It's hard to find much of anything too exciting to say about the second quarter that we just completed. Like a football team with a strong "ground game," we continued to grind out the yardage with a cash distribution yield slightly over 12% that we can re-invest and compound, growing the income factory output and building cash generation capacity for the future. Meanwhile total return moved into the plus column, with a 4.1% total return for the year through July 10, versus a -2.8% return through the end of the first quarter.
Let's review what that means. In the first quarter we had cash distributions of 3%, but an overall total return of -2.8%. While we collected cash at an annual rate of 12% (i.e. 4 times 3% to annualize the rate), a market value drop (i.e. paper loss of portfolio value) of -5.8% netted out to a total return loss of -2.8%. (i.e. 3% minus 5.8% = -2.8%.) The income factory still had 3% cash to re-invest and buy more cash generating "machines" to increase its future cash output, but the market value of the factory itself was down by 5.8%. Of course, with the reinvested 3% cash income, the owner of the factory had a higher current cash income than ever. So from an economic perspective (i.e. what it produces) our factory was more valuable to us than ever.
In the second quarter, we continued to collect cash income at a 3% per quarter (12% per annum) rate, but the market appreciated enough during the quarter (actually a quarter plus ten days, since I've "closed the books" for this article on July 10 to incorporate any trades made in the last week) that the total return has switched around to a positive 4.1% from the negative -2.8% in the first quarter. That means for the year ended July 10 we collected cash distributions of 6.2%, offset by capital depreciation of -2.1% (an improvement from the -5.8% for 1st quarter), to give us our positive total return of 4.1%.
As we have discussed many times over the years, it's the cash return that gets reinvested and compounded, growing our Income Factory output at a "Rule of 72" rate. (In this case 72 divided by 12% = 6, so the income would double every 6 years if the yield stayed as high as 12%, which I do not expect. But even 9 or 10%, a doubling in income every 7 or 8 years, would be attractive, steady growth as far as I am concerned.)
Our asset allocation hasn't changed much since April. High Yield is up by 4%, the biggest change, as a number of the new funds I've added are in the general high yield category, as we will discuss in a moment. That 4% increase, plus a 1% increase in the MLP category, was "sourced" from small reductions in each of the CLO, HY/Convertible and Equity categories. (Some of the increase/decrease by category doesn't add up precisely, due to rounding.)
Challenges and Choices
My biggest challenge right now is to decide whether to "stay the course" with a number of funds that have treated me very well over the years, but now may be expensive by some measures (especially price premium) but are still churning out attractive distributions. The problem is intensified by the fact that many of the potential replacement funds may present better value and a margin of safety from the standpoint of price discount, but don't pay as high a distribution yield.
Some of the "target" funds for possible replacement are:
- Pimco High Income Fund (PHK), which I bought about six months ago when its premium was a fraction of what it currently is. Its distribution is still an impressive 11% and may continue indefinitely (it is PIMCO, after all, who seem to have a special magic in running income funds), but I don't want to tempt fate, so I think I'll take my 15% six-month capital gain and find another yield in the 10-11% range that sells at or close to a discount and presents a better risk/reward profile. (Remember with a 32% premium, the underlying net assets within PHK's portfolio have to earn closer to 15% - with all the risks that entails - in order to pay investors an 11.2% distribution.)
- Allianz Convertible & Income Fund and Allianz Convertible & Income Fund II (NCV and NCZ), which present a harder call than PHK, because while I have 30% and 25% market gains on each of them, respectively, their premiums are not nearly so out of line - either in absolute terms or relative to what they have been historically. So I do not feel as trigger happy about trading out of either of them as I do about PHK, which is why I have taken my holding of PHK down a bit and may do more, but haven't touched either NCV or NCZ as yet (and may not.)
- Other obvious candidates are the two Calamos funds - Convertible & High Income (CHY) and Convertible Opportunity & Income (CHI) - which have performed brilliantly but are now less attractive because of their premium prices. I sold my CHY (now at a 9% price premium) already and are looking at CHI (5.6% premium), as an opportunity to take my 15% profit. Perhaps replace with Advent Claymore Convertible & Income (AVK); 9% distribution, -10.7% discount, recently increased distribution, a positive sign that somewhat offsets its relatively large negative UNII.
