Income Factory In 2018: 'Paper Losses' And Lots Of Cash

by: Steven Bavaria

Lots of "paper losses" but I am not tempted to turn them into real losses, as the "economic value" of the portfolio is unaffected by the "perfect storm" of geopolitical, economic and market angst.

Meanwhile, cash income reaches record high as portfolio distribution yield (and re-investment rate) hits 13%.

Total return for the year hit low point (-14%) third week in December and bounced back to -9.8% for the year as a whole after end of the December rally.

Further 4.5% rise in first week of January.

Will it last? Who knows? But we will keep re-investing dividends at bargain prices and sky-high yields.

2018 in Review

As I wrote almost two weeks ago, 2018 was a bit of a nail-biter for many reasons: geopolitical, economic and financial. (Here's the link.) I won't repeat all the reasons why I believe it was a "perfect storm" for creating the sort of stress and angst that caused many investors to head for the hills, leaving the rest of us with (1) paper losses that we have the option to turn into real losses if we decide to sell down our positions, and (2) potential opportunities to lock in outsize yields by re-investing income at the bargain prices and yields "Mr. Market" was (and still is) offering us. (We can also take advantage of the high yields by "tweaking" existing portfolios, selling positions that have held up relatively well and re-allocating to positions that have been unduly battered down.)

First, let's review the numbers: A week before year-end, as reported in my recent article, my total return for year-to-date 2018 was a big negative, -14%. Since I had received cash income of almost 12%, that meant there had been a drop in market value of over 25%, since total return equals cash income plus market appreciation or depreciation.

The final week of the year turned that around a bit, with my portfolio appreciating enough so that the 2018 year-end total return was -9.8%, which meant the market price of the Factory rose by about 4% in the final 4 days of trading. The cash return for the entire year was just over 11%, which means the Factory's market depreciation (paper loss) was about 21%. Obviously, if I believed that depreciation represented a permanent impairment in the portfolio's economic value or income producing potential I'd be worried. For the various reasons why I am not, please read the aforementioned article.

The charts and lists below detailing my Income Factory holdings are up to date as of January 5, so they include the impact of rising prices during the first week of 2018. My total return as of mid-day January 7 as we go to press has been about 4.5%, and while I normally recommend focusing on the income stream and trying to ignore market price gyrations, I admit that the market's reaction over the past two weeks has been helpful in confirming my view (expressed in numerous recent comments as well as last week's article) that the sky may be gray and foreboding, but it is not likely to fall.

Our Income Factory portfolio: Here is the breakdown by asset class, and as you can see, there has been little overall change from the previous quarter. I have tweaked within categories here and there, in an attempt to take advantage of unusually attractive yield opportunities, or in some cases to try to lessen risk without giving up yield. We will discuss that later on.

Asset Class 10/12/18 1/5/19 Change
BDC 7% 8% 1%
CLO 13% 13% 0%
CEF Funds 4% 4% 0%
High Yield 19% 18% -1%
High Yield/Convertible 3% 3% 0%
MLP 19% 19% 0%
Mortgage REIT 7% 7% 0%
Real Estate 7% 7% 0%
Utilities 1% 1% 0%
Equity/Option 18% 16% -2%
Multi-Sector 2% 3% 1%
Bank Loan 0% 1% 1%
100% 100%

Distribution Yields: Current Yield and Yield on Cost

As market prices dropped during the last quarter of 2018, the distribution yield on the portfolio rose from the 11.5% range where it had been most of the year to the nose-bleed level of 14.8% two weeks ago. Now it has come down slightly to where the weighted average distribution yield on our Income Factory portfolio is about 13.8%. That means new money being invested, including dividends being re-invested and compounded, gets put to work at that rate, not the rate I was investing at three or six months ago. Obviously the more money we can put to work at 13% versus 11% the better, since an income stream invested and compounded at 13% doubles itself every 5.5 years, whereas money invested and compounded at 11% doubles and redoubles every 6.5 years. That means over a 40-year investment span, your income stream would double and re-double itself one extra time at 13% than at 11%. In other words, at the end of 40 years, your income stream would be twice as large. Frankly, even compounding at an 11% rate would be a terrific return over any long period (most investors, including traditional "equity investors," would be happy to get 9-10%), but every opportunity we get to add to our Income Factory at these current unusually high yield levels boosts the average return and accelerates our rate of compounding.

Note regarding "Yield-on-Cost:" When I mentioned the increase in distribution yield in the last article, a few readers seemed to think I was claiming that my portfolio was somehow generating more cash from the same portfolio just because its distribution yield had increased (wouldn't that be nice!). I think we all know that just because your portfolio's price goes down and its current yield rises, that doesn't mean that you, having paid the higher price previously, get paid any more income than you did before the price dropped. They went on to suggest that "yield-on-cost" - i.e., today's cash distribution divided by the security's original cost - was the more relevant measure.

