Income in a Zero-Rate World - Revisited

by: Andy Sutton

It has been 18 months now since the original piece of the same name. Quite a lot has happened in those 18 months, but we still have the zero-rate world and along with it all of the accompanying problems. One positive side for fixed-income style investors has been the ability to make nice capital gains on bonds. But how about those who are interested in monthly or quarterly income and don’t wish to trade in and out of traditional fixed income instruments? In this essay, we’ll take a look at the portfolio model that was created 18 months ago and see how it has performed.

One important thing to note is that one of the Canadian Trusts (Harvest Energy) no longer does business by that name. It was purchased by Korean National Oil Corporation (KNOC) at the end of last year. It was perhaps the first casualty of Canada’s ill-fated decision to change the taxing structure for Trusts and it was a big one. Harvest was one of very few vertically integrated Oil & Gas operations, meaning that it owned refinery operations in addition to its exploration and production program. It was viciously attacked by short-sellers during the months leading up to the acquisition and when shareholders were offered a roughly 40% premium over the then $6 and change trading price, they jumped and Harvest was lost.

Trimming your Hedges

The hedging tool used in this particular Portfolio Model was the UltraShort Oil & Gas ETF (NYSEARCA:DUG) since it correlated fairly well with the mix of assets represented. However, one of the drawbacks of these ETFs is their propensity to leave gains on the table based on the objectives they pursue. This reality has become somewhat better understood by investors, but let’s go over it again if for no other purpose than to reinforce the point.

From the ProShares website:

This ETF seeks a return of -200% of the return of an index (target) for a single day. (Emphasis theirs) Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily. For more on correlation, leverage and other risks, please read the prospectus.

What they’re saying is if you purchase this type of fund and it moves 2X the inverse of the correlated index or security, that if the underlying issue moves down 20%, you would expect the price of the 2X inverse fund to go up 40%. It doesn’t always work that way. Depending on the price action, you could actually end up with a much lower gain, especially if the price action is volatile and choppy.

Again, this is not meant to be an indictment of these types of funds, but rather to point out that no hedge is going to be perfect and you’d better keep your eye on the ball if you want to be successful.

The Sample Portfolio Model

Let’s see how our components have fared over the past 18 months:

Sample Portfolio Model

For the 18 months ended June 2010, the portfolio model is up substantially not counting dividends. Assuming the purchase of the same 100 shares each and 250 shares of DUG as in the original article, our portfolio on 11/20/2008 would have cost us $31,969. As of 7/8/2010, it would be worth $47,964 for an increase of 50%. During the same time, the portfolio threw off $2,634 in dividends making the effective yield of the portfolio 8.24% and bringing in $146.33/month in dividend/distribution income. $146 doesn’t sound like a lot of money, but when you consider deploying a $100,000 or $200,000 portfolio in this fashion, suddenly you’re talking about some very nice cash flow – certainly in excess of what can be found at the local bank. The performance metrics stated above assumed that the positions were all started on 11/20/2008; a significant market bottom. Waiting until 3/6/2009 to begin them would have resulted in slightly higher gains. We put a few of these positions to work in our newsletter portfolio on 3/13/09 and they have performed in spectacular fashion.

Model Performance

During the same period of time, the Dow Jones Industrials are up just 34%, with well under one-half the yield of this model. The S&P500 is up only 33% with just over one quarter the yield of the model.


One thing that has worked extremely well for me in practice is the strategic placement and removal of hedging devices. I am not talking about trading hedges; that is a completely different animal. What I am talking about is searching for multi-month trends and then placing or removing hedges based on the results of that research. For the average investor who has neither the time nor the inclination to get involved at this level, selecting a solid hedge, putting it in place, and monitoring once a week should suffice.

Still other investors who don’t mind potential wild fluctuations in their core holdings, but are interested merely in yield, will construct a similar portfolio and put 100% of their capital to work earning dividends. We could have pumped the yield of our sample model up considerably by doing that, but decided on a more conservative approach and were willing to leave a point or two of yield on the table in favor of more stable performance.

One thing to note is that many of these components have had their dividends cut since 11/20/2008. Several have been cut significantly. A few were cut, and are now beginning to increase again. One of the lesser-known ramifications of the ongoing credit crisis is that many small and midsize companies have had a difficult time raising capital at reasonable rates. This resulted in a more protective position taken on by management as they’ve sought to preserve cash for operations. This has led to dividend cuts in many cases. Falling share prices in 2008 and 2009 made it easy to do so since they could cut the dividend and still maintain a similar yield for new investors. The argument could certainly made that this is irrelevant since 8% is 8% no matter what the price/distribution levels, but I think it needs to be mentioned to maintain a spirit of objectivity.

Disclosures: Long PWE, PGH, KMP