Our "savvy senior" IRA portfolio continued to focus on income and tried to forget about capital appreciation (or lack thereof) throughout the past two quarters. Patient followers of our "slow and steady wins the race" investment style know from past articles that I recommend trying to maximize current income and ignore short-term market fluctuations. In fact, I try to look upon market downdrafts as welcome opportunities to reinvest dividends at bargain prices and raise the overall yield on the portfolio.
This year so far has demonstrated the value of that approach, as the year started out strong in terms of capital gains but then petered out in the spring and has largely moved sideways since then, in terms of market appreciation.
Overall, my portfolio is up 11.03% for the first nine months, versus a rise of 10.06% for the first quarter of the year, and a rise of only 9.72% for the first six months. That means, in terms of total performance, that the portfolio:
- Rocketed up by over 10% (a 40% annual rate) in the first quarter,
- Dropped slightly in the second quarter, and
- Came back, but only modestly, in the third quarter to finish up by 11% for the first nine months
One might interpret this result as an endorsement of the old adage that portfolio managers should "sell in May and go away," but if I examine the components of my return - income and capital gain - I am glad I stayed around. That's because the composition of my return shifted each quarter to being less dependent on capital appreciation:
- First quarter: 10.1% overall return, 1.9% from income, 8.2% from capital appreciation
- Second quarter: 9.7% overall return, 4.3% from income, 5.4% from capital appreciation
- Third quarter: 11% overall, 6.7% from income, 4.3% from capital appreciation
My current yield is about 9%. This is up from about 8.5% three months ago, and about 8% earlier in the year. The higher yield reflects mostly my ability to reinvest dividends into the same types of high-income stocks that I have been buying all along, but at lower prices and higher yields because of the market sell-off. In that very real sense, the market drop has helped me, by raising my re-investment rate and increasing my future income above what it would have been if I'd been re-investing into a higher market.
This is why patient, long-term income investing always involves a bit of a struggle between wanting those "feel good" moments when the market is lifting the value of your portfolio, and the sober realization that your long-term income actually grows faster when the market is flat (or even down) because you get to compound your dividends at a higher reinvestment rate. This year, with market values being bounced all over the place by geopolitical, economic and domestic political events and uncertainty, a steady-eddie 9% dividend yield is very comforting.
A number of readers have asked for a list of my investments, so here is the entire portfolio as of October 10, showing the current yield of each investment, and the percentage weighting of each investment's contribution to my overall portfolio income stream, as well as the weighted average yield calculation:
A few comments:
- As readers know, I love closed end funds for long-term income-focused investors because the closed end fund market is, first of all, so inefficient, that you can often find real value, in terms of funds at a discount and at higher risk-adjusted yields than you can find in most other markets available to retail investors. In addition, it is the only market I know that allows retail investors to get the impact of leverage at "institutional" interest rates (i.e. the average closed end fund can borrow money to leverage itself at rates unheard of for most retail margin investors) and of course IRAs cannot leverage themselves anyway, so buying leveraged investments like closed end funds is a "back door way" to achieve leverage in your IRA.
- The Cohen & Steers Closed End Opportunity Fund (FOF) is my anchor in the closed end fund world. Sometimes derided as a bit stodgy and overly diversified, but I am happy to receive its 8%-plus dividend and get the benefit of its "discount on a discount" since it sells at a 12% discount, and in turn owns many other funds that it itself bought at a discount as well. Hence its ability to pay such a fat yield.
- Having said that about closed end funds, let me mention the one and only conventional mutual fund I own, the Third Avenue Focused Credit Fund (TFCIX) (which comes in two varieties, one institutional - $100,000 minimum but lower management fee, and the other with smaller minimum but higher management fee). This is one fairly high-fee mutual fund where the fee is worth paying. The Third Avenue team takes an adventurous but highly knowledgeable approach to picking their way through the credit junkyard, buying turnaround credits and workout opportunities at knocked-down prices that they believe will pay off at par. I look forward to continuing solid high single digit or low double-digit returns from this high-octane high yield fund.
- Utilities I'm big on, year in and year out. Nice dividends, plus some slow steady growth over time. Reaves Utility Income Fund (UTG), Duff & Phelps Global Utilities Income Fund (DPG), Cohen & Steers Infrastructure Fund (UTF) are all great long-term components of an income portfolio. I try to be opportunistic about re-balancing among them as their prices and discount/premium vary from time to time.
- I regard myself as a portfolio manager more than an analyst, and am happy to utilize the recommendations of fellow Seeking Alpha contributors as well as some investment newsletter editors that I lean on for ideas. Douglas Albo, of course, is superb here on Seeking Alpha, and you will see a number of his investment recommendations in the above list. Josh Peters, who edits the Morningstar Dividend service, is a source of good ideas. He follows a similar investment philosophy to mine, although he focuses on large corporate investments rather than closed end funds. And finally, Utility Forecaster has been excellent through the years in recommending utility, MLP and telecommunications stocks and funds (including UTG - thanks very much!), and I hope it continues its high quality work even though it is now under new editorial management.
