Retirement Income Strategy: Best Choices

by: Adam Aloisi

An old grade school compound value brain teaser is a good comparative to options income investors may face.

Comments on passive vs. active investment management and income growth vs. durable income realization.

A historical perspective on today's choices.

Near-term and long-term strategy and some low yield/high yield stock ideas.

A common grade school brainteaser queries whether you'd rather take a $1 million pot of money now, or double your money everyday for a month, starting only with a penny. This tale is a common introduction to the principle of mathematical compounding, but also serves as a lesson in terms of investment patience and the value of time.

Of course as you probably already know, the answer is take the penny - even we're talking about a 28-day February! If you picked one of the seven months with 31 days, you'd actually make over 10X as much (~$10.75M) as the knee-jerk decision-maker who might have smugly walked away with a cool million on day one.

Unfortunately, few of us will be faced with such an attractive monetary windfall or luxurious fiscal outcome at any point in our lifetimes. While a select few may win the lottery or come out big on a game show, fall into an unexpectedly large inheritance, or drum up the next Amazon (NASDAQ:AMZN) or Facebook (NASDAQ:FB)-type idea, comfortable retirement for most will be based on a lifetime of hard work, proverbial blood, sweat, & tears and a prudent choice of lifestyle.

Life, in virtually all aspects, is a set of choices and decisions. And while many don't put a lot of thought into early-life decisions, they are amongst the most important. I won't bore you with details on what might happen when you start saving/investing at age 25 versus age 35 or if you sock away $45 a week instead of $35, because undoubtedly you've heard or read this before.

However, the grade school compounding teaser becomes more telling in that it advocates prudent, thoughtful decision-making over knee-jerk response. It may be tempting to lock in something offering instant gratification, but you might be passing up on something much lucrative down the line if you think short-term.

Still, there are no guarantees even if you practice deliberative, textbook investment methodology, nor fall victim to knee-jerk-type investment activity. If you opt for stocks as your primary investment vehicle, you might run into protracted periods where equity investments spin their wheels or worse.

By the same token, you need only look at today's interest rate environment to understand the unrewarding proposition involved in socking your money away in FDIC insured vehicles and A-rated bonds. Still, unless you lived or managed money during the Carter and Reagan years, or are otherwise an economic historian, you may not quite understand how unrewarding risk-free yield has comparatively become.

Today, while investment choices are comparatively plentiful, each granular choice has become more difficult in my view across-the-board. That's especially the case if your personal capital situation forces you to contemplate a more aggressive approach.

Making Better Choices

In the thread of a recent article, a commenter made the point that he believed there to be,

.........a certain "best use of cash" at any given moment.

This is a view that I've always preached and would hope that all DIYers practice. To be certain you are making the soundest near-term decision you can, you need to be evaluating a host of other options around you. While it would be impossible to evaluate everything, acting simply upon Jim Cramer had to say during Mad Money the night before probably isn't prudent either.

In the bond world, for instance, when there is a perception of optimal credit and duration that leads to a favorable risk/reward yield proposition, it is sometimes referred to as the "sweet spot." In practice, however, the sweet spot might lead to liberal interpretation, depending on what one's prime investment focus involves.

If one is convinced that rates will rise and that credit risk is negligible, one would see sweet spot as a 1-year junk bond with ability for rate re-set every year. If one thinks the opposite - that rates will drop and credit risk amongst low quality issues is of grave concern - the sweet spot might be looked at as a long-term lock-in A-rated corporate.

For others who can't afford to make concentrated security bets, don't have inclination to prognosticate, or realize they won't be right with all allocation decisions, convictions might take shape as a compromise position. That might lead one to believe that today's sweet spot is intermediate-term-to-maturity with credit quality in the high junk/low investment grade range (BB/BBB rated S&P bonds).

It might also lead them in the direction of a bond ladder, a somewhat rate agnostic approach that seeks to dampen maturity-to-term risk and keep a supply of periodically maturing money.

More conservative types may see junk-rated debt totally out of the question, consequently seeing investment grade debt, no matter its duration, as the sweet spot.

On the equity side, investor perception of what constitutes the sweet spot will once again rule the day. The same conservative types might include in a portfolio that contains the investment grade and recurring cash flow attributes of a REIT like Realty Income (NYSE:O), consistent dividend culture of Coca-Cola (NYSE:KO), or current gorilla moat of something like Apple (NASDAQ:AAPL).

The goal, while maybe not uniform, may typically skew towards higher dividend (or dividend growth) capture, below-market price volatility and an acceptance of lower total return probability.

For those desiring of greater growth, higher yields, or simply something more aggressive to sink one's teeth into, there will be virtually infinite paths to take. Generally, this will be viewed as higher risk given the unproven business models, competitive vulnerabilities and cash flow risks that are perceived in higher growth or income vehicles.

