Tag Archives: yield

Global X YieldCo ETF: Not Ready For Prime Time

YieldCos are a relatively new market entrant focused on paying dividends. Despite some popularity among income investors, they are, at best, untested. But that didn’t stop Global X from creating an ETF to track them. I have misgivings about exchange traded funds, or ETFs, in general. While a good idea on one level, Wall Street has a habit of turning good ideas into misused and abused ideas. Which is why Global X YieldCo Index ETF (NASDAQ: YLCO ) caught my attention. I’d say this ETF is a risky investment that most investors should avoid. Here’s why… What’s a YieldCo? So an ETF is a collection of stocks or bonds that trade on an exchange all day long. Sort of like a mutual fund, sort of like a closed-end fund. The ability to trade all day makes ETFs similar to closed end funds. But the market price for a closed-end fund can vary greatly from its net asset value. The structure of ETFs lead them to trade pretty close to net asset value, like a mutual fund. ETFs are also very cheap to own. There is, in fact, a lot to like about ETFs, so long as you stick to large, well diversified funds. But Wall Street, seeing a hot new product, has ramped up its marketing machine. How many S&P 500 ETFs do we need? Not many. Which is why ETFs have gotten more and more obscure, often targeting niche areas and risky investment approaches. Is there a place for these vehicles? Probably. Should average investors be putting their money in them? Probably not. Which is why a YieldCo ETF caught my eye. YieldCos are a relatively new business construct, dating back to around 2012. At this point, they are very similar to a limited partnership structure in which there is a sponsor company that sells its assets to the YieldCo. The YieldCo then spits out income to shareholders. The big difference is that the YieldCo is generally a regular company, so there’s fewer tax headaches than you would face with an LP which is structured as a partnership. On the surface this sounds great. The YieldCos in existence have generally owned electric generating assets with long-term contracts in place, so there’s even some ability to predict a reliable income stream. Investments in the renewable power space (solar and wind, for example) are most often highlighted, though YieldCos own other types of electric generation, too. Growth comes from buying more and more assets. Like LPs and REITs, however, YieldCos spit out so much income that they have to issue more shares to pay for additional assets. There’s nothing inherently wrong with this, since there are obvious precedents for the business model. However, that still doesn’t mean this relatively new business model will work out as planned. Moreover, the focus on renewable power projects means that YieldCos are tapping into a current investor interest. That’s great right now, but what if investors lose interest? So, by and large, I’d say that YieldCos have an interesting story behind them. But, and this is a big but, the long-term legs of the story remain untested. So investors should tread lightly in the YieldCo space, tempering a desire for income and income growth with a bit reality about the very short life most of these entities have lived. If you want proof of these risks, take a moment to look at the recent events around NRG Energy (NYSE: NRG ) and its YieldCo NRG Yield (NYSE: NYLD ). Diversify to reduce risk Of course, one way to offset the risk of owning just one or two YieldCos would be to buy a portfolio of them, right? And that’s where Global X’s YieldCo product comes in. It owns 20 of the largest YieldCos and provides a one-stop shop for getting diversified exposure to this potentially up and coming space. Wait… There’s some problems here. YLCO does own 20 stocks, but its prospectus explains a minor detail you’ll want to watch: “The components of the underlying index are YieldCos selected from the universe of global publicly listed equities, which have a minimum market capitalization of $500m and an Average Daily Value Traded (“ADVT”) over the last three months greater than $1 million. If less than 20 securities satisfy this criteria, the market capitalization and ADVT requirements are lowered. If there are still fewer than 20 securities, the parent companies of proposed YieldCos with the nearest anticipated listing dates will be included in the index until there are 20 index constituents.” In plain English that says, “We want to own 20 YieldCos but there aren’t that many of them right now. So we buy all that we can, even really tiny ones. Since that still may not lead to 20 holdings, we’ll buy companies that aren’t YieldCos but that have said they want to spin one off.” So YLCO has built a niche ETF in a sector that doesn’t have enough stocks in it to support a portfolio of 20 sufficiently sized companies. Think about that for one second. You are buying everything in the sector without any regard to whether or not it’s a good or bad company. With only little regard to size. All a company needs to be is a YieldCo, or a company that says it wants to spin a YieldCo off, to pass muster with Global X. Sure, you’ve got broad exposure to this relatively new niche, but is that really the way you want to get it? If the YieldCo sector continues to grow and manages not to implode, YLCO could become a useful way for investors to get diversified exposure to the space. So, on that level, it’s not a bad idea. However, the YieldCo space just isn’t mature enough at this point to support what YLCO wants to offer. And, in the end, conservative investors should avoid it. In fact, I’d go so far as to say that most investors should avoid it until the YieldCo space has grown some more and YLCO has been stress-tested by the market.

