Grannies Beat Geezers In Total Return, While Income Factory Cash Distribution Reaches 12%

by: Steven Bavaria


In what's turned into a topsy-turvy market, our Savvy Senior Income Factory continues to pump out cash, most recently at a 12% rate.

Total return was more subdued - doing fine until a few weeks ago - but now down in low single digits unless the market recovers in the 4th quarter.

But if the market takes its time recovering, that's OK since we're re-investing and compounding at bargain prices.

Meanwhile the underlying economy is doing fine, which is why the Fed has the confidence to carry out its gradual interest rate increase policy.

Hence a great climate for HY investing - aka "betting on horses to finish the race" (Don't know what that means? Read the "Income Factory" tutorial at the end of the article).

Our Savvy Senior "Income Factory" continued its steady, relentless job of collecting cash and re-investing it through the third quarter of 2018, with a total return for 9 months of 6.4%, which, if annualized, would be an 8.5% yearly return. In terms of cash distributions, we collected 8.54% on our year-end 12/31/2017 starting portfolio balance, which is an annualized rate of 11.4% (currently higher with the recent market drop). That means that all of our total return for the nine months is due to our cash distributions, with about a 2.1% "give back" in market depreciation (paper loss) over that period (i.e. 8.54% in 9-month cash received minus a 2.1% market price loss leaves us with our 6.4% total return).

By comparison, the Widow & Orphan portfolio (theoretical - as of now, with plans to turn it into a real one over the next few months - that we introduced here and whose recent progress we discussed here) beat our Savvy Senior portfolio on a total return basis for the six months from March to September.

But with a more modest yield (although still a "high yield" by most measures) of about 8%, the Widow & Orphan portfolio is designed to re-invest and compound at a slower but perhaps less risky (??? - it remains to be seen) rate than our Income Factory with its more aggressive distribution yield of about 12%.

The market dive since September 30 has increased our Income Factory's market depreciation (paper loss) for the year, so our projected annual total return (at the current rate) as we write this article (Friday evening) is about 3%. On the other hand, our current distribution yield and re-investment rate has gone up to 12.1% (it had been in the mid to high 11% range throughout the first nine months), as the same basic selection of funds with the same distributions is now available to us for re-investment at reduced prices and higher yields.

We tweaked our portfolio a bit during the quarter, trading some “winners” that are still attractive long-term holds for alternatives that looked relatively more attractive from a discount/premium perspective. We also shed a couple funds whose market price deterioration was not being offset by their dividend income enough to allow us to continue to be patient, as we sometimes are when we think the market price swoon is likely to be either modest (in relation to the distribution yield) or temporary. (For example, I might be quite happy to hold indefinitely a fund that pays a distribution of 12% or higher, even if it steadily erodes in price by 1 or 2% per annum, since the net cash return, net of what I view as return of capital, is still 10% or so.)

Here is the portfolio distribution by asset class, and a table showing the change from last quarter. Note that I previously separated my equity funds into "Equity Income" (i.e. income oriented stock funds) and "Equity Option" (stock funds that boosted and, in theory, "leveled out" their income streams by selling options on the stocks in their portfolio). Looking more closely I concluded it was a false distinction and that all my equity funds were actually engaged in selling options to increase income and/or stabilize performance, or both. So I group them as a single category now, and re-stated last quarter's grouping for comparison purposes.

Change by Sector 10/12/18 7/10/18 Change
BDC 7.00% 7% 0.0%
CLO 13.00% 13% 0.0%
CEF Funds 4.00% 4% 0.0%
High Yield 19.00% 21% -2.0%
HY/Convertible 3.00% 7% -4.0%
MLP 19.00% 14% 5.0%
Mortgage REIT 7.00% 5% 2.0%
Real Estate 7.00% 5% 2.0%
Utilities 1.00% 0% 1.0%
Equity/Option 18.00% 23% -5.0%
MultiSector Income 2.00% 2% 0.0%

There weren't any major shifts or realignments, although I bulked up a little more on MLPs since they seemed particularly under-appreciated by the market. I also put a little new money into real estate funds and mortgage REITs, where I felt were under-represented generally (the former), and where I felt the yields compensated for the potential risk (the latter).

In general, I see no reason to fear the current downturn, and agree with a recent article by @Rida Morwa that rising interest rates, in the current environment, are a sign of economic strength and should make it easier for many companies to successfully "finish the race" and pay their debts and other obligations. Rida puts it this way, and I think he is spot on: "First, as we have noted above, rising interest rates in the United States is a sign that the U.S. economy is healthy. Furthermore, this extreme fear of rising interest rates comes at a time when interest rates remain close to historical low levels, and companies are still able to borrow at low rates that enable them to achieve highly attractive returns."

