'Savvy Senior' Update: A Few Tweaks But Still 'Like Watching Paint Dry'

by: Steven Bavaria

Income investing (my "income factory" approach) is all about patiently compounding your high yielding investments, so you get an "equity return" whether you own equity or not.

It works well - a 15% return so far this year - but it's about as exciting as "watching paint dry".

As funds' market values have risen, yields and discounts have dropped, so I have searched for funds with better yield and discount opportunities.

Here are the portfolio "tweaks" we have made so far this quarter.

Some readers have asked me to update them in between my quarterly reports about tweaks to the portfolio, so here goes. For the benefit of new readers or those with poor memories, I will briefly summarize my basic investment philosophy. Others should feel free to skip this part and go right to the "tweaks" down below.

My basic strategy has not changed and can be summed up in a few simple principles:

1. Rely on high yielding asset classes plus compounding to provide "growth" in the portfolio, rather than counting on the individual securities themselves to have to grow in market value in order for my portfolio to grow. In other words, a portfolio of 10% yielding closed end funds that NEVER grow their market value or their distribution will compound and double in value every 7.2 years in exactly the same way as a portfolio of stocks that also has a total return of 10%, but yields just 2% and grows at an 8% annual rate. (Which makes my investment approach just as relevant to a 25 year old that is just starting out and looking for lifetime growth as it is to a 70 year old in retirement.)

2. Don't worry much about how the market values my portfolio from day to day or week to week, and focus my attention on maintaining and growing the cash income flow. In other words think of the portfolio as an "income factory" whose book value or current value is far less important than its ability to keep producing output (i.e. cash distributions, which are plowed back into "expanding the factory.")

3. Just because we want to achieve "equity returns" (plus/minus 10% on average year after year) that doesn't mean we have to actually own equity (i.e. stocks). I particularly like earning equity returns in the credit markets, via closed end senior loan and high yield bond funds, where you are paid equity-like returns if the companies merely stay in business and pay their debts, even if the firms don't perform well enough to reward their stockholders, or even if they do if the stock markets don't fully recognize the performance. I call investing in credit markets rather than in stock markets "betting on horses to finish the race, rather than betting on them to win, place or show."

I execute this strategy as follows:

1. Buy mostly high-yielding closed end funds of the "defensive" or "credit" variety. "Defensive" meaning equity funds whose cash flow rather than potential market growth provides the portfolio growth I'm looking for, like utilities, infrastructure, MLPs, BDCs, etc. "Credit" including high yield bonds, senior floating rate corporate loans, collateralized loan obligations ("CLOs"), or other credit instruments. I may occasionally buy ETFs or ETNs that fit my overall risk/reward profile.

2. Monitor my holdings for opportunities to trade out of funds that rise to a point where their yields have fallen and discounts have narrowed, with an eye to rotating into others with higher yields and discounts. Typically when I rotate out of a fund it is not because of any dissatisfaction with that holding. Often quite the contrary, it is because the fund has appreciated to the point where it no longer yields as much as alternatives. Generally the discount has eroded too, which means I am no longer getting the "free ride" that a more heavily discounted fund provides, where you get the benefit from receiving the income from 100 cents worth of assets, but you only have 90 cents at risk to earn that income. Once the discount decreases or reaches par, you are no longer getting that "free ride." At that point I typically look around for alternative funds that still offer a discount, so I can once again enjoy the free ride. Over time, being able to earn an additional 5 or 10 percent of income above and beyond what you've paid for the asset makes a big difference.

3. I also like funds that are leveraged a bit. Closed end funds by law (The Investment Company Act of 1940) are quite limited in how much they can leverage themselves (1/3rd of total assets for debt leverage; ½ of total assets for preferred stock). Leverage at institutional (i.e. low) interest rates of 1 or 2% in recent years has been one of the few ways that ordinary retail investors have been able to benefit (just like the big banks) from the Fed's low interest rate policy of recent years. If a fund buys HY bonds or loans yielding 6 or 7%, and can buy additional ones (over and above what it can buy if it only has its unlevered capital) by leveraging at, say, 2%, the spread between the 2% borrowing and the 6 or 7% asset yield of 4 or 5%, goes right into the pockets of shareholders. That's why closed end funds can pay out 8 or 9% yields holding assets that only yield 6 or 7%. A traditional open-end fund or ETF, without the benefit of leverage, would only yield 6 or 7%.

So that's it in a nutshell. I have a portfolio virtually all of which consists of closed end funds, with an overall portfolio yield currently of 10.6%. The total return through June 12th has been 15% (cash income plus market appreciation), with which of course I'm very happy.

