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Portfolio strategy, dividend investing, REITs, value
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Despite the recent interest rate uptick, times continue to be tough for investors seeking a safe and reliable income stream. With insured CDs only earning between 1 percent and 2 percent a year, and the best money markets earning even less, risk-free yield remains elusive. While investing in equity-income and bonds in today's low rate environment certainly puts more capital in peril than would be ideal for defensive investors, it has become a necessity.

Risk Mitigation

For those nearing or in retirement, this is not a time to be taking undue risk. While risk can take many forms and is a difficult variable for investors to control, over concentration is one type of risk we can avoid. My thesis here is that income investors should hold as many positions as possible, so long as one is able to track each investment and is not engaging in "diversification for diversification's sake." What I mean is that one should not abandon sound investment thought just to add something else to the portfolio. Each position should have rationale behind it - if you don't have a good idea, hold cash until you do.

Diversification is often criticized by growth investors since, if overdone, it can hold back investment returns. However, I believe "more is more" for an income investor simply because capital appreciation has become a secondary or perhaps only negligible consideration in later years. Capital preservation and maintenance/growth of income typically become penultimate in one's later years and I believe ultra-diversification benefits both of these defensive strategies.

Asset Allocation

When constructing the backbone of an income portfolio, it is important to understand your personal variables. How much do you have? How much do/will you need? Do you have current or future sources of defined income (e.g. Social Security, work pensions)? Defining your own personality and situation begets how you will craft your portfolio. If you have $500K and want $50K of investment-related income - your choices will be limited and you will need to take substantial risk. If you have double the assets and need the same $50K, you can invest much differently.

The following will act as an updated blueprint to allocation recommendations I made about a year ago. I believe this model presents a diversified, sound approach to achieving roughly 5% yield in today's market with moderate ability to grow income and achieve capital growth. The number in parentheses is the recommended allocation and the second percentage spread is the average yield one can expect to obtain from group constituents.

  • Dividend and/or Dividend Growth Stocks (40-50%) 2-5%
  • BDCs/MLPs & other high dividend equity (10-20%) 5-10%
  • REITs (5-15%) 3-7%
  • Individual Investment Grade Bonds (10-20%) 2-6%
  • Higher Yielding Bonds (10-20%) 6-10%
  • mREITs (0-5%) 10+%
  • Cash (????) 0-2%

Security Selection

Given the relatively high allocation to dividend equity that I have placed in the model, this is the area we want to put the most due diligence into. I would suggest companies that possess one or more of the following attributes to protect and enhance the potential of the overall portfolio income stream.

  • Low dividend payout ratios relative to earnings and cash flow
  • High percentage of cash relative to current market cap
  • Low debt to equity
  • A stated intent to return cash to shareholders
  • A well documented history of dividend payments and increases

And though an income investor might be inclined to place less emphasis on equity valuation because growth of capital is a lesser goal, I would urge against such complacency. As REIT and mREIT investors found out this year, ignorance of operating multiples and book valuations can lead to quick capital destruction and lost dividend opportunity. As I've suggested in previous writings, selling or trimming equities with high valuation and low dividend yields and reallocating into equities with higher yields and lower valuations may be a viable cash flow building strategy over the long term.

Over to bonds - this asset continues to be shunned in the low rate environment. Despite the relative unattractiveness of the sector, I feel bonds still provide stability and value when thoughtfully purchased. Investors, in my opinion, are best served buying individual investment grade paper on their own and buying high-yield bonds by way of an ETF or CEF. Given the dramatic discounts one can find currently in CEFs, I think this is a space to be focused on. However, given the obvious risks a rising rate environment will have on the group, maturities should be kept short. And while default rates continue to remain low, high-yield players should monitor the credit situation carefully.

My opinion on REITs and mREITs has been well documented in other articles, so I won't ramble on here. Needless to say, their interest rate sensitivity and recent propensity to trade on "Fedspeak" has created whipsaw action over the past year. Still, used judiciously, I think they have a place as part of a well diversified income portfolio - less so mREITs, as I consider them more of a gamble. Now is probably as good a time as any to take a look at them, but I would be very particular in what I purchased. I expect dividend growth to be minimal in most equity REITs and perpetually erratic in mREIT land.

Recommendations

While this article seeks to guide and not direct one toward an appropriate income strategy, here are some of my current top income ideas from each of the above categories:

  • Dividend stocks: Microsoft (NASDAQ:MSFT), Conoco (NYSE:COP), and Aflac (NYSE:AFL)
  • High-yield equity: Prospect Capital (NASDAQ:PSEC), Calumet Products (NASDAQ:CLMT), Eaton Vance TM BW (NYSE:ETV)
  • REITs: American Capital (NASDAQ:ARCP) and NorthStar Realty (NYSE:NRF)
  • Investment Grade Bonds: Keep Maturity 7-10 years or less
  • High Yield Bonds: AB HY Global (NYSE:AWF) and Western Asset Emerging Markets Debt (NYSE:ESD) and High Yield Opp (NYSE:HYI)
  • mREITs: No holdings - recommend REM as a diversified play
  • Cash: Around 10%

Conclusion

Though the above might not be considered a magic bullet in one's quest for the perfect income portfolio, I think it provides a diversified baseline for one to contemplate their own income needs in today's market. I look forward to your comments.

Disclosure: I am long AFL, ARCP, AWF, CLMT, COP, ESD, ETV, HYI, MSFT, NRF, PSEC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.

Source: Bulletproof Your Income Stream