website has a lot of useful information besides just NAVs.

Figure 6.1 is a snapshot of the website. The fund we're looking at is Central GoldTrust (NYSE: GTU), which is a closed-end fund that holds gold bullion.

Toward the upper right-hand corner, it says the NAV is $64.86 and the market price is $65.94.

That means the value of the assets in the fund is $64.86 per share. However, to buy it, you'd have to pay more than that—$65.94 to be exact.

Two lines below is where you can see how much the premium or discount is for the fund—in this case, Central GoldTrust trades at a premium of 1.67%. In other words, for every $100 in assets, you're paying $101.67. Tomorrow that might change. If there are a bunch of investors who want to sell and no buyers, the sellers will have to lower their asking price to attract buyers, which will reduce the premium. Or the premium could go higher if there are more buyers than sellers, just as with a stock.

But why would an investor in his right mind pay $101.67 for $100 in assets or $65.94 for $64.86 in assets? For the same reason he buys any stock: because he thinks it's going higher. After all, investors pay more for stocks than their book value per share. Investors also pay higher prices or valuations for some stocks compared with their peers with the same book value per share.

Keep in mind, there are two forces at work here—supply and demand as well as the NAV. Theoretically, if the NAV increases, so should the stock price. It doesn't always work that way. If no one is interested in buying the stock, even if the NAV is going higher, the stock price will not follow the NAV. But usually, if the NAV steadily increases, so will the price.

Additionally, supply and demand forces may move the price higher, even if the NAV doesn't. For example, let's say gold goes on a tear again and everyone is piling into gold. Maybe the price of gold goes up 10%, but the price of the closed-end fund rises 15% as the premium increases, reflecting the higher demand. At that point, you may have a fund with an NAV of $71 per share but a stock price of $76 for a premium of 7%.

Discounts and premiums get tightened and widened all the time depending on the market, which sectors are hot, and sentiment. The best scenario is when you buy a fund at a discount, the NAV goes up, and the price eventually closes that discount to trade at a premium.

Let's look at another fund, Deutsche Municipal Income Trust (NYSE: KTF). Even though this is a municipal bond fund, it trades like a stock. On the CEFA website is a chart that shows the fluctuation of the discount or premium for all closed-end funds. It's on the bottom half of the page on the left-hand side and is seen in Figure 6.2.

The light grey line is the important one as that represents the actual discount and premium of the fund. The black line represents the class of funds (in this case municipal bond funds) so that you can compare the fund with its peers.

You can see that the fund started out with about a 1.52% discount and quickly rose to a 3.48% premium. Over the next 10 years, it traded mostly at a discount, hitting a low of a 16.52% discount in late 2008. At that time, you could have bought $100 in assets for less than $84.

The 10-year average discount is 4.917% (the minus sign means discount). The five-year average discount is 5.503%, and year to date, the average discount is 0.38%.

Let's look at one more picture so that you can see how the NAV and the stock price don't always move at the same pace.

We'll zoom in on the CEFA website and look at another closed-end fund. On the top half of the page on the left under the chart, we see a table that looks like the one in Figure 6.3.

The fund is the Liberty All-Star Growth Fund (NYSE: ASG). In each of the periods shown, the NAV outperformed the fund's price (market return is the return of the fund based on its price, not NAV). Over the past year and year to date, the difference has been significant—over 2% in the past one year and more than 3% year to date. In fact, the NAV was actually positive (barely) year to date, while the price of the fund lost 2.86%.

The difference between the returns of the NAV and the price goes back to supply and demand for the fund itself. The fund's price will outperform the NAV as more investors clamor to buy the fund. When that occurs, existing owners raise their price, just as with any stock.

In Liberty All-Star's situation, that was not the case year to date. Although the NAV rose, there were likely more sellers than buyers as the price of the fund fell nearly 3%.

Quite a few closed-end funds pay significant yields. Many of them combine investments, such as common stocks, preferred stocks, and fixed income, to provide a fairly high regular dividend. There are many bond funds to choose from in nearly every category—mortgage-backed securities, corporates, government, foreign government, foreign corporates, business loans, bank loans, and so on. About the only thing missing is a fund that invests in loans made by Jimmy “Knuckles” at the bar on the corner. And rumor has it the First American Loan Shark Interest Trust fund is debuting next year.

