UBS' ETracs Diversified High Income ETNs seek to offer high yield with less volatility

By Emma Trincal

New York, Sept. 19 - UBS AG, London Branch is bringing to market ETracs Diversified High Income exchange-traded notes due Sept. 18, 2043 linked to the NYSE Diversified High Income index. They target investors looking for higher yield with higher diversification in an effort to minimize volatility, said a UBS structurer.

"Investors seeking high yields typically turn to investments in narrowly focused asset classes or sectors," said Paul Somma, senior structurer in the ETracs group of UBS, in a company news release on Thursday. "[The ETN]'s exposure to a multi-asset index provides investors with access to a diversified portfolio of income-producing assets in a single, transparent, exchange-traded security."

The index was launched on Aug. 20. It measures the performance of 138 securities that historically have paid high dividends or distributions.

The ETracs priced on Wednesday and began trading on Thursday. The notes have been approved for listing on NYSE Arca under the symbol "DVHI."

Investors in the ETN receive a variable monthly coupon linked to the dividends on the index constituents minus an accrued tracking fee of 84 basis points per year, according to a UBS factsheet.

The payout at maturity or upon redemption will be par plus the index return, which could be positive or negative, plus the final coupon minus the accrued tracking fee, according to a 424B2 filing with the Securities and Exchange Commission.

The index is a price return index. Dividends and cash distributions are reflected in the variable monthly coupon only.

Minimizing volatility

"People are looking for high income, and they often find it in ETNs that give them exposure to a single sector," a market participant said.

"[Master limited partnership] ETNs that capture the returns of this high-yielding sector have been extremely popular, but they come with much greater risk. Some clients own MLPs. They love the yield, but they're exposed to a single sector that moves around a lot. There was a need to explore a strategy that gives high yield with reduced volatility by diversifying across a broad range of sectors and securities," this market participant said.

The index offers diversification across geographic regions, sectors and asset classes such as international stocks, emerging market bonds, fixed income, preferred stocks, MLPs, REITs and other types of securities, according to the filing.

The indicative yield of the ETracs as of Sept. 13 is 7.71%, excluding investors' fees.

"That's very decent even if you have to take out the 84 basis point fee. It exceeds high yield. It's just above any fixed income," said Steve Doucette, financial adviser at Proctor Financial.

The SPDR S&P Dividend ETF and the iShares Select Dividend ETF, both based on U.S. dividend-paying equities, have an annual dividend yield of 2.35% and 3.16%, respectively, the market participant said for comparison.

The UBS ETracs Alerian MLP Infrastructure ETN has a 4.59% yield, he noted.

"Those products offer competitive yields, but they're single-sector exposure. You're talking about a much greater level of volatility and correlation," he said.

"The idea behind diversifying across many sectors and asset classes is to hopefully lower volatility. And if you can combine that type of yield with a diversified index, you should see demand for this product."

The index

The index components are securities that historically have paid high dividends or distributions, according to the fact sheet. The constituents must satisfy certain dividend or distribution yield and other criteria, such as frequency of payment and liquidity.

The index allocates 60% to equities and 40% to bonds and fixed-income assets.

Within the equities group, the top two sectors are business development companies (BDCs) and energy MLPs with a target weighting of 15% for each. Mortgage REITs, REITs and U.S. stocks each have a 7.5% target weighting. ETFs representing international equities account for 7.5% of the index.

Within the fixed-income, bonds and related assets allocation, the key components are four different buckets, each made up of ETFs and each representing a 10% target weighting: municipal bonds, high-yield bonds, emerging markets bonds and preferred stocks.

Overall, ETFs make for 47.5% of the index.

"It allows diversified access in asset classes that are not the most liquid or the easiest to gain access to. It's easier to hedge, and frankly, the fees are offset by the high yield those securities can provide," the market participant said.

"It's an interesting product if you get to put together illiquid investments like these BDCs and MLPs that tend to hold their value, as they don't fluctuate as much in a rising interest rates environment," Doucette said. "The BDCs are direct lender folks offering adjustable-rate loans, so it's a little bit similar to [a] floating-rates mutual fund. Those BDCs offer higher yields because those folks are picking up the slack for the risk-averse banks to lend to what may be sound businesses."