The entire portfolio and my view of the market back in April is available here.

Since then I have tweaked it slightly, with major increases and decreases as follows (The updated portfolio is at the end of this article):

· I sold off most of my position in Cohen & Steers Closed End Opportunity Fund (NYSE:FOF). This has been a great investment and I still highly recommend this fund and also own it in several other family and close friend portfolios that I manage. But it has appreciated a lot from when I bought it, and its 8.1% yield, while still attractive, is below my weighted average yield and therefore below other "approved list" alternatives on my radar scope. (It's discount has also risen to just under 7%, which is attractive but below the discount one could get a year or so ago.

· I sold off my Pimco Dynamic credit and Mortgage income Fund (NYSE:PCI), again not because of any dissatisfaction with the fund, but because it has done so well that its yield has dropped and its discount had almost disappeared. So I happily took my capital gain and reinvested in funds closer to my current target yield.

· I sold off my Nextpoint Credit Strategies Fund (NYSE:NHF). I couldn't figure out what to do with the rights offering, or what impact the offering would have on the longer term price of the stock. So I sold my holding off at a price of about 22.5, after the ex-dividend date so I collected that month's dividend, and then distributed the proceeds among a variety of existing holdings that all yielded as much or more than NHF's generous 11% distribution. The impact of rights offerings in general in the closed end fund market, given its relatively small size, illiquidity and lack of both efficiency and transparency, make predicting or arbitraging rights offers more difficult than would be the case in larger markets. NHF's current price is about 21.5, so I am not unhappy with my decision to sell at a dollar higher (but it was luck, not smarts, that it turned out that way.)

· I sold a small portion of my LMP Capital & Income Fund (NYSE:SCD). This is a truly great investment that has paid a nice dividend and appreciated about 17% from when I started accumulating it. But I decided to lighten up and, again, put some of the money to work at closer to 10%, rather than the 8.7% that SCD currently yields. (Which is not bad at all, obviously, and at a discount over 9%, makes this a fine investment for anyone looking for good income and value in the current market.)

So where did I put this money to work?

· Fiduciary Claymore MLP Opportunity Fund (NYSE:FMO) has the highest yield (12%) of any of the MLP funds and still sells virtually at par (unusual in that sector for the higher yielding funds), and made it through the energy crash of a couple years ago without dropping its distribution (somewhat unusual). I think it makes sense to include a modest piece of the MLP sector in my portfolio for the long-term, especially having shown its resiliency through that crash. Besides FMO, I have also been adding Kayne Anderson (NYSE:KYN) over the past couple quarters. It's now at a premium so I won't be adding more for awhile, but its 11.3% yield is attractive.

· Brookfield Real Assets Income Funds (NYSE:RA), a solid income investment (loans and bonds, primarily) focusing on the debt of infrastructure, utilities, real estate and other "real" assets. Brookfield is a solid Canadian investment firm whose roots go back over 100 years. Pays a 10% dividend and sells at a 7.5% discount.

· I added some of my new money (i.e. dividends received and compounded) to my Rivernorth Opportunity Fund (NYSE:RIV) position. Although the yield is only 8.3% and discount just under 4%, the fund has also paid some large special dividends in recent years, so the 8.3% may turn out to be an understatement. Either way, the fund has performed well for me so far (some capital appreciation in addition to the cash distributions) and I like the concept of fund-of-funds generally because you get the advantage of "discounts on discounts" (see article on this topic about FOF) and expect RIV's management may be a bit more aggressive and opportunistic than FOF.

· I added some more UBS ETRACS Leveraged REIT (NYSEARCA:MORL). With a yield of just over 20%. It's relatively modest position and I don't own any other mortgage REIT exposure, so it seems reasonable and you are well paid for the risk. The security is well covered on Seeking Alpha by Lance Brofman primarily and occasionally others.

· I also added a bit more Oxford Lane Credit Corp. (NASDAQ:OXLC). As mentioned in past articles, OXLC's management seems to have learned from its past mistake in loading up with too much leverage and then having to scramble to get back in compliance. Now they have a dividend that, while still generous at 14.7%, is less of a stretch and can always be topped up with a special dividend when and if their cash flow allows. That's better than promising more than they can deliver and having to pull back.

· Those are the main tweaks, although I added marginally to existing positions in Guggenheim Enhanced Equity Income (NYSE:GPM) - 11.4% yield, 5% discount; ETFIS InfraCap MLP ETF (NYSEARCA:AMZA) - 15% yield; and Avenue Income Credit Strategies (NYSE:ACP) - 10.2% yield, 7.5% discount.