The middle-risk-ground for the equity-income investor might be evidenced by a preference for broad-based ETF indexes and an acceptance of blended market-return performance. However, without some level of targeted security selection protocol, investors give up the ability to custom-tailor an equity-income solution that best meets their needs.

Further, a broad-based passive portfolio makes no attempt to steer clear of anything. So you'll own the good and the so-so along with the bad and ugly.

Some index proponents argue that the choice is generally very easy. Buy two funds like Vanguard Total World Stock (NYSEARCA:VT) and Vanguard Total Bond Market ETF (NASDAQ:BND) and call it a day. My somewhat unscientific view would probably be that such a portfolio, while perhaps idealistic, isn't and probably shouldn't be, how most investors will choose to manage their money. On the other hand, if you are a fan of a hybrid income/capital drawdown strategy, low cost ETFs may be just what the doctor ordered.

Whatever strategic choices you make, they should be grounded in the variables applicable to yourself and only yourself.

Historical Perspective On Today's Choices

Today's general investing baseline is really the most difficult that I can remember in my almost 25 years of participating in publicly traded markets. We've had countless spells of short- and intermediate-term equity fear and greed since the early 90s, but nothing compared to the seeming absence of "no-brainer" value that has steadily developed both in equities as well as bonds during the post financial crisis years.

In the midst of the infamous multi-year Y2K Internet/tech bubble, where vast fortunes were made (and lost) sometimes in a matter of minutes, risk-free yields were such that hiding out in corporate bonds and even cash was a good idea. It was an even better idea to have held them through the "lost decade" that developed on the recover side of the burst tech bubble.

Although volatile, the 10-year traded above 5% as the bubble started to quickly deflate starting in the year 2000.

And even during the 2007-09 financial crisis panic, the 10-year never broke through 2 percent. About two of the past five years, the 10-year has traded below 2 percent.

In my last article, I commented about a "massive" 50bps move in Treasuries, to which a respondent criticized my "hyperbole." True, half a percent doesn't seem like a whole lot. But consider this, between the summer of 1993 and winter of 1994, the 10-year Treasury advanced more than 250bps, from 5.5% to 8 percent. In real terms, that's about a 45% (250/550) move.

This year, in the post-Brexit quasi buying panic, the 10-year moved from 1.336% to a recent high of 1.879%, a total of 54.3bps, or only about 20% of the real rate move in 1994. However, on a percentage basis at a 1.33% yield start, that equals better than 40% or nearly as much as the infamous 1994 rise.

10-year Treasury yield since 1990

In any case, I think it is important to understand where bonds yields were, where they are now and where you think they may be headed when you plot an income strategy. I say this because equity-income assets, some more than others, will be valued based on what bond traders have to say at any given moment.

Regardless of what that forward view may be, or even if you choose to be agnostic as such, I think the worst thing you can do today is choose to be undiversified or concentrated with equity portfolio positions. Risk is virtually omnipresent, whether you focus more on total returns or on a durable income stream.

Considered Choices To Get To Your Needed Solution

Making wholesale suggestions for income investors is difficult, since there is going to be vast interpretation of what constitutes best choice. I mentioned Realty Income above, which has developed the reputation of being the creme de la creme REIT for conservative investors. It also tends to get picked on for its undeniably high current valuation multiple relative to others in its industry.

As we have seen since Brexit, the stock has lost ground basically in lockstep with bond yields. For the investor with continued hawkish visions on the fixed-income space, this is not a stock you want to be buying right now. If you sit more in the secular dovish camp like me, however, it's a stock that might start to look interesting again should the bond sell-off continue with abandon.

Whatever you might think of the stock, I believe it fair to say that Realty Income is not generally looked at as an aggressive dividend growth idea. However, if you looked at its price chart over the past three years, you'd probably be prone to thinking otherwise.

And, again, what actually might be defined as aggressive might be in the eye of the beholder. The growth & income or total return investor might say a richly valued, low yielding stock with rip-roaring bottom-line and dividend growth rate would define aggression today, say something like Starbucks (NASDAQ:SBUX) or Visa (NYSE:V).

A highly leveraged mortgage REIT spread vehicle trading at a discount to NAV, like Annaly (NYSE:NLY) or middle market lenders like Prospect Capital (NASDAQ:PSEC) and Main Street (NYSE:MAIN), might be viewed as consummate aggressive income plays.

The somewhat rhetorical question I ask is whether it is really riskier (on a total return level) to pay a market discount to own something providing high realized cash flow from a less tested source, versus paying a market premium to own something possessing a historically durable cash flow source? The answer probably varies from investor to investor and with the specific securities involved in the comparison. Ultimately, however, you'll only know in hindsight whether a perceived risk-on position pans out or not.

