High-Yield Investing: Price Is An Illusion Of Confusion (BDCs And mREITs)

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Includes: ARCC, NLY
by: High Yield Investor

Summary

A 10 year look-back between a BDC and mREIT including the last recession.

For high-yield RIC (Regulated Investment Companies); price is an illusion of performance and High-Income is the reality.

Chart comparison between BDC, mREIT and the S&P500 ETF total return.

Introduction

What would you do if an investment you purchased ten years ago is priced 12% to 14% lower today? The emotional justification for taking a loss based on price alone could be very costly. I read this all the time with investors’ claiming they have heavy losses in their BDC or mREIT stocks as they expound their terrible investments. What if I told you for a high yield RIC investment a price lower than purchase price was a blessing, while plowing dividends back into the same asset?

I’ve been building my portfolio and reinvesting all dividends to increase income producing shares over the past four years. My investment method is to grow my income stream despite how the market will perform in the future. Sometimes I over pay and sometimes I under pay, but always know it will generate between 8 to 12% yield. My last quarterly report illustrates my previous investments, with some changes going into the end of the year. I’m new to high yield investing with only 4 years under my belt, but know how important income cash flow in retirement becomes when replacing a paycheck. I retired a few months ago taking distributions and reinvest the surplus to grow the income cash flow.

High-Yield RIC investments avoid the double taxation from the company itself and the investor. It is designed as a pass-through entity to distribute earnings to the investor and the investor pays tax as ordinary income, (best held in an IRA or ROTH). This provides a higher percentage of the earnings to pass-through directly to the investor. This unique SEC provision qualifies companies being registered as an investment company Act of 1940 to become a RIC.

For the high yield RIC investor, having the price of a stock flat to down is the best outcome to achieving high yield income growth. More shares are purchased as the price of quality stocks move lower. RIC investments must payout 90% of their earnings as dividends and allow the investor to determine how they want their cash to be deployed.

The two stocks I’m showing in Chart-1 is an example of my investment method that should generate income during a bull and bear market. I have them both in my portfolio along with others for income diversification. I published an article that demonstrates my decision to choose the high yield method over the typical dividend growth method.

The following Chart-1 displays one BDC and one mREIT that have outperform the S&P500 on a total return basis. Both investments have been around for over 10 years and demonstrate what I might expect during the next recession. They represent my portfolio design in the simplest terms.

Price and Total Return performance

The following chart displays three investments;

  • One business development company, Ares Capital (ARCC)
  • One mortgage real estate trust, Annaly Capital Management (NLY)
  • And the S&P500 ETF (SPY) for reference.

I started the chart January first 2007 since this was the start of a new year and before the S&P500 reached a new market high October 9, 2007. I wanted to capture a period of time before the financial recession to show how price acted from the market low, March 9th 2009. I added notes to the chart to indicate how low the price was at the bottom of the recession for both RIC stocks; “NLY flat” and “ARCC declined > 75%”.

Chart-1

I added some notes to the right of the chart to indicate which chart line belongs to each stock. From the start of January 2007 through October 20, 2017 we see the dividends were the driving force behind both RIC stocks, NLY and ARCC. For the entire range NLY price change at -12% and ARCC at -14%.

This is what I want to get across with RIC type of investments that are required to payout 90% of their earnings as dividends. Price of the stock is not the qualifying factor in these types of investments, but the massive dividend payout. If the dividends are reinvested back into the same stocks you can see the explosive Total-Return growth for NLY being 223% and ARCC being 194% blowing away the S&P500 at 127%.

The red circle “Breakout Jan 2016” is when both BDCs and mREITs took off well before the presidential election and indicate a shift toward high yield investments.

Dividend Percent Change

Now lets just look at the dividends. Chart-2 displays quarterly dividends and Table-1 shows actual dividend values.

Chart-2

With the massive price reduction of ARCC stock shown in Chart-1, continued to payout reasonable dividends, see Chart-2. The orange line dip for NLY after 2016 on the chart was after they acquired another company and had two dividend payments, the first was 4 cents and the second 26 cents that equaled 30 cents quarterly distribution. In effect the dividend stayed the same from 2014 to the current date.

Yearly Dividend Performance

The dividend Table-1 with the colored cells was created by Joe HYI from the Portfolio Online Tracker. The table tabulates the yearly dividends from 2007 to 2016. I wanted to show how during a recession it's possible to have increasing dividends from agency mREITs, because they are government backed investments. The BDCs will naturally decline because company loans are being placed on non-accrual and may begin to default. Both stocks will adjust their dividends according to economic conditions and is natural and expected since they must payout 90% of their earnings.

Table-1

The color change from green to red indicates the dividend has been reduced, and going from red to green indicates the dividend increase or stayed the same.

The “Total” row is just the accumulation of dividends from both companies assuming a single share purchased in 2007.

The “Diff” row is the difference from the “Total” 2007 starting value of $2.63. It shows how achieving $2.63 in dividends the first year has increased each of the following 10 years from 2008 to 2016. This is the surplus dividends from the starting value as of 2007. The current 2017 year the dividends continue to be the same as 2016.

There is something interesting I want to point out in Table-1. Notice from years 2008 to 2010 how NLY had increasing dividends, green cells and ARCC had declining dividends, red cells. From 2011 to 2014 the opposite played out, NLY had declining dividends, red cells and ARCC had increasing dividends, green cells.

This is the whole point for my investment method to generate income cash flow despite the direction of the market. The dividends should be negatively correlated to provide income during both market cycles. This may not be the case during the next recession, but the probability is high. Time will tell if this correlation will continue.

Conclusion

The future direction of the market is unknown and any back testing is not guaranteed. All we can do is build a portfolio for the increased probability of success during any market direction.

Looking at any investment method short term may discourage and give doubt to an investor, but changing its original intent will skew their results. It is the emotional behavior of our own memory patterns that needs to be rewired. As I said in my title "Price Is An Illusion of Confusion" for RIC investments because they are income machines only and not for price appreciation.

RIC investments play by a different set of rules not based on capital appreciation or total return, but by the massive income generated. Receiving the dividends upfront provide a margin of safety that will allow distributions to pay expenses during retirement. Taking 50 to 60% of the dividend income from your portfolio and reinvesting the surplus will grow your portfolio well into the future and remove the possibility of selling shares for income.

Chart-1 illustrates what could happen if the dividends were reinvested back into their own stock over the past 10 years. The majority of the return is from the dividends and not price appreciation. You’re getting your cash upfront for holding the RIC investment and not being dependent on price manipulation cause by fear and greed.

Investment Disclaimer

Please note the stocks included in the 50/50 portfolio are not recommendations. They were personally selected by the author and contain a great deal of investment risk. The stocks in the portfolio are Business Development Companies [BDCs] and mortgage Real Estate Investment Trusts [mREITs]. Both investment vehicles are Regulated Investment Companies [RICs] and are required to distribute at least 90 percent of taxable income as dividends to investors.

This is a live active IRA portfolio that I believe will withstand the markets' bull and bear movements based on my own research. The progress will be updated and tracked for feasibility of this investment method over the years. The article titled 50/50 Portfolio (BDCs And mREITs) Baseline 2014 details how the portfolio was constructed. It must be noted that investment selections are dynamic and based on management's ability to navigate economic conditions. I have made changes during the years as any portfolio manager is expected to perform.

Disclosure: I am/we are long NLY, ARCC.

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.