When is 3 percent better than 6 percent? Yeah, we all know the answer,
but only until the prices of the securities we already own begin to
fall. Then, logic and mathematical acumen disappear and we become
susceptible to all kinds of special cures for the periodic onset of
higher interest rates. We’ll be told to sit in cash until rates stop
rising, or to sell the securities we own now, before they lose even
more of their precious Market Value. Other gurus will suggest the
purchase of shorter-term bonds or CDs (ugh) to stem the tide of the
perceived erosion in portfolio values. There are two important things
that your mother never told you about Income Investing: (1) Higher
Interest Rates are good for investors, even better than lower rates,
and (2) Selecting the right securities to take advantage of the
interest rate cycle is not particularly difficult.
Higher Interest Rates are the result of the Government’s efforts to
slow a growing economy in hopes of preventing an appearance of the
three headed inflation monster. A quick glance over your shoulder might
remind you of recent times when the government was trying to heal the
wounds of a misguided Wall Street attack on traditional investment
principles by lowering interest rates. The strategy worked, the economy
rebounded, and Wall Street is trying to scramble back to where it was
nearly six years ago. Think about the impact of changing interest rates
on your Income Securities during the past five years. Bonds and
Preferred Stocks; Government and Municipal Securities; they all moved
higher in Market Value. Sure you felt wealthier, but the increase in
your Annual Spendable Income got smaller and smaller. Your total income
could well have decreased during the period as higher interest rate
holdings were called away (at face value), and reinvestments were made
at lower yields!
How many of you have mental bruises from the realization that you could
have taken profits during the downward trajectory of the cycle, on the
very securities that you now lament over. The nerve; falling below the
price you paid for them years ago. But the income on these turncoats is
the same as it was in 2004, when their prices were ten or twenty
percent higher. This is the work of Mother Nature’s financial twin
sister. It’s like acorns, snowfalls, and crocuses. You need to dress
properly for seasonal changes and invest properly for cyclical changes.
Remember the days of Bearer Bonds? There was never a whisper about
Market Value erosion. Was it the IRS or Institutional Wall Street that
took them away?
Higher rates are good for investors, particularly when retirement is a
factor in your investment decisions. The more you receive for your
reinvestment dollars, the more likely it is that you won’t need a
second job to maintain your standard of living. I know of no retail
entity, from grocery store to cruise line that will accept the Market
Value of your portfolio as payment for goods or services. Income pays
the bills, more is always better than less, and only increased income
levels can protect you from inflation! So, you say, how does a person
take advantage of the cyclical nature of interest rates to garner the
best possible income on investment quality securities? You might also
ask why Wall Street makes such a fuss about the dismal bond market and
offers more of their patented Sell Low, Buy High advisories, but that
should be fairly obvious. An unhappy investor is Wall Streets best
customer.
Selecting the right securities to take advantage of the interest rate
cycle is not particularly difficult, but it does require a change in
focus from the statement bottom line… and the use of a few security
types that you may not be 100% comfortable with. I’m going to assume
that you are familiar with these investments, each of which could be
considered (from time to time) for a spot in the well diversified
Income Portion of your Asset Allocation: (1) The traditional individual
Municipal and Corporate Bonds, Treasuries, Government Agency
Securities, and Preferred Stocks. (2) The eyebrow raising Unit Trust
varietals, Closed End Funds, Royalty Trusts, and REITs. [Purposely
excluded: CDs and Money Funds, which are not investments by definition;
CMOs and Zeros, mutations developed by some sicko MBAs; and Open End
Mutual Funds, which just can’t work because they are really “managed by
the mob”… i.e., investors.] The market rules that apply to all of these
are fairly predictable, but the ability to create a safer, higher
yielding, and flexible portfolio varies considerably within the
security types. For example, most people who invest in Individual bonds
wind up with a laundry list of odd lot positions, with short durations
and low yields, designed for the benefit of that smiling guy in the big
corner office. There is a better way, but you have to focus on income
and be willing to trade occasionally.