I think it is worth discussing this, especially if anyone wants to try to replicate my strategy or style of investing, which involves monitoring and managing a portfolio and not just buying and holding in a completely static way. "Yield-on-cost" is helpful in assessing whether your original decision to buy a security has turned out well or not. If your yield-on-cost rises, it means the distribution on the security has risen, so the amount of cash you receive today is a higher percentage of your original price than the amount of the distribution was back when you bought the security. But that increase in distribution may reflect good management on the part of the issuer of the security, or it may just reflect the fact you've held it for a long time. It doesn't tell you whether the security represents good value today, at the current price, or how it compares to other alternative securities with similar risk profiles that may pay higher or lower current yields.

Our Income Factory strategy envisions being fully invested all the time, taking a long-term view of building income and wealth, and using re-investment and compounding to achieve that. But it also envisions being alert to our securities' current yields, premiums or discounts, and relative value vis a vis other income securities. That means being prepared to "tweak" the portfolio as I often describe it, especially monitoring current prices and yields to see which holdings have been treated or mistreated better or worse by "Mr. Market" from time to time, and taking advantage of that (i.e., selling those less beaten up and buying those more beaten up; assuming, of course, they aren't being beaten up for a concrete, security-specific reason). Obviously "yield-on-cost" will be of no value in making those decisions, but distribution yield - i.e., how much the market is paying us now to hold a security at today's price - is a totally relevant and necessary input.

In short, yield-on-cost is essentially a "feel good" statistic, but provides little or no information to help you decide (1) whether to continue to hold a particular security in portfolio, (2) how it compares to alternatives currently available in the market, or (3) whether you are optimizing your returns or not by continuing to own it given the various alternatives.

Income Factory Portfolio - 1/5/2019

Here is our current Income Factory portfolio. It should look familiar, since not much changes from quarter to quarter. I do not "DRIP" but make very conscious, opportunistic decisions about what to buy with each new cash distribution. Sometimes I will use distribution re-investments as an opportunity to do further tweaking. If I accumulate a number of monthly distributions and find a fund or two that looks particularly attractive, I may decide to not only invest the new money I have just received but also to sell down some currently owned but "less favored" security (say a fund that has done well, gone to a premium and represents less of a bargain than previously, or one of my less successful fund picks that I am tired of waiting for it to turn itself around even though it may be paying a good distribution, etc.) in order to put additional money into the relatively more attractive one.

Here are some highlights from our quarterly activity:

