First the good news: our "savvy senior" IRA portfolio had a good first quarter, with a 10% overall return, of which 1.87% was cash dividend income. Annualized, that's a yield of about 7.5%. Readers of my "savvy senior" IRA articles know that my goal is to generate a continually growing stream of steady income - a 7% or 8% overall yield on principal - and that I regard capital appreciation on top of that as essentially icing on the cake. So this quarter the cake had a lot of icing.
While capital appreciation makes us all feel good, it also represents a challenge to investors like me who want to re-invest their dividends because it means higher prices, lower current yields and, therefore, less attractive re-investment opportunities than we had six months or a year ago. In this higher price, lower yield environment, the key is to harvest those investments that have risen about as far as we can reasonably expect and re-invest in asset classes that have not risen as far, or which may still represent relatively good value in terms of dividend growth potential, discount to net asset value or some other reasonable measurement.
My expectations at this point are relatively modest. Having earned over 16% in 2012 (article here) and now 10% more in the first quarter of 2013 (i.e. a 28% increase from 15 months ago), I will be delighted to just keep most of what I've made and continue to earn a 7% overall return for the rest of the year. That may be impossible, as some sort of eventual market downdraft after the run-up we've had is almost a certainty.
My overall strategy remains the same. It is to be invested in a broadly diversified portfolio that will provide a continuing and growing stream of income through all seasons, regardless of how the market values the assets in the portfolio. Focusing our attention on growing that income stream, rather than on the market value of our portfolio, is what keeps us sane and avoids our making dumb mistakes, like panicking and selling out at low points.
Readers may recall that I try to identify a mix of "fixed income" investments (high current yields of 7-8% or more, but no prospect for growth) and "growth income" investments (current yields as low as 4-5%, but with growth prospects bringing the overall potential return up to the high single digits or more). This involves rotating out of investments whose prices have risen so much that they offer less relative value than other existing holdings or investments on my target list that offer better relative value.
Recently, as I mentioned in my annual review article, cited above, I sold virtually all my high-yield bond funds, as yields have fallen over the past year or two from the 7-9% range to the 5-6% range, as a result of price appreciation. I figure if I'm only going to get a 5-6% yield and no chance of growth on a "fixed income" investment, then I might as well get almost the same yield and have some likelihood of growth by switching into a "growth income" investment. So having sold my high-yield bond funds (both open end and closed end) at the end of last year, I have continued re-investing in high dividend stocks with some likelihood of growth, as well as closed-end funds that buy such stocks. Recent examples:
- Black Rock Utility & Infrastructure (BUI) - closed-end fund; 7.44% distribution, still at a 6% discount
- Pembina Pipeline (PBA) - Canadian pipeline company; 5% yield
- Eaton Vance Tax Managed Global Diversified Equity Income Fund (EXG) - 10.4% distribution at a 10.8% discount
- Cohen & Steers Closed End Opportunity Fund (FOF) - closed-end "fund of funds" that gives you "compounded discounting" in that it sells at an 8% discount itself, and it buys many of its own closed end fund investments at a discount as well; pays a 7.7% distribution; in this case I like having professionals who follow the tricky closed end fund market for a living investing my money for me
- Duff & Phelps Global Utility Income Fund (DPG) - 7.25% distribution and a 5.65% discount
- Cohen & Steers Infrastructure Fund (UTF) - 7% distribution and a 6% discount (I've made a lot of money on this fund, but it still offers good value)
- Reeves Utility Income Fund (UTG) - another great fund that I've done very well in; a bit pricier than UTF and DPG, with a 5.9% distribution rate and 3.7% discount;
- All three - UTG, UTF and DPG - are great long term vehicles for buying utilities and getting a bit more yield than buying the stocks directly because of the cheap leverage that closed-end funds can employ (See article here to understand why).
In the past when I said I was selling high-yield bonds and replacing them with dividend-paying equities some readers asked: "Do you really think high-yield bonds and equities are equally safe?" The answer is yes; the dividend cash flow from a diversified pool of high quality investment-grade utility equities is definitely as safe and predictable as the coupon from the high yield bonds of non-investment grade companies. In fact, many portfolio managers I know regard high yield bonds as having more in common with their equity investments than with their traditional bond portfolios.
An exception to my "sell high-yield bonds" policy is the Third Avenue Focused Credit Fund (TFCIX), which I have owned quite successfully for several years and just bought more of recently. While listed as a high-yield bond fund, TFCIX is rather unique. It actually is more of a distressed debt fund, seeking out special situations, potential turnarounds, and deep value plays, where the potential return is capital appreciation when the loan or bond eventually pays off at or close to par. It was up over 15% last year, 10% per year for the past three years, and 7.9% so far this year, even as other more conventional high-yield bond funds have slowed down. Given founder Marty Whitman and Third Avenue management's record over the years as deep value investors, I have a good feeling about this fund, which I have owned since it was founded in 2009 to do bargain-hunting in the aftermath of the financial crash.
