Seeking Alpha

An Income Portfolio: High Income And Capital Preservation

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Includes: CEFL, DNP, DSE, NFJ, NMZ, PCI, PDI, PFF, RFI, RNP, UTF
by: Financially Free Investor
Summary

If you were to need the income today, a typical Dividend Stock portfolio would not fit the bill. You would instead need an income-centric portfolio.

In this article, I will attempt to build an Income Portfolio from scratch with a goal to provide high current income in the range of 8%.

Income portfolio versus the DGI portfolio - which will deliver better results?

I am a fan of dividend growth investing. I strongly believe in investing in dividend-paying and dividend-growing companies, re-investing all dividends for the first ten years and thereafter holding them for the long term. The first phase, which lasts ten years or so (often called the "accumulation phase"), helps in bringing down the cost of ownership and elevating the dividend yield on cost. Thereafter, you can enjoy the passive income, which normally grows well in excess of inflation.

But as they say, "one size does not fit all." While it is true that a long-term DGI portfolio can generate a growing and inflation-beating income, it will need a long time before it matures and starts generating a significant amount of income. What if you were to need the income today? Maybe you have some money sitting in a bank account and earning close to zero, maybe you are debating whether or not you should pay off your low-interest mortgage or instead invest this money and pay the monthly mortgage from the income that it generates. Or maybe you just feel insecure in your job and want the security of some additional monthly income. You get the point, there are situations when an income-centric portfolio will serve your needs better than a DGI portfolio. So, here is an alternative portfolio to consider.

Income Portfolio:

Sometime back, I had launched a DGI portfolio in one of my articles on Seeking Alpha and promised to provide regular updates; the first update is due in early November. But today I am going to build an alternative portfolio with two simple goals: first to generate roughly 8% income on an annual basis, second to preserve the capital. Assuming you got $200,000 to invest in such a portfolio, it would generate $16,000 a year or roughly $1400 monthly income before taxes. To keep my calculations simple, I am not going to consider the impact of taxes or trading commissions.

I will build the income portfolio with 10-12 Closed-End Funds [CEFs] that pay high distributions and may be available at a discount to their NAV (Net Asset value). The advantages that I am seeking from such a portfolio [of CEFs] are as follows:

1) By maintaining a portfolio of 10 or 12 CEFs, I can get decent diversification. To get the same level of diversification from individual stocks, I would need to buy at least 40 or 50 stocks.

2) Since this portfolio will be actively managed, I can buy CEFs when they are selling at a discount to their NAVs and sell when they are trading at large premiums.

3) It may be worth noting, as the name implies, CEFs are closed-end funds and unlike mutual funds, the CEF managers do not need to liquidate assets for redemptions in times of market panics or corrections.

4) There is a wide variety of CEFs available that invest in different sectors of the economy, for example Equity, Bonds/Credit Securities, Utility, Infrastructure, Energy MLPs, Preferred Income, Floating-rate Income, etc. A diversified portfolio can provide a low overall volatility while delivering a constant stream of income.

5) The income generated, normally by monthly (or quarterly) distributions, can either be used or be re-invested as per individual needs.

Risks:

There are definitely some downsides and risks to CEF investing. First, a majority of them have high management fees in the range of 1%-1.5% or more. In addition, there is usually an interest fee, since these funds use some amount of leverage to generate outsized yields. Also, leverage can play out on both sides, boosting returns and yields in favorable times, but resulting in bigger drawdowns during market corrections. However, I think you can offset these drawbacks if you are careful enough to buy only when their market price is at a substantial discount to the NAV, and diversifying into different types of assets, which will help to reduce the overall volatility in the portfolio.

If the distributions are not fully covered from a fund's generated income or capital gains, that is another risk. If a fund was paying distributions as the ROC (Return of Capital), thus negatively impacting the NAV in the process, it would be a red flag. We will need to keep an eye on this as we go.

Goals of the Income Portfolio:

Here are some goals that I would like to achieve. These goals will guide the buy and sell decisions as well as fund selection process.

1) Generate an average of 8% income on an ongoing basis.

2) Short-term goal: 8% income with capital preservation.

3) Long-term goal: Besides recurring income, portfolio to generate roughly 2% plus in capital appreciation over long periods of time, to achieve a total return of 10% (when recurring income is not re-invested). The total returns would be better due to the compounding factor if you were to re-invest all income.

4) One key success criteria will be to measure the growth in average NAV of the portfolio. In other words, average NAV should be net positive when compared to the average NAV at the time of purchase. (The average NAV of the portfolio is the sum total of NAVs divided by the number of positions in the portfolio).

5) While it would depend on the investor's personal situation, whether they should withdraw the monthly income or re-invest, for the purpose of this demonstration portfolio, I will withdraw up to 5% income from the portfolio at the end of each year and re-invest whatever is left (approximately 3%).