- Rivernorth Opportunities Fund (RIV) is also a candidate for re-consideration, although I am on the fence about whether to do anything with it. I reduced it slightly but have no current plans to do so further. Its distribution of 12% is attractive and its premium of 9%, while not ideal, is probably offset somewhat by the fact that the fund itself holds many other closed end funds that it probably purchased at discounts, so the discounts on its holdings may offset, at least in part, its own premium. Plus I think its manager, Patrick Galley, probably knows the closed end fund world as well as anyone, so if you are committed to CEFs, holding a piece of his fund makes sense. It pays a distribution 50% higher than its main competitor, Cohen & Steers Closed End Opportunity Fund (FOF), which I also like (8% yield; - 4% discount), so it's worth taking a somewhat greater risk for that. What's the worst that will happen? It drops its distribution at some point to a level closer to FOF's. In the meantime, the extra yield helps to offset any short-term pain from the price adjustment that would likely accompany a drop in dividend.
Here are some possible replacement candidates. In many cases they represent a step down in yield, so you are paying a price to get the additional risk/reward "safety" that a higher discount or lower premium may represent.
- Black Rock Multi-Sector Income Fund (BIT), solid long-term record, good dividend coverage and performance; 8.1% yield, -8.5% discount. I added some recently.
- KKR Income Opportunity Fund (KIO), good performance and dividend coverage; solid management; 9% yield, -4% discount. I have been adding regularly.
- Barings Global Short Duration High Yield Fund (BGH), with 9.5% distribution (recently dropped slightly and well-covered), -8.9% discount, good record and management; one of my favorite recent additions.
- Aberdeen Income Credit Strategies (ACP) has a well-covered 10.4% yield and a -7.2% discount; I will probably add to my current position.
- A number of excellent funds are still attractively priced and worth adding to portfolios that own little or none of them, although I already own plenty of them and am not currently increasing my own positions. These include First Trust Financial Opportunity (FGB) with 11.4% yield and -0.2% discount; Brookfield Real Assets (RA) with 10.4% yield and -5.7% discount; Miller Howard High Income (HIE) with its 11.3% yield (watch it and try to buy when its premium, currently a modest 2%, drops closer to zero); Nexpoint Credit Strategy (NHF) with a 10.7% yield and -9.5% discount, which has performed very well (i.e. held its price) since the recent rights offering; Clough Global Opportunities Fund (GLO), with a 10.8% yield and -8.6% discount, is a favorite holding of Rivernorth Opportunities Fund (NYSE:RIV), which owns over 1% of its shares and whose management company has reported owning as much as 8% of GLO; Neuberger Berman Real Estate (NRO) is an attractive vehicle for investing in the REIT market, with an 11.4% distribution and -4.62% discount; also let me mention Reaves Utility Income Fund (UTG), which I do not own in my Savvy Senior Income Factory, but hold in some family and friend accounts; at close to a 7% yield and -8.7% discount, this long-term "buy it and put it under your pillow" fund is at a great entry price for those looking for a solid almost 7% yielding fund. Unlike my strategy of buying high-yielding funds and holding them without expectation of the yield ever increasing, UTG does actually grow its yield over time. (In other words, a superstar fund that both DGI and Income Factory investors would love.)
- The MLP sector has disappointed on the price front but continues to deliver on the cash distribution side. ETFIS InfraCap MLP ETF (AMZA) cranks out its 21% distribution every month, slowly but relentlessly closing the "paper loss" gap represented by the difference between what I paid for it and its current price. A few more months distribution payments and I will be back in the black, so to speak, with accumulated distributions exceeding my original investment, at which point the ongoing compounding of the 21% payout will represent a significant continuing net increase in the capacity of the income factory (even if it ends up dropping to the mid-teens or whatever is sustainable for the longer term.)
