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Summary

  • This article presents an introduction to my "Buy-The-Dip" High-Yield portfolio.
  • Buying the dips in high-yield stocks or funds is a strategy to lock in higher yields and achieve potential capital appreciation.
  • The rationale for choosing the stocks in the portfolio are presented.

Introduction

In a previous article, I modeled the effect of varying dividend yield vs. dividend growth numbers for stocks with the same "Chowder number" (yield + DGR). The conclusion I found was that, employing a few basic assumptions, the total return of a high-yield, low-growth stock might be expected to be the same as that of a low-yield, high-growth stock.

Which approach is superior? I believe it largely comes down to each investor's personal preference, goals, and risk tolerance. The pros and cons of high dividend yield vs. high dividend growth and various other aspects of the issue will not be discussed here; I plan to present those ideas in a further article in that series.

Personally, I love receiving dividends or income from my stocks. I'll admit that it is a rather psychological desire, and I don't deny that stocks that forgo dividends would be expected to have higher capital appreciation, nor the fact that dividends might be inefficient from a tax point of view. And even though, due to dividend reinvestment, my "at-risk" capital is expected to be the same as someone who invested in a non-dividend paying stock, I love seeing my share count go up as those monthly or quarterly dividends come rolling in. That is why I have personally always liked high-yield securities.

In the current series of articles, I wish to lay down the framework of my own investment philosophy. This portfolio, christened the "Buy-the-Dip High-Yield" (BTDHY) portfolio, aims to "buy-the-dip" in high-yield stocks or funds as a strategy to lock in higher yields and seek capital appreciation. As a younger investor, this investment strategy is still very much a work in progress. By writing these articles, I aim to i) crystallize my own thought processes, ii) invite discussion from investors using similar (or not) strategies and iii) present actionable ideas readers may find helpful. The first article in this series will deal with the selection of securities for the BTDHY portfolio.

Asset classes

The BTDHY portfolio represents about half of my total investment portfolio. The remaining half is split into: 30% mutual funds (mostly international stocks), and 20% in speculative positions (mostly small and mid-cap US stocks).

The BTDHY portfolio itself has an approximately 85% US/15% international split. The main asset classes of the BTHDY portfolio, their approximate allocations, approximate current yields (rounded to the nearest 0.5%) for selected securities and the rationale for including them in the portfolio are given below:

  • REITs (~30%). The "bread-and-butter" of the portfolio, REITs are in the business of purchasing and leasing real estate. Barring a financial crisis, REITs can be counted on to provide dependable, rising income. My favorite individual REITs are Realty Income (NYSE:O) (5% monthly), American Realty Capital Properties (NASDAQ:ARCP) (8% monthly) and Omega Healthcare Investors (NYSE:OHI) (5.5% quarterly). I also use ETFs and CEFs to provide diversification. My favorite ETF is The PowerShares KBW Premium Yield Equity REIT Portfolio (NYSEARCA:KBWY) (5% monthly), a mid-cap REIT fund, and my favorite CEF is CBRE Clarion Global Real Estate Income Fund (NYSE:IGR) (6.5% monthly), which can currently be bought for a 11% discount.
  • mREITs (~10%). A much smaller allocation is granted for mortgage REITs. These provide higher yields but invest in credit rather than in real assets. They also employ much higher leverage compared to equity REITs. Besides their high yields, one advantage of mREITs is that they have relatively low correlation to other asset classes in the portfolio. To obtain diversification and cheap leverage, I invest in UBS ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN (NYSEARCA:MORL) (20%+ monthly, but irregular payouts).
  • BDCs (~10%). Business development companies provide high-interest loans to small companies that may not be able to receive funding through traditional conduits. They provide high yields but are sensitive to the health of the economy. If the economy sours, BDCs may fall harder than other stocks. My favorite BDCs are Main Street Capital (NYSE:MAIN) (6% monthly + special dividends), Prospect Capital (NASDAQ:PSEC) (13% monthly) and Hercules Technology Growth Capital (NYSE:HTGC) (8% quarterly).
  • MLPs (~10%). Master limited partnerships typically receive cash flow from real estate, natural resources and commodities, and then pass the profits through to unit holders. These provide moderately-high yields, and are a decent play on the ongoing energy revolution in the US. Being a non-expert in MLPs, I elected to invest in these funds: UBS ETRACS 2x Leveraged Long Alerian MLP Infrastructure Index ETN (NYSEARCA:MLPL) (8% quarterly), Kayne Anderson MLP Investment (NYSE:KYN) (6.5% quarterly, 1% premium) and Neuberger Berman MLP Income Fund (NYSEMKT:NML) (6% monthly, 7% discount).
  • Bonds (~20%). While many on Seeking Alpha are eschewing bonds due to interest rate risk, I feel that they provide a valuable element of diversification. Floating-rate and short-duration high-yield bonds still provide adequate yields while minimizing interest rate risk, although credit risk is increased. The bond funds that I am currently invested in are: Western Asset Emerging Markets Debt Fund (NYSE:ESD) (8% monthly, 10% discount), Prudential Global Short Duration High Yield Fund (NYSE:GHY) (8% monthly, 4% discount) and Nuveen Floating Rate Income Fund (NYSE:JFR) (6% monthly, 6% discount).
  • Others (~20%). This category for stocks or funds that cannot be easily categorized into any of the other categories. Included here are option-income CEFs such as Eaton Vance Tax-Managed Global Diversified Equity Income Fund (NYSE:EXG) (9.5% monthly, 7% discount) and Eaton Vance Tax Managed Global Buy Write Opportunities Fund (NYSE:ETW) (9% monthly, 4% discount), and hybrid funds such as UBS ETRACS Monthly Pay 2xLeveraged Diversified High Income ETN (NYSEARCA:DVHL) (14% monthly), ETRACS Monthly Pay 2X Leveraged Closed-End Fund ETN (NYSEARCA:CEFL) (18% monthly).

My favorite stocks and funds are summarized below. Readers are encouraged to do their own due diligence on these securities before investing.

 Yield / %TypeDividend policyPremium/Discount
(m)REITs    
O5StockMonthly-
ARCP8StockMonthly-
OHI5.5StockQuarterly-
KBWY5ETFMonthly-
IGR6.5CEFMonthly11% discount
MORL202X ETNMonthly-
BDCs    
MAIN6StockMonthly-
PSEC13StockMonthly-
HTGC8StockQuarterly-
MLPs    
MLPL82X ETNQuarterly-
KYN6.5CEFQuarterly1% premium
NML6CEFMonthly7% discount
Bonds    
ESD8CEFMonthly10% discount
GHY8CEFMonthly4% discount
JFR6CEFMonthly6% discount
Others    
EXG9.5CEFMonthly7% discount
ETW9CEFMonthly4% discount
DVHL142X ETNMonthly-
CEFL182X ETNMonthly-

Risks

There are risks to every type of security. Here, I try to lay out some of the risks that the BTDHY portfolio might face.

1. Interest rate risk. Last year's "taper tantrum" caused a sell-off in bonds and stocks that were deemed to be bond-like, such REITs and utility stocks. Just how badly were the various asset classes in the BTDHY portfolio affected? The graph below shows the total return of the six asset classes in 2013, as represented by popular ETFs/ETNs: REITs (NYSEARCA:VNQ), mREITS (NYSEARCA:MORT), BDCs (NYSEARCA:BDCS), MLPs (NYSEARCA:AMJ), high-yield bonds (NYSEARCA:JNK) and CEFs (PCEF).

