There are all different kinds of income investors that exist, but what many of them share in common is the desire for income. Today's problem is that CD and Treasury bond yields are just too small. Income hunters are now forced to go on a quest for higher yields, but in doing so will have to take on more risk as they enter the equity markets.
This series of articles will examine some popular, as well as some relatively unknown, income investments that might provide investors with new ideas. These stocks and funds will represent a broad spectrum of companies and strategies, so that a well-diversified list of potential candidates can be examined. Not all the tickers listed in this series of articles will be appropriate for every portfolio, but a well-rounded list of ideas can make it easier to select.
1. CVR Partners (UAN)
If we are going on a quest then we better have some exciting names in the mix, and UAN should be one of those names. We should first go over the basics of this very unique company. CVR Partners is a limited partnership formed by CVR Energy (CVI). Initially, CVR Energy held a 70% interest, while the other 30% is held by the public. UAN's purpose was to own, operate and grow the nitrogen fertilizer business of CVI. Its nitrogen fertilizer manufacturing facility produces ammonia and urea ammonium nitrate fertilizers, and is located in Coffeyville, Kan.
The nitrogen fertilizer plant is the only operation in North America that uses a petroleum coke gasification process to make hydrogen. UAN gets this coke from the parent company (CVR Energy), which owns and operates a refinery close by. The coke, being readily available from the parent, also tends to be much less expensive when compared to natural gas. Of course with gas prices in the basement, it makes this advantage a moot point for now. This coke is a key ingredient in the manufacturing process, and the company produces about 5% of the total UAN demand in the United States. For 2011, UAN produced 116,800 tons of ammonia available for sale, and also produced 714,100 tons of urea ammonium nitrate.
For the first quarter 2012, average realized plant gate prices for ammonia and urea ammonium nitrate saw increases with ammonia up by 9% to $613 per ton and urea ammonium nitrate up by 51% to $313 per ton, compared to $564 per ton and $207 per ton for the same period in 2011. Currently the company produced 89,300 tons of ammonia during the first quarter of 2012, of which 25,000 net tons were available for sale while the rest was upgraded to 154,600 tons of more profitable urea ammonium nitrate. In the 2011 first quarter, the plant produced 105,300 tons of ammonia with 35,200 net tons available for sale with the remainder upgraded to 170,600 tons of urea ammonium nitrate.
In mid-April 2012, UAN announced the first quarter 2012 distribution of $.523 cents per share. This distribution was the fourth consecutive cash distribution paid by the partnership since its IPO in 2011, and will result in cumulative cash distributions paid of $2.09 per share. This exceeded the company's previous distribution guidance range of $2.00 to $2.05 per common unit for the 12 months ended March 31, 2012. This represents a 9% increase over its original distribution guidance of $1.92 per common unit for the same period. Finally, the company has raised its previous distribution guidance range for calendar year 2012 from $1.50 to $1.75 per common unit to $1.65 to $1.85 per common unit.
On the surface, UAN looks like a prime target for any income investor. The problem is that a big-time investor has also entered the scene and his name is Carl Icahn. While Icahn's goals were not related to income investing, his actions will definitely have an effect. It seems that Icahn's interest lie with CVR Energy, and he was willing to pony up a tender offer for $30 in cash per share. Needless to say, the future becomes a bit murky at this point. But even before Icahn arrived on the scene, CVR Energy announced plans to sell a portion of its equity in CVR Partners. The intent was to use the after-tax proceeds of the offering to pay a special dividend to CVR Energy stockholders and also to strengthen CVR Energy's balance sheet.
The question now becomes what should income investors do now with this beast. With Icahn at the wheel, it will be interesting to see. The overall arching theme for the company and the business sector it works in has not changed. Business seems good and all the strengths still remain intact, but there still in a lingering fear as to what will happen next. The stock trades around $21.50 at the time of writing this article, and that makes for a 9.7% yield, which will be attractive to any investor. For myself, I hold shares and will continue to do so as long as the business model remains the same. I would expect the volatility to continue for some time as things get settled and the dust clears.
