But there are many different classes of high-yield stocks, some much safer and more appropriate for conservative investors than others.
Let's take a look at one popular high-yield investment class, royalty trusts, to see what investors need to know before investing in them.
Most importantly, learn why their business models and limitations likely make them inappropriate for meeting your income needs, especially in retirement.
What are Royalty Trusts?
At their core, royalty trusts usually own a non-operational interest in oil and gas minerals. Generally, royalty trusts are used as a form of financing in the energy sector, where an energy producer can sell royalty rights from oil and gas well extraction on some of its assets.
The trust then uses that stream of royalty cash flow, which is commonly tied to production volumes, to pay distributions to unit holders (what royalty trust shareholders are called).
Royalty trusts are a type of pass-through entity that is structured similarly to real estate investment trusts (REITs) and master limited partnerships (MLPs). As long as they distribute a certain level of profits to unit holders as distributions, they avoid paying federal income tax.
Their distributions are usually classified as a return of capital, meaning the payouts are a non-taxable event. Instead, the distributions reduce a unit holder's cost basis and thus defer taxes until he sells his position in the trust.
Let's use one of the largest and most popular trusts, BP Prudhoe Bay Royalty Trust (BPT), to review how these entities are structured, the nature of their operations, and the risks that make them inappropriate for most conservative income investors.
The Business Model of Royalty Trusts
Rather than own hard assets and engage in productive activities, royalty trusts serve as a financing vehicle by owning the income rights to a fixed amount of oil or gas sold by an upstream energy company.
For example, in 1989 the BP Prudhoe Bay Royalty Trust was established by energy giant BP (BP) in order to raise money to drill in Alaska's Prudhoe Bay (North Slope of Alaska). The actual trust is administered not by BP but by the Bank of New York Mellon (BK) who handles the payouts to investors.
In this case, BP Prudhoe Bay's assets are purely the cash flow being generated from BP's Prudhoe Bay unit, up to the first 90,000 barrels per day. Over time, the depletion of the oil and condensates under that acreage will naturally result in falling royalty income.
At that time, BP has the right to repurchase the trust's units from investors at the greater of the trust's current market price or the fair market value of the trust property as determined by an investment banking firm.
If BP chooses not exercise its option to buy back the trust's units, then Bank of New York Mellon, the trustee, will have the ability to liquidate what assets the trust still has, and then distribute the proceeds to unit holders.
The expected date of the trust's termination also fluctuates wildly, depending on oil prices. In 2014 when oil was over $100 per barrel, the end date for the trust was estimated at no longer than 2029.
However, during the peak of the oil crash in 2016, the firm warned investors that royalty payments to the trust might cease as early as 2019.
At the end of 2017, BP Prudhoe Bay estimated that royalty payments would continue through 2019 but drop to zero in the following year. Here's what the trust stated in its 2017 annual report:
"Based on the 2017 twelve-month average WTI Price of $51.34 per barrel, current Production Taxes, and the Chargeable Costs adjusted as prescribed by the Overriding Royalty Conveyance, it is estimated that royalty payments to the Trust will continue through the year 2019, and would be zero in the following year. Therefore, no proved reserves are currently attributed to the BP Prudhoe Bay Royalty Trust after that date.
Even if expected reservoir performance does not change, the estimated reserves, economic life and future net revenues attributable to the Trust may change significantly in the future as a result of sustained periods of change in the WTI Price, the Production Tax or from changes in other prescribed variables utilized in calculations as defined by the Overriding Royalty Conveyance. Such changes could result in the termination of royalty payments prior to 2019."
But what about owning a trust for just a few years, collecting those big distributions well before a trust reaches the end of its life? For most investors, that's still a poor idea.
The Biggest Downsides of Royalty Trusts
In other words, the dividend payments backing a royalty trust's high yield are very volatile from one quarter to the next. As a result of these variable payments, which are based on the daily production rate and the price of oil, an investor has no way of knowing exactly how much income he will receive from a royalty trust over the course of a year.
For example, in just the last three years BP Prudhoe Bay Royalty Trust's quarterly distribution has ranged from 7.2 cents per unit (in the first quarter of 2016 when the price of oil fell to $26 per barrel) to $1.47 (in the second quarter of 2015 when oil peaked at $107 per barrel).
BP has been investing less in drilling new wells on the trust's acreage since the oil crash. As a result, in the second quarter of 2018 daily average production for BP's trust fell to 84,000 bpd, down from 91,800 bpd a year earlier.
Since oil peaked in 2015, the trust's production has been consistently below its 90,000 bpd royalty cap and, according to the trustee, production is expected to be below 90,000 bpd "in most future years."
Simply put, acreage oil reserves are being steadily depleted, no new reserves are being added, and BP is not expecting to invest in drilling new wells to raise production, even with oil prices up significantly since early 2016. During the oil crash BP cut the number of rigs operating on the trust's acreage from four to two, and that figure has not been increased since.
Remember that those distributions are not taxable income but rather a return of your initial capital. On each ex-dividend date the unit price is reduced by the distribution amount, thus lowering the value of your investment.
If you buy BP Prudhoe Bay Royalty Trust at $25 per unit, for example, then you need to receive at least $25 in distributions just to break even. That's because on the trust's termination date you are likely to receive next to nothing, since the unit price is set by the market and purely based on expected future distributions. Since future royalty income and thus distributions are eventually guaranteed to go to zero, the unit price will likely fall to zero over time.
But let's say you get lucky, and the trust's payout benefits from a historic, sustained surge in the price of oil to $100 per barrel or beyond. Even then, BP Prudhoe Bay Royalty Trust is likely to make a poor investment. Here's why.
In that scenario, for the remaining 10 years of the trust's life (remember it might be far sooner), investors who buy today at $25 per unit would receive $50 in distributions over the next decade.
Since the trust's value falls to effectively zero at termination, your actual gain over this 10-year period is $25 ($50 in payouts minus $25 invested capital). You will pay long-term capital gains taxes on this figure at the time (deferred tax liability).
- bonds: 4.9% (since 1900)
- stocks: 9.6% (since 1900)
- REITs: 11.7% (since 1972)
- Dividend Aristocrats (S&P 500 companies with 25+ consecutive years of dividend increases): 12.1% (since 1990)
This shows that royalty trusts are actually a "yield trap" that makes for a far worse long-term income investment than much safer alternatives.
Closing Thoughts on Royalty Trusts
That's because they are not growing organizations with stable cash flows that support safe and growing dividends/distributions. Rather they are collections of depleting and commodity sensitive assets with a guaranteed termination date that means their mouth watering yields are an illusion. In reality all royalty trust distributions are returns of your original investment, which means that anyone investing in them is taking on substantial risk. Not just in terms of volatile swings in distributions, but in potentially generating negative total returns over time.
On top of that royalty trusts come with tax complexities that make them just not worth owning. Not when there are far superior and lower risk alternatives for generating generous, safe, and steadily growing income to help you achieve your long-term financial goals.