If the current rally continues…what’s your action plan?
by Steve SelengutMr. Selengut is a private investor and a contributing editor to Advisor Magazine. 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]
What if you could trade bonds more safely, more effectively, and less expensively than Wall Street’s “masters of the universe”? You can. There are three main reasons mere mortals invest in fixed income securities (government and corporate bonds, notes, loans, and preferred stock) and in variable income vehicles like mortgages, royalty trusts, real estate, etc:
- Corporate debt securities are inherently much safer than same company common stock… a 50% income asset allocation is much safer and theoretically less volatile than a 100% equity exposure… government securities are even safer.
- They provide significantly more income than their equity cousins, and the income is significantly more secure than common stock dividends.
- They are capable of doing their job (income production) regardless of what is going on in either the stock or bond markets.
In addition to having less financial risk, falling market values in high quality paper have no impact on the income paid to investors.
There are four significant problems with direct investment in “individual” income purpose securities, fixed income or variable:
- The securities are generally illiquid, difficult to price, and impossible to sell without serious costs
- They may be expensive to buy, own, maintain, and to market
- They may require a depth of knowledge or expertise that the average investor doesn’t possess
- It may be hard to develop a dependable stream of fixed monthly income
Masters Of The Universe
Unlike Tom Wolfe’s “Masters of the Universe”, most of us are not bond traders, real estate moguls, commodity dealers, or shopping center operators. We need a simplified, practical, income productive, liquid as the stock market, way to be invested in income purpose securities and enterprises… just like any self respecting MOTU.
Surprisingly, individual investors/traders have a distinct advantage over Wall Street operatives. Fixed income traders don’t care about income production… buying and selling inventory is their business model, and they must trade at market prices. If our income inventory shrinks in market value, we don’t have to sell our positions…. they do.
If only we had a way to take advantage of the bargain prices that accompany down markets… we do.
And that should be a “eureka” moment for any of you who are still holding individual bonds, preferreds, rental properties, or private REITs… simplified, practical, income productive, and liquid income purpose securities are readily available, and have been for decades. The very first Closed End Fund (CEF) was developed in 1893, some 30 years before the first Mutual Fund…several have been in operation for more than 90 years. CEFs are the perfect tools for direct and liquid investing in illiquid, income purpose, securities.
You’ll recall the “bond crisis” media reports late last year, before the “Fed” decided to stop raising interest rates “for the foreseeable future”. How many of us went out and bought bonds, shopping centers, oil pipelines, preferred stocks, or private mortgages? Closed End Fund (CEF) Investors have been taking profits for months on the ones they purchased during the 2018 bond crisis.
CEFs are professionally managed portfolios that can contain hundreds of individual securities, either growth (equities) or income purpose. Income CEFs may contain various types of income producers, or they can specialize in specific sectors. There are hundreds of “experienced portfolios” to select from and they are traded routinely on the New York Stock Exchange, just like common stocks. There are even CEFs that contain public REITs, Master Limited Partnerships… and other CEFs:
- They provide (and improve upon) all of the safety and income benefits described above.
- They eliminate all of the inconvenience with owning individual fixed income securities, while providing both professional management and instant diversification.
- They are slightly more “interest rate sensitive” than the securities inside, thus becoming the only mechanism out there that allows us to buy whole portfolios of securities at a discount to NAV.
- In combination, equity and income CEFs provide a direct path to achieving “retirement income readiness”.
Dealing With IRE Sensitivity
When dealing with all varietals of income purpose securities, investors have to learn to deal with “Interest Rate Expectation (IRE) Sensitivity”, or the fact that their market values vary inversely with interest rate expectations…. the 2008 financial crisis being the only exception.
Since the Federal Reserve’s January “no more rate hikes” announcement, income CEF market values have risen to near 52-week highs… while continuing to generate an average current income above 8%. This income, and the realized capital gains that the rally has generated, can be used to compound future income growth in two ways:
- Additional shares of owned CEFs can be purchased to reduce cost basis and increase yield at the same time.
- New CEFs yielding higher than the current portfolio average may be purchased (in smaller than normal quantities) facilitating future additions at lower prices when IRE changes.
The Net Asset Value (NAV) of CEFs is the sum of the values of perhaps hundreds of securities, but unlike open end Mutual Funds and ETFs, no effort (manipulation of shares outstanding) is made to make the market value equal to the NAV. It’s helpful to think of each individual CEF as a marketable “protective dome”, where only the investment manager can trade what’s inside.
The prices of the individual securities within the domes will vary with interest rate, economic, and market cycles while CEF investors trade the domes themselves. It’s nearly always possible to reduce existing position cost basis while increasing yield, to take advantage of discounts from NAV, and to take reasonable profits before they disappear with the next cyclical change.
Nothing Changed… Except The Price
This was precisely what was going on during the last few months of 2018. Individual income security prices (inside the domes) were being forced down by the expectation of rising interest rates and significant discounts were available. Absolutely nothing had changed with respect to the quality of the securities or the income being produced.
As the price of the domes moved lower, current yields were rising. No change in the securities, their quality, or contractual payments… only the price of the package had changed. There they were, just waiting for you to pad your retirement portfolios with income above 8.5%.
This is the genius of income CEFs. Only here are portfolios of discounted debt, preferreds, convertibles, mortgages, and the like nearly always available for fractions of the cost of the individual, non-diversified paper. These sweet discounts, and the ability to trade the “domes” on the New York Stock Exchange (without broker mark ups), are only available through
Closed End Funds
Only here can mere mortals turn Wall Street’s higher interest rates phobia into an income portfolio worth bragging about. Not even during the Financial Crisis, did properly diversified CEF investors feel any “income reduction” pain, even as discounts to NAV grew to their broadest levels ever.
So don’t be concerned the next time you see the “OMG, bond prices are falling” headlines… that’s Wall Street’s problem. CEF yard sales don’t occur that frequently… embrace the volatility and fill up those shopping carts.
And if the current rally continues… what’s your action plan? ◊