2. Atlantic Power (AT)
Our second candidate for your review is Atlantic Power. This company is a leading publicly traded power generation and infrastructure company that has a diversified portfolio of assets in both the United States and Canada. The assets are made up of 31 power generation projects totaling 2,140 MW of generating capacity which operate in 11 states and 2 provinces in North America. AT also has an 84 mile, 500 kilovolt transmission line in California, as well as an additional 351 MW projects under construction in Oklahoma and Georgia.
Looking to the company's most recent first quarterly results, we find that project adjusted EBITDA, including earnings from equity investments, increased by $56.9 million, or 158%, to $92.9 million for the quarter ended March 31, 2012. This is a positive upswing compared to $36.0 million for the same period in 2011. This increase is primarily due to contributions from the 18 projects added to AT's portfolio when it acquired Capital Power Income last year. It seems that AT's aggressive growth plan is working out for the better so far as they are much larger entity that operates more than half of its own projects. These power generation projects sell electricity to utilities and other large commercial customers under long-term power purchase agreements, which make for a more stable cash flow.
For the three months ended March 31, 2012, the cash that is available for distribution increased by $43.2 million compared to the same period in 2011. Once again this was primarily due to an increase in the 18 projects added to AT's portfolio. The payout ratio for the quarter ended March 31, 2012, was 55% compared to 114% for the same prior-year period. It should be known that the payout ratio will fluctuate from quarter to quarter, but for 2012 AT's payout ratio is expected to be 90% to 97%.
When AT looks forward it expects to receive distributions from its projects in the range of $250 to $265 million for the full year 2012. They also expect that the overall levels of operating cash flows in 2012 to be improved over 2011 levels due to full year contributions from the acquisition of Capital Power Income assets.
When the income investor starts to look seriously at AT, some decisions have to be made. Is pulling the trigger on AT going to have too much risk involved, or is the reward worth it? Currently the company pays a monthly dividend, which is 8.2%. That in itself would attract any investor, but with a payout ratio of 90% to 97% that gives one pause for concern. The company has shown it has the ability to grow quickly, but can it bring all the new assets into the fold in a cost-efficient manner?
Clearly there are lots of questions and concerns. Being on a similar quest for income, I have to admit that I did pull the trigger on this one. Obviously there is much more of the story to come and I will wait to see if this name was worth the risk.
3. Gabelli Global Gold, Natural Resources and Income Trust (GGN)
Like mentioned before, not all income investments are individual companies. Sometimes these candidates can take the form of closed-end funds (CEFs). There are many CEFs out there, and they come in a wide variety of shapes, colors, and sizes. For our first name we will focus on just one, and that is the GAMCO Global Gold, Natural Resources & Income Trust.
GGN is a non-diversified, closed-end management investment company with $1.3 billion in total net assets whose primary investment objective is to provide a high level of current income. The fund is not an investment in physical gold or natural resources as the name might suggest. The fund makes investments in equity securities of firms operating in the gold and natural resources industries including companies in exploration, mining, fabrication, processing, distribution or trading of gold, financing, managing, controlling or operating of companies engaged in gold-related activities. It also invests in companies principally engaged in the exploration, production or distribution of natural resources, such as gas, oil, paper, food and agriculture, forestry products, metals and minerals as well as related transportation companies and equipment manufacturers. To earn income the fund engages in a strategy of selling covered call options on the equity securities in its portfolio.
Unlike the other names in this article, GGN is going to have some interesting attributes that will attract investors. The fund makes monthly distributions payments which have held steady at $0.14 per share. Currently that makes for a yield of 12% as the shares trade close to the $14 mark at the time of this article. Also being associated with gold, silver, and natural resources will also attract investors.
So what risks do we find with this closed-end fund? On closer examination we find some concerning characteristics to contend with:
Net Asset Value (NAV)
One characteristic that CEFs have is that their share price is based upon demand and not on their net asset value . That being the case, the shares can trade well above or below the net asset value of the holdings that make up the fund. GGN has a tendency to often trade at a premium. Currently that premium is running 8%, but as history has shown it can and will trade even higher than that. One reason for this is that some CEFs are actively managed, meaning that they can and will be employing all kinds of strategies and unique investing practices. As a result the holdings are often unknown at all times, which means that an exact calculation of the NAV can be challenging to derive. The final result is there is a risk of overpaying for the assets which has a negative aspect to any type investor.