Are You Afraid Of Rising Interest Rates? Here’s A Possible Solution

Summary The yield curve is an important graph that offers key information about the economy. Given that investors in a bull market are afraid of rising interest rates, other opportunities are being looked at. The Steepener and Flattener ETNs offer opportunities to take advantage of an increase in interest rates. The Fed recently decided to keep interest rates flat. But I believe interest rates will not remain flat forever. Therefore, it is worth taking a look at how someone could protect themselves against the rise of interest rates in the future. This article will focus on the characteristics of the yield curve with an emphasis on the Steepener ETN (NASDAQ: STPP ) and the Flattener ETN (NASDAQ: FLAT ). ETNs are structured products that are issued as senior debt notes, while ETFs represent a stake in an underlying commodity. These two ETNs are perfect opportunities to protect any investor against rising interest rates, as this surge will have an adverse effect on the stock market (NASDAQ: QQQ ). The Yield Curve The yield curve is a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity. Here’s the current U.S. yield curve: (click to enlarge) Source: Treasury.gov . The short-term interest rates are administrated by the FOMC , while the long-term interest rates are created by the forces in the stock market. The Yield Curve Spread The yield curve spread is the yield differential between two different maturities of a fixed instrument. For example, the difference in yield between a two-year Treasury note and a 10-year Treasury note would create another line, a so-called spread. The later-maturity leg is considered a back leg and the leg that matures first is called the front leg . The spread between the two- and 10-year Treasury instruments has shown significant patterns over the last few decades, as seen here: Source: Forbes . The spread increases during bubbles, such as the tech bubble (1999-2001) and the mortgage crash (2007-09). This indicates that this strategy (taking advantage of the difference between the two- and 10-year yields) can be played out from time to time when equity markets might be under threat and heading toward a bear or bull market. This pattern is perfectly described below: (click to enlarge) Current times make things interesting, as interest rates are expected to increase in the future. This is a situation that has happened over and over again the last few decades: (click to enlarge) Source: Fed . As the graph above depicts, interest rates cycled upward and downward during the bull and bear periods of the economy. Yield Curve Strategies – Steepener and Flattener Source: Created by author. Flattener Strategy A flattening curve is a situation where the yields on the short-term and long-term dated treasuries are converging. In other words, they are coming closer together. From a bank perspective, this is not always considered favorable as banks borrow money at short-term rates while lending it out at long-term rates. When the yield curve converges, the short- and long-term yields come closer to each other and thus diminishing the profit for the bank. Yet, the steeper the yield curve gets, the higher the differential between long-term yields and short-term yields. That means more profit for a bank. When the yield curve becomes more flat, the iPath U.S Treasury Flattener ETN comes into play as it tracks the spread between the two-year and 10-year yields. One should not forget that these ETNs are leveraged, as a 0.1% move in the spread will indicate a 2% price change for FLAT . The flatter the yield curve gets, the better for the Flattener ETN. Steepener Strategy When the differences in yield in the short and long term are diverging (i.e., getting more steep), the iPath U.S. Treasury Steepener ETN is another option. The objective of this product is to hold a weighted long position in the two-year Treasury future and a weighted short position in the 10-year future, in contrast to the flattener. With a steepener you buy the spread, while with the flattener you sell the spread. They are opposites: Negative Rates As this article assumes rates will eventually go up, a potential scenario with negative rates — even though it has been deemed unlikely by Janet Yellen — should not be ignored. That’s because some economists believe the economy is still not growing as expected, and negative rates would basically indicate that anyone who wanted to borrow money would get paid. This would act as a potential strong stimulus to the economy. Even though it might appear to be an unlikely scenario at first, there are places in Europe that currently have negative rates in place, such as Switzerland. In the Fed’s projections, a negative Fed Funds rate was deemed plausible: Source : Fed . Summary Investors do not have to worry about a potential increase in interest rates as there are good investment vehicles to protect themselves against these potential rate hikes. As the yield curve has shown many predictable signs of explaining the economy , it’s important to keep an eye on how the yield curve develops over time. I currently do not hold positions in either ETN. However, both are on my watch list as I consider them splendid investment opportunities for when the equity markets dwindle lower or when the Fed finally decides to start increasing the Fed rate. Liquidity is a minor issue with both ETNs, but when interest rates eventually increase I expect liquidity to increase as well. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

TerraForm Power: Is It Time To Buy This YieldCo?