VNQ Total Return Price Chart

As can be seen from the above graph, REITs and mREITs were the asset classes that were most affected by the taper tantrum, with drawdowns of 18% and 25%, respectively, and total returns of -3% and -4%, respectively. Higher interest rates led to direct reductions in the book values of mREITs, and were also supposed to make it more difficult for REITs to finance growth for the future. High-yield bonds also did not fare so well, and finished with a total return of -1% for the year. The fund-of-CEFs PCEF, whose constituents include a sizable number of fixed-income funds, managed a slight positive return for the year. However, the best performers last year were MLPs and BDCs, which achieved total returns of 22% and 13%, respectively. This suggests that rising interest rates, or the threat thereof, does not affect all of the income classes equally. Granted, none of these classes matched SPY's awesome performance (+32%) in 2013, but no one should expect income securities to outperform a strong year (the best since 1997) of a bull market.

2. Market risk. Here I am using the term "market risk" to simply describe the risk of all asset prices falling during a market correction. To assess this risk, I obtained the 3-year correlation ratios between the six asset classes and SPY (credit macroaxis).

 SPYVNQMORTBDCSAMJJNKPCEF
SPY10.54-0.050.310.340.52-0.03
VNQ-10.010.50.560.71-0.05
MORT--1-0.010.01-0.010.08
BDCS---10.370.450
AMJ----10.52-0.01
JNK-----1-0.01
PCEF------1

This data shows that the six asset classes are not correlated to moderately correlated with each other, with REITs and high-yield bonds having the highest correlation of 0.71 over the past three years. However, none of the assets have a significant negative correlation to each other. This is not surprising because the strong bull market over the past few years lifted nearly all boats. If anyone has data on these asset classes that stretches over a longer period, please let me know! It is desirable in general to have asset classes that are negatively correlated, because it means that when one class is lagging, others are leading.

Also included within the concept of market risk might be the issue of the 2X leveraged ETNs. These provide a higher income but you are exposed to twice the movement of the index, whether up or down.

3. Credit risk. There are two types of credit risks that are present in the BTDHY portfolio. The first is the obvious risk of companies going bankrupt -- this particularly affects high-yield bonds and BDCs. The second is the use of exchange traded notes, or ETNs, which are unsecured debt obligations of the issuer. However, as explained by SA contributor and Professor Lance Brofman in the article "UBS Leveraged ETNs: Separating Fact From Fiction" the redemption feature of the 2X leveraged funds mitigates the credit risk associated with ETNs. Basically, deteriorating credit worthiness of the issuer (UBS in this case) should not affect the value of the ETNs because they can be redeemed at face value.

4. Recession risk. This could be considered to be an extension of credit risk. In a severe financial meltdown like 2008, all of these asset classes, with the possible exception of MLPs, are expected go down the toilet. While REITs are generally (incorrectly?) perceived to be "safe" stocks, they collapsed in the financial crisis of 2008 due to their inherent leverage and inability to retain significant cash flow. This portfolio does not contain treasuries or investment grade-bonds that might be expected to go up during a financial crisis. Therefore, this portfolio has to be monitored carefully for signs of recession. Seeking Alpha contributor Jeff Miller, who writes the "Weighing the Week Ahead" column, provides updates on the calculated chances of recession each week. At the moment, the data show that a recession is not in the cards.

5. Currency risk. The hybrid funds DVHL and CEFL, the option-income funds EXG and ETW and the emerging markets bond fund all have international exposure. Hence, they are subject to fluctuations in non-US currencies. However, this can actually be a good thing because it adds diversification to the portfolio.

Summary

This article provides an introduction to the types of securities that are selected for the Buy-the-Dip High-Yield portfolio. The second article of this series will consider the philosophy and practice of the portfolio: how might one effectively go about "buying-the-dip" in high-yield stocks? This is a relatively active strategy and seeks to achieve gains in capital appreciation in addition to income.

Credits

As a younger investor, I have learned a lot from other Seeking Alpha contributors, and wish to thank these experts here. I encourage newer investors to follow these fantastic sources of knowledge as well!

REITs: Brad Thomas
2X Leveraged ETNs: Lance Brofman
BDCs: BDC Buzz
CEFs: Douglas Albo
Market outlook: Jeff Miller
Asset allocation: Larry Swedroe
Swing trading: Ocean Man

Source: My 'Buy-The-Dip' High-Yield Portfolio: Security Selection