Income Perspective

More That Dad Forgot To Tell You About Income Investing

Why should a client invest for income? Read on…

by Steve Selengut

Part II in a two-art series on income investing. Read part I here.
Mr. Selengut is a private investor and a contributing editor to LIFE&Health Advisor. He is the author of the book ‘The Brainwashing of the American Investor: The book that Wall Street does not want you to read.’ He can be reached at [email protected]

As I said in Part I,One of the biggest mistakes investors make is to ignore the “income purpose” portion of their investment portfolios… many don’t even realize that there should be such a thing. The second biggest mistake is to examine the performance of income securities in the same manner as they do “growth purpose” securities (equities).Just the other day, I was discussing “retirement readiness” with a small group of individuals, several of whom were already retired. Not one of them owned, or had even heard of, either equity or income Closed End Funds (CEFs)… vehicles that I have been using in professionally managed portfolios for decades.

So, assuming you have read Part I, I continue the Q&A here.

7. Why does it seem like CEFs, Public REITs, and Master Limited Partnerships are being ignored by Wall Street, the Media, and most Investment Advisors?

All three are income producers, and once they are “out there” in the marketplace, they trade like stocks… on their own fundamental merits and at a price solely dependent on supply and demand. Unfortunately, income programs have just never attracted the kind of attention and speculative zeal that has been there for any breed of growth vehicle.

Income mutual funds and ETFs can create shares at will, holding market value equal to NAV (net asset value). But the sole purpose of each is to grow the market value and to produce a stock market comparable “total return” number… income is rarely mentioned in their product descriptions.

An income purpose security may stay in the same price neighborhood for years, just spitting out 6% to 10% in income to fund college educations, a retirement lifestyle, and world travel. But most investment advisors, ETF passivists, and mutual fund managers are rated on the annual “total return” that their portfolios or indices produce… income programs just don’t generate year end trips and six figure bonuses.

I was fired a few times myself, just before the dot.com bubble burst, because my 10% to 15% “returns” from high quality stocks and income producers just couldn’t compete with the speculative fever that propelled the NASDAQ to 5000…
But as the markets crumbled in 2000, the “no NASDAQ, no IPO, no mutual funds =’s no problem” operational credo produced significant growth and income.

Another issue is broker/advisor compensation in Wall Street firms… totally based on selling proprietary products and “investment committee” recommendations. There’s no room for slow growth based on high quality dividend paying equities and income purpose closed end funds.

Finally, government cost and market value performance myopia precludes any inclusion of CEFs in 401k and other employer sponsored investment programs. Vanguard’s VTINX retirement fund pays less than 2% after a minimal fee; hundreds of much better diversified CEFs pay 7% and better after 2% or more in fees. Yet the DOL, FINRA, and the SEC have somehow determined that 2% spending money is better than 7% in what they have incorrectly labeled “retirement income programs”

You will never see a CEF, even equity or balanced portfolio CEFs, in a 401k security selection menu. Public REITs and MLPs are not likely to be there either.

8. How many different types of CEFs exist; what do investors pay for them; and are there any penalties for trading them frequently?

CEFConnect.com lists 163 tax free funds, 306 taxables, 131 US equity, and 204 non-US and other.

A partial list of types and sectors includes: biotech, commodities, convertible bonds, covered call, emerging markets, energy, equity dividend, finance, general equity, government securities, health, high yield, limited duration bonds, MLP, mortgage bonds, multi sector income, diversified national municipals, preferred stock, real estate, senior loans, 16 different single state municipals, tax advantaged equities, and utilities.

CEFs are purchased in the same manner and at the same cost as individual stocks or ETFs, and there are no penalties, fees, or extra charges for selling them frequently… they trade for free in managed, fee-only, accounts, and always pay more income than their peer ETFs and mutual funds.

9. What about DRIPs (Dividend Reinvestment Programs)?

There are at least four reasons why I choose not to use DRIPs:

  • I don’t like the idea of adding to positions above the original cost basis.
  • I don’t like to make purchases when demand is artificially high.
  • I prefer to pool my monthly income and select re-investment opportunities that allow me to reduce position cost basis and increase yield at the same time.
  • Investors rarely add to portfolios in down markets; just when I need flexibility to add new positions

10. What are the most important things investor’s have to understand when it comes to income investing?

I was fired a few times myself, just before the dot.com bubble burst, because my 10% to 15% "returns" from high quality stocks and income producers just couldn't compete with the speculative fever that propelled the NASDAQ to 5000...