Payouts and Return of Capital (ROC)
Yield is what drives our income investor, but the real issue is how that yield is derived. When it comes to GGN any investor will want to make sure that the source of the yield is generated from ordinary income or capital gains. If GGN does not generate sufficient earnings to cover its dividend, then the amount distributed in excess of the earnings would be deemed a return of capital. Needless to say, a situation where the distributions are classified as a ROC suggests that management is not successfully running the fund. Basically if this was the case then the CEF would be cannibalizing itself and your money.
It should be known that not all ROC is bad. Consider an instance where a CEF is generating its yield via complex option strategies or capital gains much like GGN. It might take some time for these strategies to come to fruition, so in the meantime management will distribute ROC to keep a consistent revenue stream going for investors. If the CEF is listing a ROC as its source of yield, then an income investor better be able to determine what is the cause and if they should pull the trigger or not.
Management Fees
Another possible risk that comes with this type of investment is management fees. These fees are what the companies will charge for their expenses to operate the fund. CEFs that are actively managed incur higher fees than more passively run ones. Unfortunately lots of dastardly items can hide within the realm of fees. The bottom line is that these fees and expenses can and will eat into your returns. It is up to each investor to determine what they are willing to put up with when it comes to fees. Some will forgo the investment all together, while others might be comfortable with it. Either way it's a risk and must be addressed. According to the latest number I find the management fees and other expenses for GGN are 1.36%.
Obviously GGN presents its own unique blend of rewards and risks. As an income investor I like this CEF, and have purchased it in the past and continue to do so. I like the industry and the exposure to the covered call strategy that GGN offers. Of course this does not mean that GGN won't turn on me at some point. I acknowledge there are risks, but at this time I am currently willing to accept them on a cautionary basis.
4. American Capital Agency Corp. (AGNC)
If one is going to kick off a series on potential income investments, then one would be remiss to not make note of the Mortgage Real Estate Investment Trusts (mREITs). These income investments are some of the most complex financial instruments, and they require a good deal of understanding to comprehend the risks involved. That being the case, there are no other assets out there that are offering such great yields.
MREITs are entities that specialize in investing in mortgage products and trading mortgage backed securities. MREITs can only deal with mortgages, and 90% of earnings must be paid out to their investors. The principal goal is to generate income for stockholders through regular dividends that are generated from the spread between the interest income on their portfolio and the interest costs of their borrowings and hedging activities. On top of that, the companies can and will leverage themselves to get extremely high yields. As a result they will be very sensitive to changes in the interest rates.
With that brief introduction we turn our attention to AGNC. This company is a real estate investment trust that invests in agency pass-through securities and collateralized mortgage obligations. The principal and interest payments are guaranteed by a U.S. government agency or U.S. government sponsored entities. The company funds its investments primarily through short-term borrowing structured as repurchase agreements. As a form of protection the company has significant amounts of hedging in place as well. The company pays a quarterly distribution which is currently yielding a 15.6% return.
With the quantitative easing and other Federal Reserve program in place, it would seem that AGNC would be an easy pick. The problem is that this investment has some real risks that can quickly turn on anyone not paying attention. For example, hedging and derivatives are very complex financial matters, and even the experts can get them wrong. Also consider a new round of interest rate hikes or credit issues that would lead to higher rates, which could have a negative impact on spreads or roll over repurchase agreements. The problem is that these events can happen quickly, and any uninformed income investor could suffer quite a mauling of their portfolio value.
AGNC's management states that it believes the Federal Reserve should keep short-term interest rates near zero through late 2014. If this is the case, then it would support the likelihood that both attractive funding and lower hedging costs will continue for the company. In this scenario AGNC should thrive and be firmly in any income investor's sights.
I hold shares of AGNC and so far it has proven to be a winner. I am very cautious though and know that this name will someday not be so friendly. Until such time I'll keep one eye on it and see which way the tide turns.
In conclusion, the four names above are our first candidates that one could add to their income portfolio. Remember, though, that this article is about balancing risk with reward. There are big rewards to be had, like high yields and possible price appreciation. On the flip side there is also lots of risk. In the next article of this series we will try to identify more interesting and unique names as the quest is never done, and there are always more names to consider on the horizon.