Considering the recent downfall in TerraForm Power stock levels we look at if it is worth investing in this security. We review various risk factors and our assessment on required yield based on the risk factors. Currently we view the valuation range of $17.50 to $20 subject to downward revision if Vivint Acquisition goes through. Over the last year, we have been consistently negative on YieldCo valuations and did not see a reason to invest in any of the YieldCos in the market. We were of the opinion that the market was mispricing risk in the long term assets held by these YieldCos. However, the yield bubble that we were in for much of the last year has caused many of the YieldCos to be priced at incredibly high valuations and consequently drove project developers like SunEdison (NYSE: SUNE ) go on an unsustainable growth path. One of the risks of this yield mispricing is that project developers counting on low yields tend to develop projects at unacceptably low margins. When yields rise, as they did recently, these developers find themselves cash strapped and with limited options on exiting from the projects under development. That is the quagmire that SunEdison finds itself in today. Companies affected by this same malady but to a much lesser extent, in an approximate order of declining risk, include SolarCity (NASDAQ: SCTY ), Vivint Solar (NYSE: VSLR ), SunRun (NASDAQ: RUN ) in the residential sector and Canadian Solar (NASDAQ: CSIQ ), SunPower (NASDAQ: SPWR ), Fist Solar (NASDAQ: FSLR ), Trina Solar (NYSE: TSL ) and JinkoSolar (NYSE: JKS ) in the large scale project sector. Of the above group, we are skeptical about the survival chances of the residential solar installers as their risks are far in excess of what the markets currently comprehend. Of the latter group, we believe the risk factors are more manageable given the manufacturing component of the companies, the much smaller project component, cost/margin advantage due to the use of in-house panels, and the location and returns of the assets under development. Of the solar asset holding companies, only SunEdison, First Solar and SunPower have their own YieldCos. When it comes to these companies many investors have tended to tie the performance of these sponsor companies with their YieldCos. As misguided as that line of thinking was, the markets and the Wall Street analyst community played a role in reinforcing that sentiment. However, we believe the time has now come to decisively cut the cord between sponsors and YieldCos and look at these companies separately and objectively. With this mindset, we now review the prospects for TerraForm Power (NASDAQ: TERP ). It should be noted that TerraForm Power has fallen from a peak of about $42 in April of this year to about $22 today – almost a 50% correction for a so called stable yield vehicle. At the current price, TerraForm Power yields about 6% on a TTM dividend basis and about 8% on forecasted 2016 dividend basis. Is the current stock price a reasonable approximation of the Company value? Or, conversely, is the yield level appropriate for this class of assets? To evaluate this, we believe one has to consider the risk factors of the asset base of the YieldCo and assess an appropriate risk/yield level. Our view of the required yields and risk factors are as follows: – To begin with, when it comes to energy assets, investors should note that not all solar asset classes have the same risk. We are of the opinion that, all else being equal, US utility assets deserve a discount rate of about 8%, US high grade commercial assets about 10%, and US residential assets about 12%+. – While TerraForm Power management prides in saying the YieldCo consists mainly of OECD assets and thus low risk, we believe investors should keep close tabs on the source of the assets. Not all OECD countries have similar currency and country risk profiles and some countries have a vastly higher set of risks than others. Several of the currencies have depreciated significantly vis-à-vis dollar and there is not much of a compelling story on why the trends should reverse. In general, assets from any country with likely future depreciation against dollar should cause the yield to increase. – Remaining life of the PPA is also a significant risk factor. With the rapidity of the changes in the solar industry, it is likely that some of the solar PPAs will not even be renewed. To the extant they are renewed, it is likely that they will be renewed at prices far lower than the existing PPA levels. – It is also likely that many of the assets would require significant upgrades for them to be renewed. For example, the utility or commercial customer may demand certain amount of dispatchability or a shaping of the energy. The capital costs required at renewal for any