- If you agree with many of those who follow the MLP sector, like Hinds Howard here on SA, the MPL sector is not going away and will eventually settle down to the perhaps boring but steady cash-flow generator it has been in the past. I am continuing to bet on that and am willing to hold a portion (currently 14%) of my portfolio in MLP funds (plus AMZA, an ETF) that are managed by professionals hopefully capable of discriminating between the strong and the weak players. For those who are not yet in the sector and want to be, my current holdings are probably good candidates. They include Duff & Phelps Select Energy MLP (DSE), 10.7% payout, -5.1% discount; Clearbridge Energy MLP Opportunity (EMO), 11.6% payout, -5.5% discount; and Fiduciary Claymore MLP Opportunity (FMO), 11% payout and -4.4% discount. I hold these already and they are all underwater in terms of what I paid for them. But like AMZA, with every distribution payment they are bailing out the boat and within a few months will have returned me more than what I paid for them. Therefore I see no point in selling them unless I think their payouts are in jeopardy, which I have no reason to think at present.
- Which is not to say that there won't be occasional distribution cuts - in MLPs and in other funds as well - but I think they are manageable with appropriate diversification and a certain amount of vigilance (See recent article on this topic).
- Other funds I do not own but am actively looking at currently include Cohen & Steers Infrastructure Fund (UTF), 7.8% payout and -5.6% discount; Cohen & Steers REIT & Preferred Income (RNP), 7.6% payout and -10.9% discount, and Cushing Renaissance Fund (SZC), 8.9% payout and -8.6% discount.
- Finally i am still quite happy with my CLO funds, Eagle Point Credit (ECC) and Oxford Lane Capital (OXLC). Both funds have high risk/high reward investment profiles, with a fair amount of complexity that the average investor (even those of us who know a bit about CLOs and leveraged loans) can have trouble understanding. I like the management of both funds and am comfortable with the risks, but you need to watch them like a hawk, especially as credit market conditions can change quickly.
As mentioned earlier, it is hard to decide whether to trade out of a less attractively priced (i.e. higher premium) fund that still pays a high yield, and to replace it with a more attractively priced but lower yielding fund. The lower yielding funds may have more "staying power" in terms of holding their distribution yield where the premium priced funds may be under more pressure to drop their yields which may in turn cause a drop in price. But sometimes funds maintain a yield that may seem "too high" for a long time and if you bail out too soon you leave money on the table.
By moving new money into lower yielding funds I would reduce my average portfolio yield, but may strengthen the base by making it less dependent on the "higher flyers." I would still be growing the income stream (factory output) by compounding, but at a slightly lower growth rate. So it's a trade-off between (1) stability (if the lower yielding funds actually turn out to be more stable) and (2) higher yields and faster factory output growth.
As I noted in my recent article on dividend cuts, it is hard to predict which funds will cut and which ones won't, so I need to be really diversified so random cuts to distributions do not impact my overall yield or rate of compounding too much. If we hit a major recession and/or market downturn where cuts are so rampant that they hurt my income stream in a substantial way (25-30% or so), then I'll have the "comfort" of knowing that other market strategies (DGI, etc.) are probably being hit even harder.
A recent article here on Seeking Alpha raised questions about whether my investment strategies and security picks could have actually generated the returns that I claimed they did in my articles over the years. At first I admit to having been a bit annoyed that someone would question the facts I had reported about my own portfolio performance, feeling like Columbus might have if, upon disembarking in the West Indies, someone had presented a "model" to him proving that he could not have crossed the Atlantic in his three wooden ships. (Let me hasten to add that I am not in any way suggesting any personal similarity to Columbus or to his achievements, other than our sharing a common Italian heritage.)
But the spirited discussion this article precipitated made me realize that perhaps what is obvious to me is less so to other readers, so let me explain simply and clearly how we calculate our investment results.
Like most investment professionals, I compute total return on a regular basis, and I calculate it exactly how any other investment professional would. Total return, of course, includes the change in value of one's investment portfolio from all sources - cash dividends and other distributions received, plus the impact of any appreciation or depreciation in market value. In a closed investment vehicle like an IRA that has no funds flowing into or out of it during the year except for internally generated dividends and distributions, which stay in it and are reinvested, (which has been the case with my Savvy Senior portfolio during most of the past 25 years that I have been tracking it), calculating total return is easy. It is the ending market value of the portfolio minus the beginning market value of the portfolio.