Searching for yield

The quest for yield has been on investors' minds with rates being as low as they are given the Federal Reserve's continued low interest rate and stimulative policy. Sources said that Wednesday's surprise decision by the Fed not to taper, which caused yields to plunge, may cause investors to resume searching for alternative ways for high income.

"We didn't anticipate yesterday's decision," the market participant said.

"Until investors feel that rates are attractive enough, they will continue to look for income-focused ETNs when their banks are paying five basis points on their checking and the Treasuries, double-digit basis points. The quest for yield is still on as the government keeps sending signals that they will keep interest rates low for quite some time."

The index methodology incorporates minimum free float market capitalization as well as dividend yield, liquidity and asset class and sector weighting requirements. The index is rebalanced quarterly to maintain the sector target weightings, according to the filing.

"The overall construction is based on a broadly diversified source of fixed income," Doucette said.

"That's good. The next phase would be to do some due diligence and see how they do the rebalancing. They charge 84 basis points a year to put it all together. But how much flexibility do they have with their target weightings?

"I'd be curious to see what the signals are when it comes to reallocating to the buckets. You don't want the weightings to be too rigid."

The index portfolio is rebalanced quarterly and is weighted by market capitalization.

"The selection process chases the sectors that produce the highest income over the past 12-month trailing and also the most liquid assets," an index industry source said.

The inter-quarter weightings will fluctuate as some assets will grow more than others, explained the market participant.

"But it gets rebalanced quarterly based on the target weightings, which are fixed. All the sectors will be weighted again according to the target weightings. You want the weightings to be fixed because those weightings are set to capture the highest dividends. You want them to rebalance accordingly," he said.

No tapering

Another concern for investors, said Doucette, is interest rate risk.

"Eventually rates will go up even though the Fed surprised the market yesterday by keeping its stimulus unchanged," he said.

"Even though BDCs and MLPs hold up well in a rising interest rate environment and while they make for 30% of this index, you still have 70% subject to the interest rate risk.

"It's still a concern for any bondholder.

"Anytime you have a 40-year trend of decreasing interest rates - and we've only seen a couple of months of increasing rates - what do you do? You have to pay attention to interest rates, for sure.

"For now we've been working on mitigating that risk using securities that are less interest rate sensitive.

"We've bought reinsurance bonds. We're still doing autocallables that pay huge coupons when the equity moves the right way. But you have to be very selective."

The market participant agreed.

"Interest rate risk is one that most bondholders have to face. It's true of many high-income-producing securities: They'll have some exposure to rising interest rates. Maybe at that point, people will reduce their exposure. In the meantime, interest rates would have to rise significantly, and before that happens, I think investors will continue to pile into these high-yield ETNs," the market participant said.

Smaller shelf

The notes have a face amount of $25 each.

The company plans to sell up to $25 million of the notes, according to the prospectus. The remaining $15 million will be sold from time to time at varying prices.

UBS typically registers for $100 million.

"But the registration fee is based on the amount, and it can be quite expensive," the market participant said.

"Some ETNs never grow, so the idea is to register for only $25 million. It's always possible to increase the size by refiling."

The notes are putable, subject to a minimum of 50,000 notes and a redemption fee of 0.125%. They are callable in whole beginning Sept. 23, 2014.

As of Sept. 13, the five largest index constituents were the PowerShares Emerging Markets Sovereign Debt ETF (9.97% weight), the iShares iBoxx $ High Yield Corporate Bond ETF (9.93% weight), the iShares US Preferred Stock ETF (7.04% weight), the Market Vectors High Yield Municipal Index ETF (4.94% weight) and Ares Capital Corp. (4.15% weight).

In the case of a redemption, the final index level will be the average of the index's closing levels on the five business days ending on the business day following the redemption notice date.

UBS Investment Bank is the agent.

The index was created on Aug. 20 and therefore has no track record, UBS said in the filing. The index sponsor is NYSE Group Inc.

The Cusip number for the notes is 90267L805.

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