such changes and upgrades should be rolled into the IRR and yield calculations. – The rate of the PPA compared to the current market should also be a consideration. The larger the disparity between market and PPA rates, the higher the motivation for the customer to renegotiate and a chance that the asset may become distressed. – The potential for curtailment for each of the assets should be evaluated and discounted. – Wind resources, on the other hand, have a different risk profile than solar. Wind has an energy profile that complements the solar production and may end up holding up better in terms of PPA prices in the future. Wind resources may also likely need smaller battery support to make the power plant resources “pseudo dispatchable”. In other words, the wind assets may have a lower risk factor at renewal time than solar assets. – Investors should note that this is only a partial list of risks and any other risks specific to an asset or asset class should also be considered and impact evaluated While having a checklist can be useful, there are multiple challenges in evaluating the risks and costs we present above starting with disclosures. Even if the risks and costs can be reasonably identified, weighing of the factors is, at best, an informed estimate. When dealing with such unknowns, a reasonable safety margin is mandatory. Without using much scientific rigor in analysis, our estimate is that the current portfolio of assets in TerraForm Power need to yield at least 10% to provide a satisfactory risk adjusted return to investors. This, in turn, would imply that the valuation of TERP is likely around $17.50 a share based on forward guidance. Note that this valuation does not give any premium for growth. One question to ponder in this context is how much growth is possible at the new and increased cost of equity. To understand the Company’s growth potential, one has to estimate the future cost of capital for TerraForm Power. Firstly, while it is true that the cost of equity has gone up substantially for TERP, we believe that there is a reasonable chance that TerraForm Power can obtain debt capital at attractive rates. Secondly, markets have consistently demonstrated that unsophisticated investors are likely to buy debt and equity at surprisingly high valuations. If TerraForm Power can attain a WACC in the 8 to 10% range, we believe that growth, though hard to come by, is possible. Discounting for possible growth, and assuming a fairly benign yield environment, we can see TerraForm Power’s intrinsic value reaching about $20 by the end of 2016. This, of course, assumes that asset quality remains reasonable. As we wrap up this discussion, investors should consider another key factor when acquiring a YieldCo stock. While the current yield bubble has burst, it is neither the first one not will it be the last one. With Wall Street’s penchant for newfangled metrics, and with no shortage of investors subscribing to yet another non-standard valuation methodology, managements will always be faced with bubbles in the stock price and yields and will be issuing new equity or debt to take advantage of it. When the prices of these instruments correct from bubble levels, the preexisting stockholders who acquired the equity at a lower level will be beneficiaries of the largesse of the new stockholders. To benefit from this effect, it is very important for yield oriented investors to accumulate the YieldCo stock when the asset class is out of favor and shun purchases when the asset class is trading at rich valuation levels. All things considered, for yield oriented investors, we see TerraForm Power as a buy in the $17.50 to $20 range. While the stock has not gotten to this trading range, alert investors may be able to enter the position when there is a market weakness. Alternately, given the limited downside from the stated levels, the position can also be entered through selling puts at the $17.50 or $20 levels. The key risk factor at this point for this YieldCo is the acquisition of Vivint Solar . While this deal makes increasingly less sense, management has continued to stick with it to date. Vivint asset purchase and the aggressive addition of residential assets ahead of ITC step down could push up the risk adjusted yield requirements of the portfolio to north of 11%. In such an event, the entry point to TerraForm Power should be adjusted accordingly. Given the emerging nature of the energy landscape, we believe there may be several unanticipated risk factors for this equity and from that view, TerraForm Power can be considered overvalued. Summary Of Our View: Enter through selling put contracts in the $17.50 to $20 range. Disclosure: I am/we are long FSLR, SUNE, JKS, TSL, CSIQ. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.