A healthy economic environment should be positive for the funds that make up my largest holdings: First Trust Specialty Financial Opportunity (FGB), Brookfield Real Assets (RA), Eagle Point Credit (ECC), and Oxford Lane Capital (OXLC), all of which are heavily invested in corporate credit (high yield loans and bonds) of the sorts of companies that will benefit from a continually improving economy.

The Current "Savvy Senior" Income Factory:

Savvy Senior "Income Factory" - 10/9/18 Symbol Distribution Yield Premium/ Discount Portfolio Income % This Holding Portfolio Income % Last Quarter Increase/ Decrease Asset Class
First Trust Spec. Fin. Oppty (FGB) 11.3% 1.5% 7.2% 7.3% -0.1% BDC
Brookfield Real Assets (RA) 10.6% -6.0% 6.9% 7.1% -0.1% High Yield
Eagle Point Credit Co. (ECC) 13.4% 7.1% 6.6% 6.7% -0.1% CLO
Oxford Lane Capital (OXLC) 14.9% 6.9% 6.0% 6.1% -0.1% CLO
ETF InfraCap MLP (AMZA) 17.7% NA 5.9% 6.0% -0.1% MLP
Clough Global Opportunities (GLO) 12.0% -8.6% 5.5% 5.6% -0.1% Equity/Option
Neuberger Berman RE (NRO) 11.2% -5.5% 4.7% 4.8% -0.1% Real Estate
CS 2XLev Mtge REIT (REML) 20.0% NA 4.6% 3.2% 1.4% Mortgage REIT
Guggenheim Enhanced Eq Inc (GPM) 11.6% -3.0% 4.6% 4.7% -0.1% Equity/Option
Miller/Howard High Income (HIE) 11.9% 0.3% 4.4% 4.0% 0.4% Equity/Option
CenterCoast Brookfield MLP (CEN) 13.1% -0.7% 4.1% 0.0% 4.1% MLP
Nexpoint Credit Strategy (NHF) 10.9% -9.7% 3.9% 3.7% 0.2% High Yield
Rivernorth Opportunity (RIV) 14.3% -2.3% 3.9% 3.9% -0.1% CEF Funds
Clearbridge Energy MLP Oppty (EMO) 11.4% -7.1% 3.2% 3.0% 0.2% MLP
Barings Global Short Duration (BGH) 9.6% -10.3% 3.0% 2.4% 0.6% High Yield
Allianz Conv & Income II (NCZ) 11.7% 6.5% 2.7% 2.8% 0.0% HY/Convertible
UBS ETRACS Leveraged REIT (MORL) 20.1% NA 2.5% 1.8% 0.7% Mortgage REIT
Aberdeen Global Premier Property (AWP) 10.4% -10.7% 2.2% 0.0% 2.2% Real Estate
Aberdeen Income Credit (ACP) 10.3% -6.3% 2.1% 1.6% 0.4% High Yield
Eaton Vance Risk Mgd Div Eq (ETJ) 9.6% -4.9% 2.0% 2.0% 0.0% Equity/Option
Fiduciary Claymore MLP Oppty (FMO) 10.6% -6.1% 1.9% 1.9% 0.0% MLP
Eaton Vance Tax Mgd Global Div (EXG) 10.3% -0.3% 1.7% 3.0% -1.3% Equity/Option
Kayne Anderson MLP Midstream (KYN) 11.1% -7.1% 1.7% 0.00% 1.7% MLP
KKR Income Opportunity (KIO) 9.3% -8.0% 1.5% 1.4% 0.1% High Yield
Barings Corporate Investor (MCI) 8.0% 0.7% 1.4% 1.3% 0.1% High Yield
Duff & Phelps Select Energy MLP (DSE) 10.0% -6.7% 1.3% 3.2% -1.9% MLP
Reaves Utility Income (UTG) 6.7%% -6.3% 1.1% 0.00% 1.1% Utilities
BlackRock Multi-Sector Income (BIT) 8.4% -12.3% 1.1% 0.7% 0.4% MultiSector Income
Virtus Global Multi-Sector Income (VGI) 12.2% -9.8% 1.0% 1.6% -0.6% MultiSector Income
First Trust Energy Inc & Growth (FEN) 10.5% -3.5% 0.9% 0.00% 0.9% MLP
Nuveen Real Estate Inc (JRS) 8.6% -8.2% 0.4% 0.00% 0.4% Real Estate
Pimco High Income (PHK) 11.9% 27.0% 0.0% 3.2% -3.2% High Yield
Virtus Total Return (ZF) 14.9% -14.4% 0.0% 3.1% -3.1% Equity/Option
Allianz Conv & Income (NCV) 11.6% 9.7% 0.0% 2.4% -2.4% HY/Convertible
Calamos Conv & Inc (CHI) 9.2% -3.6% 0.0% 1.4% -1.4% Hy/Convertible

