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.
Steve
Selengut
http://www.sancoservices.com
Professional Portfolio Management since 1979
Author of: "The Brainwashing of the American Investor:
The Book that Wall Street Does Not Want YOU to Read",
and "A Millionaire's Secret Investment Strategy"