Income-paying, closed-end funds can be very attractive because of their high yields. When you have an investment that pays a decent yield, whose stock price trades 10% to 20% below the value of the fund's assets, those yields become even more enticing. But you should check these funds out carefully.

Wall Street is not in the habit of giving away free money. If a fund has a yield of 14% when 10-year Treasuries are paying 2.5% and a strong common stock yield is 4%, you should have a clear understanding of why the fund's yield is so high. Are the assets distressed? Is the dividend sustainable? Will the fund company remain solvent?

For example, some closed-end funds are known as buy-write funds. They invest in stocks, often dividend payers, and then sell calls against those stocks, boosting the yield.

Sounds like a great way to increase the income that the investment produces. And it can be. (We go into further detail in Chapter 10.) The problem can arise when the investments in the funds aren't generating enough income to keep the sky-high dividend sustainable.

Here's what I mean. Let's assume there is $1 million in the fund. The assets in the fund generate $50,000 in income, or 5%. However, the fund has promised investors a 10% yield. That means the fund managers have to dip into the capital to send investors their $100,000 in income. They'll use the $50,000 in income that the investments generated, take $50,000 out of the $1 million, and send the total back to investors.

That's called a return of capital. Return of capital distributions actually can have some tax benefits because they are not taxed like dividends. Return of capital is usually tax deferred and comes off the cost of your investment.

MLPs

Now that you understand the concept of return of capital, let's examine master limited partnerships (MLPs). An MLP is a company that has a special structure that bypasses corporate taxes because it passes along (nearly) all of its profits to its unitholders in the form of a distribution. A bit of lingo—MLPs have units, not shares, and pay distributions, not dividends. This isn't just jargon; there are important differences from a tax perspective.

These distributions are treated as returns of capital by the Internal Revenue Service (IRS), so investing in MLPs can be a tax-deferred strategy for generating income. As we discussed in the section on closed-end funds, the return of capital lowers your cost basis.

I'm simplifying things with this example, but if you bought an MLP at $25 per share and for 10 years received a $1 per share distribution that was all return of capital, your cost basis would be reduced to $15.

Over those 10 years, you would not pay taxes on those $10 in distributions ($1 × 10 years). However, when you sell, you will pay a capital gain tax on the difference between $15 and the selling price.

If your cost basis eventually goes down to zero, the income you receive will be taxed from that point forward—usually at the capital gains rate.

The distribution most MLPs pay is usually 80% to 90% return of capital. But each MLP is different and the distribution may vary from year to year. Be sure to read the investor relations page of the website of any MLP you are considering investing in to get a thorough understanding of the way the company pays distributions.

Talk to your tax professional before investing in MLPs, because the tax implications can be complex. Additionally, you receive a K-1 tax form from the company, which is different from the 1099-DIV that you get from regular dividend-paying companies. This can add to the cost and timeliness of your tax preparation.

About 80% of MLPs are energy companies. Most of them are oil and gas pipelines that aren't affected much by the price of oil or gas. Their businesses rely on the volume of product that flows through their pipelines.

Other MLPs include infrastructure companies, amusement parks, financial firms, and even a cemetery operator.

MLPs are popular with income investors because of their strong tax-deferred distributions. The risk is that since all of the company's profits are distributed back to shareholders, any decrease in earnings can result in a dividend cut. Although the distribution is high, it is usually not as stable as a strong dividend player, like Clorox, which pays out only 66% of its profits in dividends and has raised its dividend for 37 consecutive years.

However, there are several MLPs that are also Perpetual Dividend Raisers. Plains All American Pipeline (NYSE: PAA) has raised its distribution for 13 consecutive years, and TC Pipelines (NYSE: TCP) has a 15-year streak of annual distribution increases.

REITs

Real estate investment trusts (REITs) are also very popular with income investors. A REIT is a company that has a collection of real estate, usually rental properties. Like an MLP, a REIT does not pay corporate taxes and instead must distribute the profits back to shareholders. So REITs often have fairly high yields.