This Quarter's "Tweaks"

As readers know, I tend to be patient with my portfolio and probably hold onto marginal performers longer than I should in some cases. Of course it's easier to be patient when you're receiving 10% per annum or more in cash on a regular basis. But once I feel that the cash I'm getting is largely my own money (via erosion of capital and/or market value) and I see no reason to believe that's likely to change, then it's time to find a replacement. I came to that conclusion about both Virtus Total Return Fund (ZF) and Virtus Global Multi-Sector Income Fund (VGI), both of which continued to take back their generous distributions through continuing market value declines.

My other sales were largely "victory laps" with funds that had done well and I decided to take profits and move into funds with bigger discounts or other attractive features. These included sales of Pimco High Income Fund (PHK) and Allianz Convertible & Income (NCV), both of which had been successful holds, now at premiums, but both of which I'd welcome back to the fold at the right price in the future. Similarly Calamos Convertible & Income (CHI), which was a long-term successful hold, a great fund, but had moved to a substantial premium (although it's back to a discount again, for anyone looking for a good current buy).

Biggest Portfolio DECREASES Decrease %
Pimco High Income Fund PHK -3.2%
Virtus Total Return Fund ZF -3.1%
Allianz Convertible & Income NCV -2.4%
Duff & Phelps Select Energy MLP Fund DSE -1.9%
Calamos Convertible & Income Opportunity CHI -1.4%
Eaton Vance Tax Mgd Global Div Inc Fund EXG -1.3%
Virtus Global Multi-Sector Income Fund VGI -0.6%

I sold some of my Duff & Phelps Select Energy MLP Fund (DSE), not because I didn't like it, but because I wanted to add some other MLP funds, like CenterCoast Brookfield (CEN), Kayne Anderson MLP Midstream (KYN) and First Trust Energy (FEN), to the mix as well. I obviously added more than I sold, because my MLP portfolio share rose, as noted earlier, from 14% to 19%.

@Stanford Chemist reported in his recent weekly CEF report that "the sector with the highest yield is MLPs (9.75%)." Other factors, like reports from experts like @Hinds Howard that underlying MLP cash flows are solid, despite the sector's continuing unpopularity in the market, make me feel comfortable increasing my exposure. (For further thoughts on my MLP holdings, see my recent article on the ETF AMZA (AMZA) and other MLP funds.)

KYN in particular looks attractive right now. "The most undervalued fund in the group today is the Kayne Anderson MLP Fund (KYN) with a negative Z-score of -2.50. Currently, the fund is also at a record discount of -8.74%" per @Arbitrage Trader's recent MLP CEF review. And it yields over 11%.

Note I also bought some Reaves Utility Income Fund (UTG), one of my favorite funds even though it's dividend doesn't meet the target 8% or higher I normally set. I think UTG's in a class by itself as far as CEFs go generally, with its 19% ten-year total return record, and I regard it as a real bargain when it's selling at a yield over 6.5% (currently 6.8%).

Biggest Portfolio INCREASES Symbol Increase %
CenterCoast Brookfield MLP & Infrastructure CEN 4.1%
Aberdeen Global Premier Property Fund AWP 2.2%
Kayne Anderson MLP Midstream Fund KYN 1.7%
CS X Links 2X Leveraged Mtge REIT REML 1.4%
Reaves Utility Income Fund UTG 1.1%
First Trust Energy Income & Growth FEN 0.9%
Barings Global Short Duration Fund BGH 0.6%

Appendix: "Income Factory" Tutorial

For the benefit of some of our newer readers and followers let us briefly describe what our Income Factory strategy and goals are, and are not, since some comments on past articles suggest there may be some confusion about this. (For the full story, feel free to check out this article.)

Our long-term goal, like most equity investors, is to achieve a total return of about 9-10%, which is the average equity return over the past century or so.

What’s different about our Income Factory approach, is that we focus our attention on growing our cash income at that 9-10% rate, through re-investing and compounding a high-yield distribution stream (i.e. the output of our Income Factory) If our income stream grows at a 9-10% annual rate, then the stream will double and redouble every 7 or 8 years, providing all the growth that most long-term equity investors would want, regardless of their age.

