Review Of 2013: Why My 9% Yield Excites Me More Than My 18% Total Return

by: Steven Bavaria

Last year was a good year for what I began referring to a while ago as my "Savvy Senior" IRA portfolio. (Curious about the name? Read this).

Total return for 2013 (capital appreciation plus dividends) was 17.8%, which I am quite happy with, especially given that my moderate-risk portfolio yielded just over 9% in cash dividends and distributions.

Readers of past articles know that my primary investment goal is to grow my cash income over time, and that I regard growth in the market value of the portfolio as more of a "nice to have" than an essential. Each year that goes by, as I watch my income stream grow and get compounded on a tax-deferred basis, the more convinced I am that this investment philosophy makes sense, especially for people saving for retirement or early enough into their retirement (like me) that they still have a 15 to 20 year (or more) investment horizon.

I think of my investment portfolio as essentially a "factory." Unlike a conventional factory, this one doesn't produce physical goods, but rather produces an income stream. When I get cash income in the form of dividends and/or distributions, I re-invest these in additional income producing securities. I think of this compounding as essentially increasing the size of the factory each year. So if I earn 9% and re-invest it, then my factory will be 9% bigger than a year ago and will produce 9% more income next year than this year (assuming a similar re-investment rate). The following year it will produce 9% more than that, and so on. Obviously that is just the basic concept of compound interest at work. (By contrast, if my investment return were all or mostly capital appreciation, then at the end of the year, I'd have virtually the same-size factory producing income as a year earlier, but the factory would be valued at a higher price. That would only help me if I wanted to sell the factory, but it wouldn't help me if my goal was producing more each year.)

As long as my factory is growing each year and producing more income, I don't really care too much how the market values the factory. In fact, focusing too much on how the factory is valued can be counter-productive if it takes my attention away from the main focus: maximizing the factory's product stream - i.e. the income it produces. Paradoxically, I am often happy when the market sells down in value, because then I can re-invest my cash dividends at a lower price (i.e. higher yield). In other words, when the market swoons, I can expand my cash-producing factory more cheaply.

To execute this strategy, I have been turning more and more to the closed end fund market in recent years. Closed end funds are a quirky, idiosyncratic market that has a lot of advantages for long-term income-oriented investors, including the opportunity to buy in at a discount, enjoy leverage at institutional rates otherwise unobtainable by most retail investors, and generally find unique income opportunities unavailable elsewhere.

In the spread sheet down below is my current portfolio as of February 12, 2014. Readers will see a few changes from the list from last October.

I eliminated 6 positions that together had represented about 14% of my income stream:

Positions Eliminated
Name Symbol Current Yield % Share of Current Portfolio Income
IRR Risk Managed Natural Resources Fund IRR 10.4% 4.50%
LMP Capital & Income Fund SCD 7.7% 3.44%
Blackrock Global Opportunities Fund BOE 8.9% 2.72%
Royal Dutch Shell (B Shares) RDS/B 5.4% 2.41%
Nuveen Credit Strategies Income Fund JQC 8.7% 0.77%
Allianz Equity & Convertible Income Fund NIE 6.2% 0.11%

I added ten positions that represent about 24% of my income stream:

Positions Added
Name Symbol Current Yield % Share of Current Portfolio Income
Pimco Dynamic Credit Income Fund PCI 8.34% 8.16%
TICC TICC 11.34% 3.80%
Credit Suisse HighYield Bond Fund DHY 9.03% 3.27%
Nuveen Preferred Income Oppty Fund JPC 8.34% 2.66%
John Hancock Preferred Income Fund HPI 8.93% 2.42%
Cohen & Steers MLP Income and Energy Opportunity Fund MIE 7.05% 1.37%
Helios Multi-Sector Income Fund HMH 8.49% 0.92%
ING Global Advantage Fund IGA 9.60% 0.76%
Neuberger Berman MLP Fund NML 6.84% 0.66%
Nuveen Real Asset Income & Growth JRI 9.13% 0.23%

The 10% difference between what I eliminated and what I added came from reducing (although not eliminating) several other positions, the principal ones being Cohen & Steers Closed End Opportunity Fund (NYSE:FOF) and Reaves Utility Income Fund (NYSEMKT:UTG). Several readers commenting on my last article suggested that FOF is sort of a boring old fund that is too much of a CEF "index fund" to be really interesting. I took their point and reduced the position, replacing it with some more interesting investments (see below.) On the other hand, I still hold a good bit of it and enjoy the good yield (over 8%) and the ability to get "discounts on discounts" by buying a CEF that holds other CEFs. UTG is a great fund, but I had done very well with it and exchanged part of my holding near a high point for other funds that yielded more.

Some of the changes may just represent random tweaking - replacing some funds that may have risen to premiums with other funds also on my "approved list" that may have been at discounts - to take advantage of the pricing idiosyncrasies of the CEF market. Other changes represent a more strategic view. The shift into higher yielding credit investments - Pimco Dynamic Credit Income Fund (NYSE:PCI), TICC (NASDAQ:TICC) (a hybrid business development company and CLO investor) and Credit Suisse High Yield Bond Fund (NYSEMKT:DHY) - represented my feeling toward the end of last year, as the stock market went higher and higher, that replacing some equity risk with credit risk (especially if I was being paid in the 8-11% range) was not a bad trade.

