Before the Great Recession, retirees could buy long term CDs and receive 5% - 6% income while preserving principal. In the new economy CD rates remain stuck under 2% forcing income investors to seek other options to earn significant regular income while preserving principal. The quest is fraught with risk.
There are a large number of income funds to choose from that invest in income paying securities across all sectors - government and corporate bonds, high yield bonds, preferred stocks - and many of them mention capital appreciation or preservation of capital as an investment objective. But things are not always as they appear.
Despite the stated investment objectives of capital appreciation or preservation of capital, most of the funds I analyzed failed to preserve investor's original investment. To illustrate, Chart 1 shows the average performance of several popular income funds for the period 2005 - 2015. If a hypothetical investor invested $1000 in the funds at 1/1/2005, they had a residual value of $473 at the end of 2015 assuming the investor did not reinvest the dividends.
Charting Note: Charts for income funds may plot the closing price or the closing price adjusted as if all dividends were reinvested in the fund. The chart above shows closing price without reinvestment of dividends to illustrate the experience of an investor who takes all of the dividends as income.
Many factors can cause the share price of an income fund to shrink over time. Return of Capital is where the fund distributes dividend income in excess of earnings. Financial regulation requires that shareholders be informed in writing when the fund distributes amounts from any source other than net income (Section 19(a) of the investment Company Act of 1940).
Even if a fund does not report a return of capital on a Section 19(a) distribution report investors could still suffer shrinking principal. The fund's share price may decline because the values of the underlying securities decline, which can occur in response to rising market interest rates, rating downgrades, defaults, bankruptcy or failure of the issuer.
Closed end funds trade at a market price not tied to the net asset value per share. The difference between the market price and the net asset value per share is called the premium or discount and varies each day. The net asset value per share moves up and down with the market value of the underlying securities but the market price of the fund moves up and down in response to investor buy and sells orders. Closed end fund shares often trade relatively small daily volumes, so a large purchase or redemption order can cause the market share price to move suddenly although the net asset value is unchanged.
STRATEGY 1: INVEST IN FUNDS THAT PRESERVE INVESTORS' CAPITAL
I looked for income funds that yield at least 4%, pay consistent distributions monthly or quarterly, and preserved investor's capital. I evaluated fund performance during the period from 2005 through 2015 in order to include years leading up the Great Recession and the subsequent anemic recovery. For each fund I calculated how much of my principal I would have at the end of 2015 if I had invested $1000 at 1/1/2005 and taken all of the dividends as income. I also calculated how much principal would be left if I invested $1000 spread out in equal dollar amounts invested at the end of each year throughout the period (dollar cost averaging).
The best performing income funds I found that fit the criteria are the John Hancock Premium Dividend Fund (NYSE:PDT) and John Hancock Tax-Advantaged Dividend Income Fund (NYSE:HTD). These are closed end funds that invest in preferred and common stocks with emphasis on utilities and financial sectors. HTD invests at least 80% of fund assets in stocks that pay qualified dividends that are taxed at the lower capital gains tax rate. Both funds utilize about 30% leverage. PDT was created in 1989; net assets are $777 million and the expense ratio is 1.85%. HTD was created in 2004; net assets are $1,322 million and the expense ratio is 1.63%. Both of these funds provided modest capital appreciation over the period in addition to paying reliable monthly dividends. PDT currently yields 6.92%, HTD 6.11%. $1000 invested in PDT was worth $1173 at the end of 2015, while HTD grew to $1137.
The Fidelity New Markets Income Fund (MUTF:FNMIX) is a mutual fund that invests at least 80% of assets in securities of issuers in emerging markets. The expense ratio is 0.85%. The fund was created in 1993 and has been managed by John H Carlson since 6/19/1995. Current yield is 5.87% distributed monthly. Net assets are $4.253 million. The value of $1000 invested in FNMIX was worth $1013 at the end of 2015.
The Federated High Yield Trust (MUTF:FHYTX) is a mutual fund that invests primarily in high-yield, lower-rated corporate bonds of domestic companies. The fund may invest in securities of international and emerging markets. The expense ratio is 0.99%. The fund was created in 1984. Current yield is 5.04% distributed monthly Net assets are $848 million. The value of $1000 invested in FNMIX was worth $989 at the end of 2015.
The Ellsworth Growth & Income Fund (NYSEMKT:ECF) is a closed end fund that invests in convertible securities and preferred and common stocks in the information technology, healthcare, financials, consumer staples, energy, and utility sectors. ECF shares recently traded at a deep discount of 15.7% from net asset value per share. The fund was created in 1986. The expense ratio is 1.1% and net assets are $120 million. Current yield is 5.74% distributed quarterly but actual yield is usually higher due to a large dividend often distributed near the end of the year. $1000 invested in the fund was worth $959 at the end of the period.