Based on the above goals, here is how I am going to build a portfolio of 11 CEFs:

- I always like to stagger my purchases, so I will invest 50% of the money now and the remainder over the next 12 months.

- For this demonstration portfolio, the total capital (contribution) will be $200,000, with $100,000 to be invested now and the remaining over the next 12 months.

- 8% of the capital will be invested in each of the 10 CEFs; $8000 now and an additional $8000 during the next 12 months.

- We will try to maintain roughly 15% of the portfolio in cash at all times, which should come handy during significant market declines in the future.

- The dividends or income will not be re-invested automatically. We are going to withdraw from the portfolio 5% of the income on a yearly basis, and any excess amounts will be invested in the original or new securities when prices are attractive.

- There is one more twist to the portfolio formation. I will also invest up to 6% in UBS ETRACS Monthly Pay 2xLeveraged Closed End Fund ETN (NYSEARCA:CEFL). This is a more risky security than in the rest of our portfolio since it is leveraged two times on the underlying Closed-End funds (which also carry some amount of leverage). The purpose of including this risky instrument is to boost the overall yield of the portfolio and offset the near-zero yield coming from our roughly 15% cash position. The risks that come with ETN investing and from CEFL in particular are widely discussed in many other articles on the SA forum.

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Initial composition of the portfolio:

9 CEFs - 8% each = 72%

1 ETF - 8% = 8%

1 ETN - 6% = 6%

Cash - 14% = 14%

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TOTAL 100%

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TABLE-1 below shows the list of 11 securities (9 CEFs, 1 ETF and one ETN) along with the information on what sectors of the economy they are invested in. The focus is on diversification in different types of assets, ranging from Equity, Bonds, Preferred equity (hybrid), REIT and Energy MLPs. Some of these asset classes tend to move in opposite directions, helping our goal of low volatility and capital preservation.

Fund Name

Symbol

Fund's composition

1

Duff & Phelps Select
Income (NYSE:DNP)

DNP

Utility (80%)

2

Duff & Phelps Select Energy MLP fund (NYSE:DSE)

DSE

Energy MLP CEF fund
(MLP - Master Limited Partnership)

3

ALLIANZGI NFJ DIV INTST & PREM STGY (NYSE:NFJ)

NFJ

Equity CEF fund

4

Nuveen Muni High Inc Opp (NYSE:NMZ)

NMZ

Muni Tax Free (Tax free yield 10.68%)

5

PIMCO Dynamic Credit Income (NYSE:PCI)

PCI

Global Income, including corporate debt, mortgage-related and other asset-backed securities

6

PIMCO DYNAMIC INCOME FD (NYSE:PDI)

PDI

Debt obligations and other income-producing securities

7

ISHARES US PREFERRED STOCK ** ETF **

(NASDAQ:PFF)

PFF

Preferreds 90% (This is an ETF, not CEF)

8

COHEN & STEERS TOTAL RETURN REALITY Fund (NYSE:RFI)

RFI

REIT (Real Estate) CEF

9

COHEN & STEERS REIT & Preferred Income fund (NYSE:RNP)

RNP

Preferred is 48%, 50% REIT

10

Cohen & Steers Infrastructure (NYSE:UTF)

UTF

Utility+Infrastructure (50% is International)

11

UBS ETRACS Monthly Pay 2xLeveraged ETN

CEFL

Exchange Traded Note (based on the index of CEFs)

TABLE-2 below shows the list of same 11 securities/CEFs with other relevant information like market price, fund NAV, discount/premium, distribution of dividend yield, etc.

TABLE-3 below shows the Income Portfolio, based on market prices as of 10/17/2014 (assuming all the initial purchases were made on 10/17/2014).

Please note that only 50% cash is invested at this time, while the nearly remaining 50% will be invested during the next 12 months, keeping a cash buffer of roughly 15% at all times.

Comparison of DGI-portfolio versus Income-Portfolio:

I will provide regular updates and comparison on both of these portfolios, the Passive DGI portfolio (that I discussed in my August article) and the Income portfolio discussed today. I think the DGI portfolio will fare better in the long run, perhaps because all the dividends will be re-invested, at least for the first 10 years. On the other hand, the income portfolio would provide 8% income right from day one, conserve capital and possibly provide some modest growth as well. So, as for how to choose, the answer will depend on the investor's time horizon, risk tolerance and short-term/long-term goals. Ideally, I would want 70% of my money in a long-term DGI portfolio and 30% in an income portfolio.

Full Disclaimer: The information presented in this article is for information purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Every effort has been made to present the data/information accurately, however the author does not claim for 100% accuracy. The portfolio or other investments presented here are for illustration purpose only.

Disclosure: The author is long DSE, PFF, NFJ, PCI, PDI, RNP, RFI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.