The other recent addition to my portfolio, which I see as a potentially high-yielding performer somewhat immune to market downdrafts (and yielding so high that if it does drop I'll just use that as an opportunity to buy more) is Oxford Lane Capital Corporation (OXLC). Oxford Lane gets grouped with the closed end floating rate bank loan funds, which I have worked closely with and owned for many years, and have written about and recommended as an asset class extensively. Fortunately - or unfortunately - depending on your point of view, the market has discovered closed end floating rate loan funds (mainly as an alternative to fixed rate bonds at a time when interest rates are more likely to rise than drop further) and bid them up so most sell at premiums and offer lower yields than they did a year or two ago. Many of us have made good money on funds like Nuveen Credit Strategies Income Fund (JQC), Eaton Vance Senior Income Trust (EVF), and Black Rock Floating Rate Strategy (FRA), which all are still good holdings but unfortunately have risen so far they now sell at premiums.
But Oxford Lane is different. It does not buy loans directly, the way other bank loan funds do. It buys equity and debt of collateralized loan obligations, also called "CLOs." If "CLO" sounds familiar, it is because "CDOs," or collateralized DEBT obligations, were the vehicles that bought up all the sub-prime mortgages and home equity loans that crashed and burned, precipitating the great financial crash of 2008. There are many types of "collateralized" or "securitized" (they mean the same thing) vehicles out there that buy up different types of debt securities (corporate loans, mortgage loans, student loans, auto loans, credit card loans, etc.) The thing they all have in common is that they buy hundreds or thousands of individual loans and then turn around and sell various classes of debt that have different rankings with respect to their repayment priority. For example, a 100 million dollar pool of loans might sell 70 million of "tranche A" debt that had first claim on the assets for repayment. That 70 million dollar tranche would most likely be rated "triple-A" because the 100 million dollars of assets would have to shrink in value by over 30% before the holders of that debt would lose a single penny. Each debt tranche down would be junior in payment to the debt tranches above it, until you reached the equity - perhaps 8% or so - at the bottom which would absorb all the losses before any of the debt above it lost anything. Besides absorbing all the losses, the equity also gets all the residual coupon income from the assets, once the various debt tranches above it are paid off. And that residual coupon income can be a lot of money.
All this may sound complicated, but it is worth trying to understand because it explains why an Oxford Lane Capital Corporation (the only investment of its kind available to retail investors that I am aware of) can 1) pay a 13.9% current yield to its investors, and 2) let them still sleep soundly knowing that it is far more secure and predictable than most other yields in the high single digits or teens.
Most securitizations have worked fine and repaid their investors. The sub-prime mortgage CDOs of the past decade that failed were the exception to the rule in the world of securitizations, but they dragged a lot of other securitized instruments with similar acronyms ("CLO" sounds a lot like "CDO") down with them. So at the height of the financial crisis most collateralized loan obligations (CLOs) sold off along with CDOs, even though they were a totally different asset class, with much simpler and more transparent structures, and comprised of secured corporate loans most of which never missed a beat. Investors who held their CLOs through the crash or bought in at the bottom did very well with annual returns in the high teens and 20% range and above. Since the crash, the CLO market has come back and new ones are being created through the securitization of new corporate loans. Oxford Lane holds some of each: older CLOs that it bought when the market was down, and newer ones created more recently.
In a recent announcement (2/27/2013), Oxford Lane said that the cash payments from its portfolio for the 4th quarter of 2012 were 4.6% of the fund's total portfolio at fair value. Since you can buy it at a 9% discount, that represents cash flow of 5% per quarter as a percent of market value. Annualized, that's cash flow of 20% a year, which explains why Oxford Lane has plenty of cash flow to pay healthy fees to its management (it takes a large professional staff to analyze and manage complex instruments like CLOs, compared to normal stocks and bonds) and still be able to pay out a distribution to shareholders of almost 14%, all of it income and none of it return of capital (an important point to many closed-end fund investors.) Anyone interested in the fund may wish to check out its website. I plan to do an article examining Oxford Lane in more detail shortly, explaining the math of CLOs and how the equity ends up earning such high returns. For corporate finance types out there, it's all about recognizing that you can earn an "equity" return by investing higher up the balance sheet, in the secured senior debt of the same cohort of companies, and then leveraging that investment. CLOs are a diversified vehicle for leveraging that investment in the senior debt so as to create a very attractive and reasonably predictable cash-flow return that is arguably less volatile than the return from the equity in the same companies would be. In doing so you are trading away equity market risk and replacing it with credit risk, which most bankers and credit people feel more capable of analyzing and predicting. (By the way, while I recommend Oxford Lane for sophisticated investors, and hold it myself, it is still an aggressive investment that should only represent a small part of one's diversified portfolio.)
Additional disclosure: I am also long Third Avenue Focused Credit Fund (TFCIX).