That difference - how much the value changed during the year - is the sum of all dividends and distributions collected plus the effect of market changes - up and down - of the assets in the portfolio (including any new assets acquired by re-investing the dividends and distributions). For example, suppose you start with a portfolio valued at $100 and at the end of the year the portfolio is worth $110. The difference between the starting and ending values is $10, which represents the total return. As a percentage it is $10 divided by the starting value of $100, or 10%.
That is how I calculate my total return, by comparing the beginning and ending value of my IRA accounts and calculating the total return just as I would if it were a pension, endowment or mutual fund. With any portfolio, including mine, you have to adjust the total return for any external flows into or out of the portfolio. In our example above, if you removed $5 from the portfolio during the year, so your ending value had $5 less in it, not because of any investment activity, then you would have to add that $5 back for purposes of calculating the total return for the year. Similarly if you added $5 from an external source to the portfolio during the year. You would have to subtract that $5 from your ending value to calculate the total return, since that $5 increase in value was not due to any investment activity. You would, of course, use the adjusted amount as your starting portfolio value for calculating the next year's total return.
The total return calculation is indifferent to whether the $10 return was achieved by collecting $10 in dividends and having no growth in the underlying assets' market value, or collecting zero dividends and having the market value increase by $10.
Since the long-term growth in the stock market over a century or more has been plus or minus 10%, that is a good target return for many investors (including me) who want to achieve an "equity return" in order to save for retirement or meet other long-term investment goals. Typical dividend growth investors ("DGI") look to collect about 3 or 4 percent of that equity return in cash dividends and then make up the rest of the 10% target return via growth of 6 or 7 percent in the annual dividend payments (which growth, in turn, they expect the market price to reflect as well, over time). Some investors, of course, have higher aspirations and seek greater growth rates over time, usually through "growth" stocks that generally pay even smaller dividend yields but have greater price appreciation expectations.
But "total return" is calculated the same for all of them. It is the amount your investment changes in total value during a period, whether that increase or decrease is due to cash flow from the investments themselves (i.e. dividends and distributions) or by market appreciation or depreciation.
The only unique feature of our "Income Factory" strategy is the idea that:
- You can achieve that 10% total return target completely through dividend and distribution payments that you reinvest and compound (i.e. there is no requirement that your individual securities grow in value at all); in other words, "growth" is "growth" however achieved; and
- Once you realize that, then it becomes obvious that ANY investment security capable of generating a 9-10% or higher cash return can be your instrument of growth, so your "equity return" doesn't even require you to invest in equity (i.e. high yielding DEBT will do; why bet on the horse to WIN the race, when merely FINISHING the race will suffice?)
- Also, since you are creating the growth in your income factory by re-investing and compounding distributions, you also soon learn that your factory output grows faster when market prices are flat or dropping, rather than rising, since you are re-investing your cash at cheaper prices and higher yields.
By the way, the total returns, calculated as described above, for my own IRA portfolio (what I started calling the Savvy Senior portfolio in about 2012) have averaged on a yearly basis:
- 11.22% per annum for the past 25 years
- 11.52% per annum for the past 15 years
- 10.89% per annum for the past 10 years
This means I have been doubling the income from my income factory, on average, about every 6 or 7 years for the past 25 years.
Here is the portfolio as of July 11.