The unfortunate paradox here is that the investor who most needs to take investment risk is the one that can least afford to shoulder negative outcomes associated with actual elevated risk-taking. Sort of akin to the notion that banks are least inclined to loan money at favorable rates, if at all, to those that need to borrow the most.

The choices for someone in that situation are numerous, but probably not too appealing. A mix of high-yield plays and capital drawdown may be considered, but if the high-yield bet does not pan out, capital drawdown may ultimately have to be accelerated. This would only worsen an already difficult situation.

Strategy Session

My somewhat broken record advise continues to advocate caution, diversification and a dollar cost average approach. Now is not the time to be making huge bets or concentrate price volatile positions. With the market seemingly going through a risk-off income space correction right now after a big early-year run, we've got pre- and post-election volatility/uncertainty and tax loss selling to deal with through the year's final holiday-dominated days.

To accumulators though, volatility should be seen as an opportunity to buy quality and even elevated-risk income-equity, on the cheap. In terms of actual allocation. I have no personal aversion to high-yield investing, although, again, one has to look long and hard in the mirror when they consider allocating in meaningful fashion to those kinds of stocks.

In terms of actual stocks, I continue to recommend B&G Foods (NYSE:BGS), which got hit recently on a less than stellar quarter and outlook than what investors have come to expect. Restaurants on a wholesale level appear to be having problems which might suggest that packaged food purveyors are a decent place to be right now. On that same line, I'd look at Kroger (NYSE:KR), although I suspect tax loss selling might provide lower entry opportunity, given the tremendous overhead supply.

The announced DOJ investigation into generic drug price collusion hit that group very hard yesterday. Although I've been somewhat negative on drug/biotech companies for some time now, the drop in Teva (NYSE:TEVA), along with widespread weakness amongst marquee drug makers should be looked at closely by value seekers.

Elsewhere in drugs, Bristol-Myers (NYSE:BMY), Gilead (NASDAQ:GILD), Amgen (NASDAQ:AMGN) and Pfizer (NYSE:PFE) all look interesting. However, clearly, the likely Clinton Presidency and again tax loss selling could cause further near-term price deterioration. While she alone cannot dismantle the pharmaceutical space, the relative failure of Obamacare and generally runaway costs in the healthcare space, all combined, should give investors pause. I'd argue that inept Washington lawmakers will be so gridlocked, however, that reform, whatever shape it might take, won't come for a long time.

Even better at this point would be healthcare real estate owners. Opportunity is knocking for the big landlords like Welltower (HCN) and Ventas (NYSE:VTR). I also like the private pay aspect inherent in senior ALF/ILF player New Senior (NYSE:SNR) despite its leveraged balance sheet. The covered yield has increased to a whopping 11.5% once again. I sold into the early year rally, but am buying once again.

Despite the balance sheet risk, I'd prefer New Senior over the government reimbursement risk that faces skilled nursing owners like Omega (NYSE:OHI) and Sabra (NASDAQ:SBRA), despite their also growing yields.

REITs as a whole are starting to look somewhat interesting, but you must have a dovish rate outlook to even tippy toe in here. STORE Capital (NYSE:STOR) would be my favored NNN position as an aggressive alternative to Realty Income. A little bit more off the beaten path would be Hudson Pacific Properties (NYSE:HPP), a West coast owner of A-class office space. Back to high-yield, Apollo Commercial Real Estate Finance (NYSE:ARI), a secured lender, is a long-time favorite of mine.

I continue to like the aircraft leasing companies. There you can opt for Aircastle (NYSE:AYR), which is a slower growing 5% yield play, or you can pick the faster grower, Air Lease (NYSE:AL), which only yields a little better than 50bps. Air Lease's plane portfolio is virtually unencumbered, with the right side of the balance sheet dominated by more attractive unsecured debt.

Sticking in the aviation world, while Boeing (NYSE:BA) is a good long-term hold, I'd not recommend buying right now after the last up-leg. Instead, I'm recommending Embraer (NYSE:ERJ), the Brazilian manufacturer, which has been pummeled this year. The company is coming out with a new generation of single-aisle medium-haul jets and has a strong customer niche. Despite a strong bounce already off 52-week lows, I think this stock goes higher.


The uncertainty and low risk-free investment yields with which we live today makes the fortunate abundance of income investment choices somewhat, well, unfortunate compared to times past. If your capital situation is less than ideal, you need to think long and hard about the amount of perceived risk you are willing to take in order to get to a place you want, or need to be.

Risk/return assessment is not an exact science, however. With so many factors out of an investor's control, it might be easy to convince yourself that you are taking less risk than what you really are. And that, my friends, could be a disastrous determination to make after it is too late to do anything about it....

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Disclosure: I am/we are long AAPL,AL,AYR,ARI,BA,BGS,ERJ,HCN,HPP,KR,MAIN,PFE,SBRA,SNR,STOR. 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.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.