Reviewing the entire portfolio (below) reveals my roots as a credit person long before I became an "investor." For the right price (i.e. yield) I will often prefer a credit instrument to an equity one. If my goal is to have a steady predictable cash return in the high single digits, compounding away in my tax deferred IRA, then I think credit markets can be as dependable and predictable for delivering that as the equity markets. That's why my three biggest holdings are credit related:

  • Third Avenue Focused Credit Fund (MUTF:TFCIX), a deep value credit fund that seeks equity-type returns by buying debt instruments that are perceived and priced by the market to be in worse trouble than Third Avenue's analysts conclude they really are. It's earned 9.5% over three years, 15.75% for the past year and gets 5 stars from Morningstar. It's the only open-end mutual fund I own, and it's a gem.
  • Oxford Lane Capital Corp. (NASDAQ:OXLC), the only pure retail play on CLOs (collateralized loan obligations) and one of the "safer" 13% yields around (it's all relative); not for the faint-hearted or widows and orphans, but management has a convincing story and a good record so far. (See past articles on OXLC by clicking on OXLC link at top of article.)
  • Pimco Dynamic Credit Income Fund, which I just added. A Pimco fund at a 7.5% discount, paying over 8%; plus Bill Gross owns a big chunk of it.

Some more thoughts about credit versus equity risk. Sometimes investors forget that all equity investments include credit risk, although the reverse is obviously not true. If you buy the equity you take the same risk as all the creditors that the company may go bust. But then in addition, equity owners take the risk that even if the company does stay solvent and pays off its creditors, there may still be little profit or profit growth for the equity holders. So as an equity holder you should get paid considerably more than a creditor for the extra risk you take. Numerous studies have shown that long-term equity returns have averaged in the 10-11% range (dividends plus capital appreciation.) That's not much of a premium over the 8-9% available in high yield bond funds like PCI, TFCIX or Credit Suisse High Yield Bond, and is less than the equity-like returns of fixed income plays TICC and OXLC.

"Savvy Senior" IRA Portfolio - 2/12/2014
Name Symbol Current Yield % Share of Current Portfolio Income
Third Avenue Focused Credit Fund TFCIX 7.90% 10.15%
Oxford Lane Capital Corp. OXLC 13.45% 10.12%
Pimco Dynamic Credit Income Fund PCI 8.34% 8.16%
Cohen & Steers Closed End Opportunity Fund FOF 8.15% 7.73%
Eaton Vance Tax Managed Global Div. Income Fund EXG 9.75% 5.66%
Cohen & Steers Infrastructure Fund UTF 6.86% 5.59%
Eaton Vance Tax Managed Global Buy Write Fund ETW 9.81% 5.28%
Duff & Phelps Global Utilities Income Fund DPG 7.41% 4.40%
Eaton Vance Risk Managed Div. Equity Income Fund ETJ 9.76% 3.97%
TICC TICC 11.34% 3.80%
Eaton Vance Enhanced Equity Income Fund EOI 7.94% 3.47%
Nuveen Equity Premium Advantage Fund JLA 8.86% 3.35%
Credit Suisse HighYield Bond Fund DHY 9.03% 3.27%
Allianz NFJ Dividend Interest & PremiumStrategy Fund NFJ 9.97% 3.20%
Nuveen Preferred Income Oppty Fund JPC 8.34% 2.66%
Eaton Vance Tax Managed Buy Write Fund ETV 9.42% 2.43%
John Hancock Preferred Income Fund HPI 8.93% 2.42%
Calamos Global Dynamic Income Fund CHW 8.35% 2.38%
Reaves Utility Income Fund UTG 6.15% 1.77%
First Trust Specialty Financial Opportunities Fund FGB 8.54% 1.64%
Wells Fargo Advantage Income Oppty Fund EAD 8.70% 1.60%
Cohen & Steers MLP Income and Energy Opportunity Fund MIE 7.05% 1.37%
Enbridge Energy Management LLC EEQ 7.76% 1.23%
Seadrill SDRL 9.75% 1.21%
Helios Multi-Sector Income Fund HMH 8.49% 0.92%
ING Global Advantage Fund IGA 9.60% 0.76%
Neuberger Berman MLP Fund NML 6.84% 0.66%
Kinder Morgan KMR 7.08% 0.57%
Nuveen Real Asset Income & Growth JRI 9.13% 0.23%
Weighted Average Portfolio Yield 9.08%

One final thought: Besides my fixed income concentration, I have a number of other equity-oriented funds, some of which are leveraged and some of which are more defensive non-leveraged funds (like some the Eaton Vance and Nuveen funds) that sell options to enhance their dividend income. In the current economic environment, I am content to have some of both. I don't think the Fed will be raising interest rates very fast, so the leverage doesn't bother me. I also don't see the economy (or the stock market) taking off like a rocket from here either, so I'm happy to have an attractive albeit somewhat capped return that the buy/write types of equity funds offer.

Finally, thanks to so many other Seeking Alpha contributors whose investment ideas are reflected in my portfolio. Keep up the good work.

Disclosure: I am long DHY, TICC, OXLC, FOF, PCI, UTG. 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.