By focusing on growing the income, which is pretty much under our own control (it’s up to us to pick a highly diversified portfolio of high-yielding funds with fairly stable distributions), we have the advantage of being able to grow that income stream steadily through market ups and downs. In fact, our income grows faster during markets that are flat or down, since we are re-investing at lower prices and higher yields than if the market were rising.

Many people find this to be a counter-intuitive notion. It violates the conventional wisdom that “growth” has to come from the individual investment (i.e. the company whose stock you are buying) growing its payout (and its stock price, along with it). Example: “Dividend Growth Investing,” where you buy companies that may pay dividends of only 3%, 4%, even sometimes 5% per year, and then depend on the company itself to grow its dividend by another 4-5% or so per year, to bring you up to the total 9-10% equity return that most investors seek.

“Income Factory” investing does not claim to exceed the growth rates of Dividend Growth Investing or the S&P 500 or any other investing strategy. All it does is take advantage of the demonstrably obvious mathematical fact that you can achieve any given growth rate in a stream of income either by (1) earning the entire target rate of growth as a yield (that may never increase) which you merely re-invest and compound, or by (2) accepting a current yield less than your total target rate of growth, and making up the difference by having that yield grow “organically” at a growth rate that makes up the difference between the current yield and the target total return.

If that sounds complicated, it’s really not. Suppose Portfolio A (the Income Factory) earns a yield (net of returns of capital or long-term erosion of portfolio principal) of, say, 10%. The securities paying that yield never grow their yield but merely pay at that rate indefinitely. We collect the income and re-invest it in similar securities paying 10%. The net income will grow at a compound rate of 10% per year, doubling itself about every 7 years (per the Rule of 72).

Compare that to Portfolio B (a Dividend Growth portfolio), that earns a yield of, say, 4%, but the securities in the portfolio grow their own dividends at a rate of 6%, on average, each year. If you reinvest the 4% dividends and the dividends themselves grow at 6% per year, your compound annual growth rate will be similar to the Income Factory described above, a 10% compounding yield.

Neither is necessarily better or worse than the other. But each strategy is equally capable of achieving the long-term growth of 9 or 10% or whatever target one sets. In other words, math is math.

Obvious as this may seem (and if you want to see excel spread sheets spelling it out clearly, they are attached to the article linked here), it was branded heresy in some circles here on Seeking Alpha when I first proposed it about five years ago. It flies in the face of the popular notion (encouraged by CNBC, Fox Business News and others) that investing is like a sport where market growth is essential and needs to be followed 24/7, hopefully on their particular network.

Rather than a sport, I compare investing to a manufacturing process, like auto making. If Ford Motor builds a plant to make cars, the only ones who worry about what the plant is actually “worth” from day to day or month to month are the accountants. Everyone else focuses on how many cars and trucks the plant produces, and how to grow that number each month by re-investing, adding new machines, etc. That’s my model for thinking about investing. Our portfolio is an “Income Factory” that produces income. We don’t worry unduly about how the market values it, as long as it keeps producing the income that we can re-invest to continually grow the “factory” as we are younger, and then begin consuming (part or eventually all) the output as we get older.

Another essential element (and I think one of the most useful insights) of the Income Factory strategy is that it does NOT depend on the securities you buy having to grow their payouts. Companies need to merely continue making the same payouts they are currently making. This is a less “heroic” expectation than expecting and requiring “growth” from your investments in order to meet your long-term investment goals. That’s why I liken it to “betting on horses to merely finish the race, rather than having to win the race, or even place or show." See this article for details.

If anyone is still reading at this point............

Thanks for your patience. As I suggested earlier, this is a tough period for investors, with the market reacting in ways that may not reflect what is - to me - a definitely improving economy with all that implies for corporate health. But this sort of environment - improving macro-economy but falling stock prices - seems tailor-made for an Income Factory approach.

Once again, thanks to readers and followers for your helpful messages and comments, and especially to my many fellow contributors. You are my highly effective and much appreciated "research staff."

Steven Bavaria, a former executive of Bank of Boston and Standard & Poor's, writes extensively about his high yield “Income Factory” investment strategy. You can "follow" him and/or check out his book and other writings on his personal profile page here on Seeking Alpha (link: Steven Bavaria's Articles).

Disclosure: I am/we are long AMZA, FEN, DSE, CEN, FMO, EMO, EXG, VGI, ZF, PHK, UTG, KYN, CHI.

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: I am long all the securities listed in the Income Factory table, whether or not mentioned specifically in the article, except those identified as having been sold during the last quarter.