There are REITs for nearly everything: REITs that specialize in apartment buildings, office buildings, shopping centers, hospitals, medical offices, nursing homes, data storage centers. . . .

REITs do not have the same tax implications as MLPs. In an MLP, you are considered a partner in the business. In a REIT, you are a shareholder. The dividends you receive from a REIT will usually be taxed as ordinary income, not at the dividend tax rate, although a portion of the income you receive may be considered return of capital, which would be tax deferred and would lower your cost basis, similar to an MLP. (However, it's usually a much smaller percentage than with an MLP.)

Again—and I can't stress this enough—talk to your tax professional about any questions you may have.

REITs can be volatile, just like the real estate market. If real estate values fall, so do the NAVs of the properties the REIT owns. Additionally, a weak economy can lead to a greater number of vacancies, reducing profits and, as a result, the dividend. A change in interest rates may make borrowing money more difficult for the REIT, lowering its growth rate, or making it tougher for its tenants to pay the rent.

Of course, the opposite is true. During the real estate bubble, the MSCI REIT Index rose 43% between January 2005 and January 2007 (of course, many houses appreciated considerably more), but it plummeted 78% over the next two years as real estate prices collapsed.

Examples of REITs that are also Perpetual Dividend Raisers include Health Care REIT (NYSE: HCN), which owns housing facilities for seniors and other health care–related properties and has lifted its dividend for 11 straight years—and Tanger Factory Outlet Centers (NYSE: SKT), which develops and operates shopping centers and has boosted its dividend every year since 1993.

BDCs

A business development company (BDC) is a publicly traded private equity investment firm. Usually you need boatloads of money or connections to get into a private equity investment. Not too many common folk were able to buy into Facebook before it went public.

Private equity firms create funds and usually invest in early-stage start-up companies. They can be anything from a biotech company with a new technology for treating cancer to a chain of coffeehouses. Some private equity companies specialize in certain sectors, such as biotech, technology, or retail; others are generalists, entertaining opportunities wherever they lie.

Why would someone invest in a private equity fund? We all know how wealthy you could have become if you had invested in Microsoft and Apple when the companies had their initial public offerings (IPOs). Imagine how rich you would have been if you had invested even before they went public.

When early-stage companies are private and raising money, they can still sell shares, just not to the public in the markets. They sell them in privately arranged transactions. These transactions may be facilitated by pretty much anyone—an investment bank, a board member, or the CEO's mom.

These kinds of deals are usually done by knowing the right people. When looking for funding for Marc Lichtenfeld's Authentic Italian Trattoria, I may have reached out to some well-heeled investors whom I know have funds dedicated to this type of speculation. Or my mom may have mentioned it to her mahjong group, and one of her friends decided to invest $100,000 with me.

When you invest in an early-stage company, you typically get a larger portion of equity than if you bought shares once the company's stock is publicly traded. In 2004, venture capitalist Peter Thiel invested $500,000 in Facebook (NYSE: FB). For his half-a-million-dollar investment he received 10.2% of the company.

When Facebook went public in 2012, a $500,000 investment would have bought just 0.0005% of the company.

Today, a 10.2% stake in Facebook is worth over $21 billion. A 0.005% holding is worth just over $1 million.

Young companies have to sell larger portions of themselves early on to attract investment dollars. Those equity positions can become very lucrative as a company matures and particularly if it goes public.

Sometimes these private equity firms lend money to the start-up (or even more mature companies) instead of taking an equity position. For early-stage companies with little revenue, getting a business loan can be difficult, particularly now that money is tight; for this reason, the start-ups may have to go to other sources.

A private equity firm may lend money to a start-up at, let's say, 13% annual interest, even though the standard bank business loan might be 8%. Since the start-up can't get a bank loan, it has to pony up the higher interest rate since the risk is larger.

Each loan is structured differently, but it is common for the lender to take an equity position or take possession of collateral, such as intellectual property, product, or equipment, if the loan is not paid back.