The larger the portfolio, the more likely it is that you will be able
to buy round lots of a diversified group of bonds, preferred stocks,
etc. But regardless of size, individual securities of all kinds have
liquidity problems, higher risk levels than are necessary, and lower
yields spaced out over inconvenient time periods. Of the traditional
types listed above, only preferred stock holdings are easily added to
during upward interest rate movements, and cheap to take profits on
when rates fall. The downside on all of these is their callability, in
best-yield-first order. Wall Street loves these securities because they
command the highest possible trading costs… costs that need not be
disclosed to the consumer, particularly at issue. Unit Trusts are
traditional securities set to music, a tune that generally assures the
investor of a higher yield than is possible through personal portfolio
creation. There are several additional advantages: instant
diversification, quality, and monthly cash flow that may include
principal (better in rising rate markets, ya follow?), and insulation
from year-end swap scams. Unfortunately, the Unit Trusts are not
managed, so there are few capital gains distributions to smile about,
and once all of the securities are redeemed, the party is over. Trading
opportunities, the very heart and soul of successful Portfolio
Management, are practically non-existent.
What if you could own common stock in companies that manage the
traditional Income Securities and other recognized income producers
like real estate, energy production, mortgages, etc.? Closed End Funds
(CEFs), REITs, and Royalty Trusts demand your attention… and don’t let
the idea of “leverage” spook you. AAA + insured corporate bonds, and
Utility Preferred Stocks are “leverage”. The sacred 30-year Treasury
Bond is “leverage”. Most corporations, all governments (and most
private citizens) use leverage. Without leverage, most people would be
commuting to work on bicycles. Every CEF can be researched as part of
your selection process to determine how much leverage is involved, and
the benefits… you’re not going to be happy when you realize what you’ve
been talked out of! CEFs, and the other Investment Company securities
mentioned, are managed by professionals who are not taking their
direction form that mob (also mentioned earlier). They provide you the
opportunity to have a properly structured portfolio with a
significantly higher yield, even after the management fees that are
inside.
Certainly, a REIT or Royalty Trust is more risky than a CEF comprised
of Preferred Stocks or Corporate Bonds, but here you have a way to
participate in the widest variety of fixed and variable income
alternatives in a much more manageable form. When prices rise, profit
taking is routine in a liquid market; when prices fall, you can add to
your position, increasing your yield and reducing your cost basis at
the same time. Now don’t start to salivate about the prospect of
throwing all your money into Real Estate and/or Gas and Oil Pipelines.
Diversify properly as you would with any other investments, and make
sure that your living expenses (actual or projected) are taken care of
by the less risky CEFs in the portfolio. In bond CEFs, you can get
un-leveraged portfolios, state specific and/or insured Municipal
portfolios, etc. Monthly income (frequently augmented by capital gains
distributions) at a level that is most often significantly better than
your broker can obtain for you. I told you you’d be angry!
Another feature of Investment Company shares (and please stay away from
gimmicky, passively managed, or indexed types) is somewhat surprising
and difficult to explain. The price you pay for the shares frequently
represents a discount from the market value of the securities contained
in the managed portfolio. So instead of buying a diversified group of
illiquid individual securities at a premium, you are reaping the
benefit of a portfolio of (quite possibly the same) securities at a
discount. Additionally, and unlike regular Mutual Funds that can issue
as many shares as they like without your approval, CEFs will give you
the first shot at any additional shares they intend to distribute to
investors.
Stop, put down the phone. Move into these securities calmly, without
taking unnecessary losses on good quality holdings, and never buy a new
issue. I meant to say: absolutely never buy a new issue, for all of the
usual reasons. As with individual securities, there are reasons for
unusually high or low yields, like too much risk or poor management. No
matter how well managed a junk bond portfolio is, it’s still just junk.
So do a little research and spread your dollars around the many
management companies that are out there. If your advisor tells you that
all of this is risky, ill-advised foolishness… well, that’s Wall
Street, and the baby needs shoes.
The final article in this Income Investing trilogy will be on managing the Income Portfolio using the Working Capital Model.
