The Hardest Part For The Income Investor

by: Michael J. Ray

It is amazing how many great investing type quotes one can find in the most unusual places. Recently I discovered a song by Coldplay titled "The Hardest Part," which really struck a chord with me in regards to the basic principles of income investing. In the song there is a very meaningful verse:

"And the hardest part was letting go not taking part, it was the hardest part"

At first the verse seems rather nonsensical but a second look reveals a hidden meaning that could be used in any aspect of life. But since I am focused on income investing, this quote seemed to further emphasize the often overlooked aspect of diversification in an income portfolio. The principle of diversification is a well understood concept for all investors, but for some reason the income investor can often fail to adhere to it. There could be many reasons for this failure, but it seems one of the most common mistakes is that the income investor's primary focus is solely on yield and everything else gets forgotten in the hunt. No longer is anyone able to sit in CDs or U.S. Treasuries and make a decent return. As long as the U.S. government is going to keep interest rates as close to zero as possible, these income investors are forced out into the scary world of the equity markets in search of the highest yields possible. Needless to say, an investing strategy that is focused solely on yield will get one into trouble almost every time.

Canadian Income Massacre

One of the best examples to illustrate the need for diversification occurred within the world of the Canadian Trusts. This particular type of investment vehicle was very popular in the past. One of the trusts' primary purposes was to direct royalty payments or income to the trust holders. The trick was that they legally bypassed corporate taxation and the distributions were much larger than other entities that were doing business through a normal corporate type structure. Income investors quickly latched onto these investments as the yields were truly something unique. As income investors delved deeper into these investment vehicles they found that a large majority of the trust were energy related and represented some of the biggest names in the business. Companies like Penn West (PWE), Enerplus Corporation (ERF), Pengrowth Energy (PGH), and Baytex Energy (BTE) offered great yields and were just too tempting to ignore. So some income investors simply concentrated their portfolios in these trusts planning to collect a never ending high yield distribution. Some felt they had the diversification as the trusts they held crossed several sectors and industries, but they were wrong and were in for a massacre. On October 31, 2006, the Canada's Minister of Finance announced that all income trusts would be taxed in a similar manner as corporations on taxable income, and so the Halloween Massacre began. In the ensuing panic investors were said to have losses of $35 billion. Shareholder value dropped virtually overnight as the sudden announcement was made, and it was the energy sector that was hardest hit by the news. Here is where our song verse comes into play. The hardest part was letting go not taking part. No matter how much the yield or how great the companies were, one cannot ignore the diversification principle. The hardest part was for investors to pass on some of these trust names and look elsewhere even though they might have to give up some yield. The violators of the diversification principle unfortunately had to learn a hard lesson here.

Another Potential Massacre

The Halloween Massacre was painful and well publicized but the question is if the lesson was learned? Since the massacre many of the trusts have converted to corporations but have never really regained their former glory from the golden years. But that is not where the next massacre will probably occur for those income investors not diversified. Once again those not adhering to the call for diversification are gravitating toward the never-ending search for higher and higher yields. Inevitably they will wind up on the doorstep of the ever famous mReits. Now don’t get me wrong, I truly like mReits and own them in my income mix, but I would not want to make them the sole type of asset that I hold in my income portfolio. The problem though is that some people do. For example consider companies like American Capital Agency Corp. (AGNC) earning a 20% yield, Annaly Capital Management (NLY) a 14.7% yield, or even Chimera Investment Corporation (CIM) with a 20.4% yield. Outsized yields like these will attract any and all income investors, but once again diversification is the key. mReits are actually one of the most complex investment vehicles and require a good deal of understanding to comprehend the risks involved. mREITs are Mortgage Real Estate Investment Trusts, which are entities that specialize in investing in mortgage products and trading mortgage-backed securities. mREIT can only deal with mortgages, and 90% of earnings must be paid out to its investors. The principal goal of the mREITs is to generate net income for distribution to stockholders through regular dividends, from the spread between the interest income on their portfolio and the interest costs of their borrowings and hedging activities. These companies can really leverage themselves to get extremely high yields. That being the case, these companies will be very sensitive to changes in the interest rates, making them extremely complex investment vehicles to understand and track. The quantitative easing and other Federal Reserve programs have placed mREITS among some of the best income investments. But a rapid rise in interest rates or some political announcement can bring it all crashing down rather quickly.

In the end diversification is the key to success in income investing. Investors might have to sacrifice yield, but the benefits well outweigh the possible risks. Of course diversification does not completely mitigate all risks, for there are some factors that have overall arching impacts across all income investments. Rapid increases in interest rates will have an adverse impact on most every income investment. But in the end a well diversified portfolio will fare better and let inventors sleep at night.

Disclosure: I am long PWE, AGNC.