- Finally, let me comment on one of my favorite, but also most challenging (in terms of analyzing and understanding it) investments, Oxford Lane Capital (OXLC). Oxford Lane is sort of a "fund of funds" in that it is a closed end fund that buys tranches (debt and equity) of collateralized loan obligations (CLOs). CLOs are leveraged vehicles that buy corporate loans that have been underwritten by banks. The typical loan is about 6-8 years in maturity, with a coupon that floats (i.e. is re-adjusted every three months) at a spread over LIBOR. Generally the coupon (LIBOR base plus spread) is 5 or 6 percent (although new loans have been trending lower) and the loans are secured by the assets of the borrower, so they suffer much lower credit loss than high yield bonds, which are unsecured, or even subordinated to other debt. What really adds the juice, in terms of return, to CLOs is that they buy up all these loans yielding 5 or 6 percent, and then they leverage themselves 8 or 10 times (the older ones even more), borrowing at perhaps 2 or 3 percent (for say, the top 70 or 80% of their liabilities) and then at increasingly higher interest rates for the more "junior" liabilities. The equity, which may be the bottom 10% or so of the structure, gets all the excess from the 5 or 6% yield on the assets in the structure after paying off the 2-3% or so average cost of the liabilities of the CLO structure. That 3% spread leveraged 8 or 10 times can provide a 20-30% return for the equity, which is what allows OXLC to pay its shareholders a 14% yield, even after generously paying its management.
That's the theory, and having worked in the loan world for many years and known people who ran and invested in CLOs, I know personally that the math works. There are also a lot of moving parts and changing assumptions (like different levels of credit losses and changes in LIBOR) that can cause the actual returns to vary from the "model" results. The variation can be both positive and negative, and the market for CLO tranches is highly inefficient. At the time OXLC was established, post crash in 2011, there were lots of CLO investors still in shock over the state of the credit markets generally, and willing to part with CLO tranches at what seemed then and appear in retrospect to be prices below their economic value. OXLC's managers, who have significant amounts of their own money invested in the fund, set up OXLC to take advantage of that opportunity.
So far they seem to be delivering, with a 14% dividend that appears to be money actually earned and received. One wrinkle that I haven't fully figured out the long-term impact of is that they pay out their dividend based on "taxable income" (in fact, as a "registered investment company" they are required to pay out most of it) which is a higher number than what is recognized as income under normal GAAP accounting. So while the amount of their dividend is fully earned and required to be paid out under SEC and tax laws, some of it is not actually earned under GAAP principles and therefore, under GAAP represents a return of capital. This means the company's stated NAV is slightly eroded every time they make a dividend payment, but from everything I can figure out, there is no actual erosion in their economic value or their ability to keep on paying dividends.
In fact, there doesn't seem to be a lot of logical connection between changes in their NAV, changes in their market value and the economic value of the assets that are pumping out the dividends. For example, at June 30, OXLC held 32 investments, 12 junior debt tranches and 20 equity tranches from various CLOs maturing between 2018 and 2030, but mostly clustered around 2021. Based on the Annual Report of March 31, 2013, along with the additional information from the June 30 report, we see that these various CLO tranches carry yields between 15% and 60% (yes, 60% - that's not a typo), because of the deep discounts some of them were bought at, and, once they begin generating cash (there is a lag of a few months before newly issued CLOs begin to make payments) throw off quarterly payments of between 4.5% and 10.6%. (Annualized that would be 18% to 42%.) And yet, some of their CLO tranche holdings that threw off the largest cash payments during the second quarter, actually dropped in "fair value" (management's estimate of what they'd sell for if there were an active market for them, which there isn't) during the quarter. Go figure. That's why I'm inclined to think that cash generation ability, rather than a somewhat theoretical NAV, is key in judging the value of OXLC as a long-term investment.
Having met management (I was the only shareholder at their recent annual meeting, which is not unusual for small closed end funds) and had some additional conversation since, I believe the guys running this seem highly professional, and I feel comfortable with the risk/reward of my own investment. The fact that the managers and also Charles Royce, the well-known founder and manager of the Royce Funds, have millions of their own cash invested, gives me additional comfort.
For anyone who wants a somewhat similar investment, with the same management group but a bit more analytical coverage and transparency, I would recommend looking at TICC Capital Corp. (TICC), which has a 12% yield and is a business development corporation that also buys CLOs. It too has heavy insider ownership by the same management group that runs OXLC (including Royce), but it is more widely followed, including by writers here on the Seeking Alpha site. Finally, if even TICC seems a bit risky, I recommend readers consider buying the Oxford Lane Capital Preferred (OXLCP and OXLCO). They both yield about 8%, and since they are senior obligations of the fund, are essentially secured by assets above them in about a 6 to 1 ratio. (They would get paid off in full before any equity owner gets a distribution.) Bulldog Investors' principal Philip Goldstein bought a big chunk of the preferred for his closed-end Special Opportunities Fund (SPE) last year because he could get at that time a virtually risk-free 8.5% yield. (Now it's down to about 8%, but still a good deal.) Read Goldstein's rationale in his annual report.
Thanks for reading, and as usual I look forward to a spirited dialogue with many of you.