Overall I see no reason to run for the sidelines to protect capital or prepare for a downturn, as some writers have been suggesting. That is in part because I believe having a 10% yielding portfolio changes the risk/reward outlook considerably when you begin thinking about how or whether to hedge your bets for downturns that may or may not occur. (See my article about this, entitled "It Don't Worry Me")

In a nutshell, if you have a portfolio that yields you 10%, then your opportunity cost of moving cash to the sidelines (i.e. the cost of "shorting" your own portfolio) is 10% per annum. That's the income you give up if you sell in anticipation of a market drop. If, on the other hand, you are a "dividend growth" investor that only makes 2 or 3% yields on your portfolio and has to rely upon 7 or 8% market growth to get your 10% overall total return, then (1) you have a lot more to lose if the market drops than I do, because I'm continuing to make my 10% cash return all through the drop, cushioning its impact, and (2) your opportunity cost of moving to the sidelines (i.e. your cost of shorting your portfolio) is only 2 or 3% out of pocket cash cost, versus my opportunity cost of 10%.

That suggests to me that it is actually more rational (and perhaps necessary) for a dividend growth investor to move to the sidelines and batten down the hatches if they see (or fear) a market drop coming, than it is for an "income factory" or compound-your-own-growth investor like me to do so. They also have a greater risk of missing the train if the market continues to move up and decides not to crash or drop at all.

Hence my intention to stay fully invested in my high yielding portfolio, and continue to see market drops as opportunities to increase the compounded growth rate, although I will do some shifting from one fund or asset to another to take advantages of market inconsistencies in yield and discount.

As always, thanks to all my readers and commenters for your insights and encouragement.

Savvy Senior Portfolio June 11/2017 Symbol This Holding As % of Portfolio Income This Holding % of Portfolio Income 2 Months Ago Increase or Decrease as % of Portfolio income
Eagle Point Credit Co. ECC 11.70% 11.85% -0.15%
Oxford Lane Capital OXLC 7.61% 6.34% 1.27%
Calamos Global Dynamic Income Fund CHW 5.99% 6.07% -0.08%
First Trust Specialty Financial Oppty Fund FGB 5.43% 5.49% -0.07%
Guggenheim Enhanced Equity Income GPM 5.23% 4.71% 0.52%
Voya Global Equity Dividend IGD 5.10% 4.96% 0.13%
MFS Intermediate High Income CIF 4.64% 4.70% -0.06%
LMP Capital & Income SCD 4.43% 5.19% -0.76%
ETFIS InfraCap MLP ETF AMZA 3.93% 3.36% 0.57%
Miller/Howard High Income HIE 3.69% 3.66% 0.03%
Eaton Vance Tax Mgd Global Div Inc Fund EXG 3.65% 3.70% -0.05%
Kayne Anderson MLP Inv Co KYN 3.55% 2.50% 1.05%
UBS ETRACS Leveraged REIT MORL 3.33% 1.59% 1.74%
Pimco Income Strategy Fund PFL 2.94% 2.97% -0.04%
Fiduciary Claymore MLP Oppty FMO 2.85% 2.85%
Allianz Convertible & Income II NCZ 2.79% 2.82% -0.04%
Rivernorth CEF Opportunities Fund RIV 2.56% 1.40% 1.16%
Macquarie/First Trust Global Infra Fund MFD 2.50% 2.19% 0.30%
Avenue Income Credit Strategies ACP 2.49% 1.90% 0.58%
Allianz Convertible & income NCV 2.42% 2.45% -0.03%
Eaton Vance Risk Mgd Div Equity Fd ETJ 1.91% 1.94% -0.02%
Pimco Income Strategy Fund II PFN 1.76% 1.78% -0.02%
Brookfield Real Assets Income Fund RA 1.66% 1.66%
Eaton Vance Managed Div Equity Fd ETY 1.64% 1.67% -0.02%
Calamos Conv Oppty & Income CHI 1.44% 1.46% -0.02%
Allianz Diversified Inc. & Conv. Fund ACV 1.31% 1.33% -0.02%
Calamos Conv & High Income CHY 1.26% 1.27% -0.02%
Cohen & Steers CEF Oppty Fund FOF 1.17% 4.15% -2.98%
Zweig Fund ZF 1.01% 1.39% -0.37%
Nextpoint Credit Strategies Fund NHF 0.00% 2.56% -2.56%
Pimco Dynamic Credit Income Fund PCI 0.00% 4.59% -4.59%

Disclosure: I am/we are long SCD, FOF, AMZA, MORL, OXLC, PCI, NHF, FMO, , RIV, KYN, RA, GPM, ACP. 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.