The Buffalo High Yield Fund (MUTF:BUFHX) is a mutual fund that invests primarily higher-yielding, higher-risk debt securities rated below investment grade, generally with intermediate-term maturities. The fund may invest up to 20% of its net assets in ADRs and securities of foreign companies that are traded on U.S. markets. The fund invests in consumer discretionary, health care, industrials and information technology sectors. The fund was created in 1995. Current yield is 5.26% distributed monthly. The fund has an exceptionally low volatility of 14%. $1000 invested in the fund was worth $959 at the end of the period.
STRATEGY 2: REINVEST A PORTION OF THE DIVIDEND TO GROW PRINCIPAL
Even the best income funds will not reproduce the constant value guarantee that a CD provides given the inevitable ups and downs in the market. Since we are looking at these funds in hindsight we know that they (mostly) preserved investors' capital over the period. However in real life, the income investor does not have a comforting guarantee that yesterday's share price decline is temporary. Ideally we would like to have an income portfolio where we have confidence that our principal will recover from short term price dips in order to reproduce as much as possible the pleasant experience of investing in CDs back in the good old days.
If we know that our portfolio is growing over time then we gain assurance that dips in market value will be overcome over the long term and the value of our income portfolio will recover. We can improve our income investing experience by reinvesting a portion of the periodic dividend income back into the fund. A 2% compound annual growth rate would grow our $1000 investment to $1243 over the eleven year period and provide our portfolio with a nice comforting upward trend. The chart below illustrates the value of $1000 invested in the Fidelity New Markets Income Fund with 31% of the dividends reinvested back into the fund to achieve 2% annual growth in the principal with a net yield of 4.05%.
Dividend reinvestment programs can be used to periodically reinvest a portion of dividends without commissions. Table 2 shows the net yield for each fund with a portion of the dividend reinvested to achieve a growth rate of 2% per year.
Reinvesting a portion of every dividend has effectively converted our income funds into growth and income funds. Growth and Income investments may be the best option for income investors seeking high current income and preservation of capital, with the added benefit that the income provided by the portfolio will grow over time.
STRATEGY 3: GROWTH AND INCOME INVESTMENTS
Moving from income funds to growth and income investments opens up a lot of new opportunities. I searched for growth and income funds that existed as of 12/31/2004, yield at least 3%, distribute consistent dividends monthly or quarterly, and grew investor's capital over the period under review. Table 3 presents information for three growth and income funds that meet my selection criteria.
The Reaves Utility closed end fund (NYSEMKT:UTG) provided reliable high yield monthly income and steady long term growth of invested capital, albeit with more volatility that the other funds, due in part to the 25% leverage employed by the fund. UTG recently traded at a 5.65% discount to net asset share value. A $1000 investment in the fund at the beginning of the period grew to $1,307 without reinvestment of any dividends, a 2.5% compound annual growth rate. The fund has a relatively high expense ratio of 1.65%.
The Vanguard Select REIT Index fund is marketed as a mutual fund (MUTF:VGSIX) and as an ETF (NYSEARCA:VNQ). The fund invests to match the performance of the MCSI U.S. REIT Index. It yields 4.18%, pays dividends quarterly, and grew investors' original $1000 investment to $1428 over the period, a CAGR of 3.5%.
The SPDR Utilities Select ETF (NYSEARCA:XLU) yields 3.46% paid quarterly and grew an original investment of $1000 to $1,572, a CAGR of 4.2%.
All of these funds grew investors principal over the period while paying regular income.
UTG data by YCharts
It is no surprise that some of the best growth and income funds for income investors are utilities and REIT funds. Both sectors provide excellent investment opportunities for income investors.
Utilities are protected monopolies that provide services that are essential to government, industry, and civilization. Rates are regulated but the need to provide a fair return to investors is recognized in order to assure availability of capital that is essential to maintain and expand facilities. It is inconceivable that a utility company of any significant size in the United States would be allowed to fail. Risk costs tend to be passed on to rate payers rather than investors. Utilities occupy a secure position near the top of the economic food chain. Dividends from utility companies often qualify for a reduced federal income tax at the filer's capital gains tax rate.
REITs are trusts that invest in real estate assets, which may be financial assets like mortgages, or real assets including land and buildings. Federal income tax rules require REITs to distribute at least 90% of net income to investors in a timely manner and REITs themselves pay no income tax. Some REITs are the landlords for Fortune 500 corporations, government entities, and medical offices, holding long term triple net leases with built in rent escalation clauses.
Our search for income investments that preserve investors' capital led us to conclude that growth and income investments are the best choice for income investors because they provide long term growth of the principal that ensures that our original investment will not shrink. Growth and income investments also provide the benefit of growing our income over time. Investors seeking the highest returns may wish to consider owning a diversified portfolio of REITs and utility stocks that have a solid fundamental business strategy and an established record of successful management through good times and bad.
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Disclosure: I am/we are long PDT, HTD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.