|Savvy Senior "Income Factory" - July 9, 2018||Symbol||Distribution Yield||Premium/ Discount||Total Portfolio Income % This Holding||Total Portfolio Income % Last Quarter||Increase/ Decrease||Asset Class|
|First Trust Specialty Financial Oppty Fund||FGB||11.4%||-0.2%||7.3%||7.2%||0.10%||BDC|
|Brookfield Real Assets Fund||RA||10.4%||-5.7%||7.1%||7.0%||0.10%||HY|
|Eagle Point Credit Co.||ECC||13.0%||10.8%||6.7%||7.6%||-0.97%||CLO|
|Oxford Lane Capital||OXLC||15.3%||4.7%||6.1%||6.0%||0.08%||CLO|
|ETFIS InfraCap MLP ETF||AMZA||20.1%||NA||6.0%||4.8%||1.17%||MLP|
|Clough Global Opportunities Fund||GLO||10.8%||-8.6%||5.6%||5.6%||0.04%||Equity/Income|
|Neuberger Berman Real Estate||NRO||10.3%||-4.6%||4.8%||4.7%||0.06%||REIT|
|Guggenheim Enhanced Equity Income||GPM||11.2%||-0.7%||4.7%||4.6%||0.06%||Equity/Option|
|Miller/Howard High Income||HIE||11.3%||2.2%||4.0%||3.2%||0.77%||Equity/Income|
|Rivernorth Opportunity Fund||RIV||12.1%||9.3%||3.9%||4.3%||-0.36%||CEF|
|Nexpoint Credit Strategy Fund||NHF||10.7%||-9.5%||3.7%||2.3%||1.41%||HY|
|Pimco High Income Fund||PHK||11.2%||32.1%||3.2%||3.7%||-0.49%||HY|
|CS X Links 2XLeveraged Mtge REIT||REML||20.8%||NA||3.2%||3.2%||0.04%||Mortgage REIT|
|Duff & Phelps Select Energy MLP Fund||DSE||10.7%||-5.1%||3.2%||4.3%||-1.17%||MLP|
|Virtus Total Return Fund||ZF||12.8%||-3.1%||3.1%||4.3%||-1.15%||Equity/Income|
|Eaton Vance Tax Mgd Global Div Inc Fund||EXG||9.6%||2.9%||3.0%||3.6%||-0.53%||Equity/Option|
|Clearbridge Energy MLP Oppty Fund||EMO||11.6%||-5.5%||3.0%||2.5%||0.53%||MLP|
|Allianz Convertible & Income II||NCZ||11.4%||6.1%||2.8%||2.7%||0.04%||HY/Convertible|
|Barings Global Short Duration HY Fund||BGH||9.5%||-8.9%||2.4%||2.1%||0.33%||HY|
|Allianz Convertible & Income||NCV||11.1%||11.0%||2.4%||2.4%||0.03%||HY/Convertible|
|Eaton Vance Risk Mgd Diversified Eq Inc||ETJ||9.5%||-2.6%||2.0%||2.0%||0.04%||Equity/Option|
|Fiduciary Claymore MLP Oppty||FMO||11.0%||-4.4%||1.9%||1.9%||0.03%||MLP|
|UBS ETRACS Leveraged REIT||MORL||21.0%||NA||1.8%||2.0%||-0.21%||Mortgage REIT|
|Virtus Global Multi-Sector Income Fund||VGI||11.0%||-5.1%||1.6%||2.0%||-0.36%||MultiSector Income|
|Aberdeen Income Credit Strategies||ACP||10.4%||-7.2%||1.6%||1.6%||0.02%||HY|
|Calamos Conv Oppty & Income||CHI||9.6%||5.6%||1.4%||1.4%||0.02%||HY/Convertible|
|KKR Income Opportunity Fund||KIO||9.0%||-4.6%||1.4%||0.0%||1.36%||HY|
|Barings Corporate Investor||MCI||7.9%||-0.4%||1.3%||0.7%||0.63%||HY|
|BlackRock Multi-Sector Income Trust||BIT||8.1%||-8.5%||0.7%||0.0%||0.69%||MultiSector Income|
|Calamos Conv & High Income||CHY||9.2%||9.7%||0.0%||1.7%||-1.71%||HY/Convertible|
|Voya Global Equity Dividend||IGD||10.0%||-3.9%||0.0%||1.3%||-1.31%||Equity Option|
|Gabelli Equity Trust||GAB||9.46%||-1.55%||0.0%||0.63%||-0.63%||Equity|
So ends another quarterly chapter in the Savvy Senior "Income Factory" saga. Thanks for all the support and encouragement that so many of you share on an ongoing basis.
Steven Bavaria, a former executive of Bank of Boston and Standard & Poor's, is a financial writer and consultant. Check out his book Too Greedy for Adam Smith: CEO Pay and the Demise of Capitalism (link to Amazon), and his articles on "income growth" investing on Seeking Alpha (Steven Bavaria's Articles).
Disclosure: I am/we are long ACP, AMZA, BGH, BIT, CHI, DSE, EMO, FGB, FMO, GLO, HIE, KIO, NCV, NCZ, NHF, NRO, PHK, RA, RIV, UTG. 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.