BDCs that specialize in equity investments may have more inconsistent dividends as their payout could depend on when they are able to sell their positions. If a BDC sells $10 million worth of stock in one quarter and only $2 million in another, depending on the company's dividend policy, the dividend may fluctuate.

However, the BDC that makes a lot of equity investments may have more upside potential or some very strong yields during good years.

BDCs that specialize in making loans to companies may have more reliable dividends as they can pretty much project what their income stream will be from loan payments (assuming the default rate isn't higher than expected). So in that case, you may have less upside but more consistency when it comes to income.

That being said, just because a BDC lends capital to other companies doesn't mean you can't get a high yield.

As I write this, New Mountain Finance (Nasdaq: NMFC) pays a 9.2% yield. New Mountain lends money to cash flow–positive companies, often in a particular niche that has high barriers to entry (difficult for new competitors to enter the space).

Like closed-end funds, BDCs also have an NAV that helps determine the price of the stock but ultimately rely on supply and demand. It's usually best if you can find a high-yielding BDC trading below NAV, though in a low interest rate environment, that's not always easy to do as investors are willing to pay up for more yield.

You Don't Have to Play Mahjong with Mrs. Zuckerberg

Many investors would love the opportunity to get in on the early stages of exciting new companies. But unless you play mahjong with the mother of the next Mark Zuckerberg (founder and CEO of Facebook), or you're otherwise well connected, learning about these opportunities can be difficult.

BDCs allow the everyday investor to get involved with a portfolio of companies, spreading out the risk and very often paying a nice income stream.

For example, Main Street Capital Corporation (Nasdaq: MAIN) is a $1.4 billion market cap BDC that, as of October 2014, paid a yield of about 6.7%.

It makes both equity and debt investments and has a wide variety of companies in its portfolio, including:

• Hydratec Holdings, LLC, a Delano, California, manufacturer of microirrigation systems for farmers
• River Aggregates, LLC, a Porter, Texas, sand and gravel supplier
• Ziegler's New York Pizza Department, a Phoenix, Arizona, pizza chain

Many BDCs pay a robust yield, but as with any investment, there is no such thing as a free lunch. (Unless you're an investor in Main Street—maybe Ziegler's hooks you up with a free slice of pizza. I don't know, but it's worth a shot.) The higher the yield (or potential reward), the higher the risk. So if you're considering investing in a BDC with a high yield, do your homework on the company, see how consistent the dividend has been, and try to ascertain whether it will be sustainable.

Doing that might not be as easy as with your typical dividend-paying company, where you can look and see how many widgets it sells and what its profit margins and cash flow are. However, if a BDC has a long and consistent track record, you should have a bit more confidence that it can continue paying the dividend.

As with a REIT, the IRS treats a BDC's dividend differently. To pay no corporate income tax, a BDC must pass through at least 90% of its profits on to shareholders. Most pass an even higher percentage of the profits on.

Generally, you'll be taxed on the kind of income the BDC received. If it earns interest on a loan, you probably will be taxed on that portion as ordinary income. If it sells a company for a capital gain, you will be taxed on that portion at the capital gain rate.

The BDC will send you a form with the breakdown, so you'll have all the information you'll need.

Once again, if you have any tax-related questions, repeat this with me now: Talk to your tax professional.

Closed-end funds, MLPs, REITs, and BDCs can be an excellent way to add yield to your income portfolio. Many of these businesses generate a ton of cash and must pass that cash along to shareholders, which is why they are able to pay investors more than other companies can.

When ExxonMobil makes a profit, management decides what do to with that cash. Does it invest in new equipment, put a gym in the corporate headquarters, buy back stock, or give some back to shareholders in the form of a dividend? MLPs, REITs, and BDCs, by the laws of their corporate structure, must return profits to shareholders.

Keep in mind that such investments can be volatile as they are usually concentrated in one (often-cyclical) sector and have more complex tax ramifications for shareholders. But if you don't mind doing a little homework and talking to your tax professional (or handling it yourself with tax software), these investments can be an excellent way to boost the amount of income you receive every year.