Actually, if an investor can wrap his mind around just three things, he can become a more successful.

  • Market value change has no impact on income paid, and rarely increases financial risk,
  • Income security prices vary inversely with interest rate change expectations (IRE)
  • Income purpose securities must be evaluated on the amount and dependability of the income they produce.

Let’s say that, thirty years ago, we purchased a 4.5% IBM bond, a 30 year 2.2% treasury note, and 400 shares of a 5.7% P & G preferred stock, all at par, and invested $10,000 in each. The $1,240 annual income has just been accumulating in cash.

In this time frame, interest rates have ranged between a high above 12% and recent lows around 2%. They have made no less than fifteen significant directional changes. The market value of our three “fixed income” securities has been above and below “cost basis” dozens of times, while the portfolio “working capital” (cost basis of portfolio holdings) was growing every quarter.

And every time the prices of these securities moved lower, their “current yield” increased while the same dividend and interest payments were being paid.

So why does Wall Street make such a fuss when prices fall? Why indeed.

Over the years, we’ve accumulated $37,200 in dividends and interest; the bond and treasury note matured at $10k each, and the preferred stock is still paying $142.50 per quarter.

So our cash account is now $57,200 and our working capital has risen to $67,200 while we haven’t lifted a finger or spent a moment concerned about fluctuating market values. This is the essence of income investing, and precisely why it makes no sense to look at it in the same way as equity investing.

Investors need to be re-programmed to focus on the income production of income purpose investments, and to realize reasonable profits when they are produced by growth purpose securities.

  • What if we reinvested the income every quarter in similar securities? Or sold the securities when they went up 5% or so… and reinvested the proceeds in portfolios of similar securities (CEFs), rather than individual entities, for diversification and higher yield?
  • Assuming just $500 profit per year and a 5% average interest rate, the portfolio “working capital” would grow to $168,700… a gain of roughly 462%. Income would be $8,434… a gain of 680%

I’m hoping that these conservative income numbers get you a little more excited about having a serious income purpose allocation in your “eventually a retirement income portfolio”… particularly income CEFs. Don’t let your advisor talk you out of it; stock market investments are not designed to get the income job done… dependably, over the course of our retirement lifetime.

  • CEFs allows anyone to invest in diversified portfolios of fixed income securities, and by design, always at higher than individual security rates.
  • CEFs provide a uniquely liquid entity that allows investors to benefit from IRE caused price changes in either direction. Yes, that’s what I meant to say.

11. Why take profits if the income from a security hasn’t changed?

Compound interest is the “holy grail” of income investing. A 5% profit realized and reinvested today will work a whole lot harder than 5% received over the course of the next several months. Also, when interest rates are rising, profit opportunities are scarce, and proceeds can be put to work more productively than in falling or stable interest rate environments.

So let’s say we have a “limited duration” bond CEF yielding 6%. We’ve held it for 8 months so we’ve already received 4.5% and we can sell it today at a 4% profit. Thus, we can realize a nifty 8.5% (actually a bit more since we’ve reinvested the previous earnings), in just eight months.

Then, we can shop around with the proceeds for a new CEF yielding 6% or higher and hope to do a similar trade sometime soon with another of our holdings.

A second re-investment strategy is to add to several positions that are priced below current cost basis and yielding more than the CEF we just sold. This is a great way to improve the “current yield” of existing positions while, at the same time, assuring that you’ll have more abundant profit taking opportunities when interest rates cycle downward.

12. How does one keep “working capital” rising

Total working capital, and the income it produces, will continue to grow so long as the income exceeds all withdrawals from the portfolio. Note that capital losses have no impact on income if the proceeds can be reinvested at a higher “current” yield… but working capital does take a temporary hit.

Portfolios are kept on their asset allocation “track” with every batch of monthly re-investment decisions, but the larger the income purpose “bucket”, the easier it is to assure steady growth in both income and working capital.

13. What is Retirement Income Readiness?

It is the ability to make this statement, unequivocally:
Neither a stock market correction nor rising interest rates will have a negative impact on my retirement income. In fact, it is more likely that either scenario will allow me to grow both my income and my working capital even faster.