Preferred Stocks

Preferred stocks are sort of a combination of a bond and a stock. They pay a higher dividend, sometimes can be converted into common stock, and are higher in the pecking order than common stock if the company is liquidated. However, they come after bonds in that situation.

If a company declares bankruptcy and its assets are sold off, bondholders will be paid first. Next come preferred shareholders, then shareholders of common stock.

Many preferred shares, known as cumulative preferred stock, will accumulate if the dividend is not paid. When a dividend of a common stock is not paid or is cut, the shareholder is out of luck. If, sometime in the future, the company reestablishes a dividend, the shareholder starts from whatever dividend the company declared.

Cumulative preferred shareholders, however, see their dividends accumulate during the period that the company did not pay dividends. So if a company has an annual preferred dividend of $1 per share, stops paying a dividend for two years, and later introduces a $1 preferred dividend in year 3, the preferred shareholders will have to get paid out $3 per share ($1 plus the $2 missed) before any common shareholders can receive a dividend.

Because of this greater stability, preferred shares are not as volatile as common stock. Preferred share investors typically will not see the swings in share price that investors will see with common shares—although during the financial crisis of 2008 and 2009, numerous preferred shares of financial stocks were decimated because of fears that the companies might collapse. However, many of them came roaring back in 2009 and 2010.

Because preferreds have high yields, they often behave similarly to bonds in that interest rates affect the prices. Just like a bond, rising interest rates will likely lower the price of a preferred stock.

Also like a bond, a preferred is issued at par value, and the dividend is usually fixed. The dividend is not going to grow like a Perpetual Dividend Raiser. But for some investors, particularly those who need the income now, the higher rate today may be worth sacrificing growth tomorrow.

Another similarity to bonds—the dividend is rated by credit rating agencies. And unlike a stock, preferred shareholders have no voting rights. They are not owners of the company; they are creditors.

Financial institutions make up about 85% of all preferreds, so if the financial sector is strong, preferreds should do well. If financials are weak, as they were during the 2008 crisis, preferreds will be hit hard.

For example, insurer MetLife has the MetLife preferred stock, Series B (NYSE: METPrB), that pays a fixed rate of 6.5% annually (on the par value, which is $25), with dividends paid quarterly. As I write this, it is trading at $25.41, slightly above par value, so the yield is 6.4%. If you can buy a stock below par, you can get a yield higher than the declared yield, just like a bond.

Preferred stocks are often redeemable 30 years after they are issued, although some have no redemption date. Of course, you can always sell the stocks in the open market; however, they are generally not as liquid as common stock.

I'm not a huge fan of preferreds because they are much closer to bonds than to stocks and typically don't grow dividends. A 6.5% yield might be attractive today, but it won't keep up with inflation, even a low level of inflation, such as 3%.

Think about it this way. If you invest $1,000 in a preferred with a 6.5% yield, you'll receive $65 per year. However, in three years at 3% inflation, you'll need $1,092 to have the same buying power as $1,000 three years prior. Your $65 per year won't keep up with inflation. You need a dividend growing faster than inflation to do that.

The benefit of a preferred stock is that the dividend is higher than a stock, particularly for a blue chip company. The downside is that it probably will not keep pace with inflation. Also, most preferreds do not let you reinvest the dividends in more preferred shares. Some let you reinvest the preferred dividends into common stock, however.

Like some of the other higher-yielding, less traditional income investments, there's nothing wrong with sprinkling one or two preferreds into a portfolio. But since preferreds are a kind of quasibond, you want the majority of your holdings to be Perpetual Dividend Raisers.

Summary

• Closed-end funds are mutual funds that trade like stocks.
• Return of capital is a cash distribution that is tax deferred and lowers your cost basis.
• REITs invest in real estate assets.
• MLPs are partnerships, often energy pipelines.
• BDCs are similar to publicly traded private equity firms.
• Preferred stocks are as much like bonds as they are like stocks.
• Closed-end funds, REITs, MLPs, BDCs, and preferred stocks are alternatives to regular dividend payers in that they usually have higher-than-average yields—but they can have complex tax implications as well.
• Playing mahjong with Mrs. Zuckerberg might be a great way to get lucrative investing ideas.