  • I have maintained my position in MLP funds, since I believe there will still be a demand for pipelines and storage facilities to transport and contain gas and oil products. I own Center Coast MLP & Infrastructure Fund (CEN), ClearBridge Energy MLP Opportunity Fund (EMO), First Trust Energy Income&Growth Fund (FEN), Nuveen All Cap Energy MLP Opportunities Fund (JMLP), Kayne Anderson MLP/Midstream Investment Company (KYN), Duff & Phelps Select Energy MLP Fund (DSE) and Fiduciary/Claymore MLP Opportunity Fund (FMO). All have double-digit distributions and some are selling at discounts, although even without a discount the MLP sector is probably cheap relative to its long-term economic value right now. I also own the InfraCap MLP ETF (AMZA), but it is - for me - somewhat harder to understand and evaluate, so with the great values currently offered by more transparent closed end funds, I have shifted some but far from all of my AMZA exposure to the other MLP funds listed. In recent days, Samuel Smith published an article on SA (link here) interviewing AMZA manager Jay Hatfield that, along with its valuable comment string, contributes some additional transparency.
  • I sold my Aberdeen Income Credit Strategies Fund (ACP) after reading a very thoughtful article (link here) about it by Stanford Chemist. I thought I could get an equivalent yield but with a better credit profile by buying Invesco Senior Income Trust (VVR). Was my face red when I realized a few hours later (thanks to an astute comment from @adam22164) that CEFConnect had misreported the distribution yield on VVR as twice what it actually was, so my "trade" of one high yielder for another wasn't quite what I expected it to be. I plan to unwind it and trade the VVR for something more appropriate this week, perhaps old favorite Calamos Global Dynamic Income Fund (CHW), which I've been buying again lately as its price has come down and yield risen in recent months. Although bought by mistake, VVR has treated me well, gaining about 3% in price in the three days I have owned it.
  • I finally bailed out of Virtus Global Multi-Sector Income Fund (VGI), which was making little progress even before the downturn and was sinking further along with the market as a whole. I replaced it with Wells Fargo Advantage Income Opportunities Fund (EAD), which yields less (9.63%) but sells at a comfortable discount (-11.58%) and has a much better performance record.
  • Similarly, I got a bit impatient with my Clough Global Opportunities Fund (GLO) and sold off some of my position, using the proceeds to buy some more CHW as well as some JMLP.
  • In my recent article, I wrote admiringly of First Trust Specialty Finance (FGB) which invests mostly in business development companies ("BDCs") which are finance companies that lend to small and mid-size businesses. FGB was so hard hit by the recent downdraft that its current distribution yield rose to almost 14%. Now it's recovered a bit but the yield is still over 13%, historically quite high. I would buy more if it weren't already my largest holding. But I did increase my position in that sector slightly by buying some of the UBS ETRACS 2X Leveraged Long Wells Fargo Business Development Company ETN (BDCL), which is paying a distribution of about 17%. In general, I think the pessimism about the loan market has gone overboard, with some investors expressing fears of a credit crash, when what I believe we may face (eventually) is more of a typical cyclical low.
  • Finally, it is worth noting that both Oxford Lane Capital (OXLC) and Eagle Point Credit (ECC), our two closed-end funds that buy CLO equity, have announced and committed to their regular monthly distribution payments through March. A certain amount of angst seems to accompany each fund's anticipated quarterly announcement of future monthly distributions (OXLC's announced back in November; ECC's just last week), and it was heightened this quarter by the overall nervousness in the credit and equity markets generally. So there was a lot of relief among ECC owners, especially when that fund's announcement of its distributions came out, confirming the same 20 cents/month level as previous.
  • There is a new CLO fund on the block, OFS Credit (OCCI), a closed-end fund that just launched in October, that is sporting a distribution yield of 13% based on its first three months payouts. We will have to keep an eye on it and try to learn more about it. It is a sign that the CLO and bank loan industry are looking more and more to the retail investing market as a source of investor capital. I hope the industry recognizes that if it wants to attract retail investors in a permanent way, and not just have them hop on the train for high yields during good times and then hop off quickly at the first whiff of anxiety, they will need to educate investors better and more transparently (i.e. in plain English) about their business, especially how they compute and characterize income, how much of their distributions are GAAP income, "constructive" return of capital, "destructive" ROC, etc.
Income Factory - January 5, 2019 Symbol Distribution Yield Discount/ Premium Total Portfolio Income % This Holding Total Portfolio Income % Last Quarter Increase/ Decrease From Last Quarter Asset Class
First Trust Spec. Fin'l Oppty FGB 13.08% 0.56% 7.27% 7.22% 0.05% BDC
Brookfield Real Assets RA 12.27% -12.07% 7.00% 6.95% 0.05% High Yield
Eagle Point Credit ECC 15.78% -7.87% 6.61% 6.56% 0.05% CLO
Oxford Lane Capital OXLC 16.33% -0.50% 6.02% 5.98% 0.04% CLO
Center Coast Brookfield MLP & Infra CEN 17.15% 5.87% 5.13% 4.15% 0.98% MLP
Guggenheim Enhanced Eq Inc GPM 13.99% 1.17% 4.61% 4.57% 0.03% Equity/Option
CS XLinks 2X Mtge REIT REML 24.00% - 4.49% 4.59% -0.09% Mortgage REIT
Miller/Howard High Inc HIE 13.75% -2.29% 4.43% 4.40% 0.03% Equity/Option
Neuberger Berman RE NRO 11.37% -12.11% 4.19% 4.68% -0.49% Real Estate
NexPoint Strategic NHF 11.82% -15.77% 3.95% 3.93% 0.03% High Yield
RiverNorth Opportunities RIV 15.33% -0.60% 3.89% 3.86% 0.03% CEF Funds
Clough Global Opps GLO 12.56% -13.09% 3.36% 5.54% -2.18% Equity/Option
ClearBridge Energy MLP Oppty EMO 14.80% -5.30% 3.24% 3.21% 0.02% MLP
Barings Global Short Duration BGH 10.96% -11.95% 3.14% 2.99% 0.15% High Yield
InfraCap MLP ETF AMZA 22.00% - 3.05% 5.89% -2.84% MLP
AllianzGI Conv & Inc II NCZ 14.65% 1.05% 2.74% 2.72% 0.02% HY/Convertible
Calamos Global Dynamic Inc CHW 12.28% -6.27% 2.68% 0% 2.68% Multi-Sector
UBS ETRACS Lev REIT MORL 22.00% - 2.47% 2.46% 0.02% Mortgage REIT
Aberdeen Global Prem Property AWP 11.90% -13.95% 2.96% 2.22% 0.74% Real Estate
Fiduciary Claymore MLP Oppty FMO 13.38% 0.83% 1.89% 1.87% 0.01% MLP
Eaton Vance Risk Mgd Div Eq ETJ 11.30% -10.04% 1.76% 2.01% -0.25% Equity/Option
KKR Income Opportunity KIO 10.38% -11.23% 1.75% 1.50% 0.25% High Yield
Kayne Anderson MLP Midstream KYN 12.62% 2.18% 1.70% 1.69% 0.01% MLP
Nuveen All Cap Energy MLP Oppty JMLP 12.16% -5.63% 1.60% 0% 1.60% MLP
Barings Corporate Investor MCI 8.03% -3.20% 1.44% 1.43% 0.01% High Yield
Duff & Phelps Select Energy MLP DSE 13.82% -2.65% 1.32% 1.31% 0.01% MLP
Invesco Senior Income Trust VVR 6.31% -13.36% 1.27% 0% 1.27% Bank Loan
Eaton Vance Tax Mgd Global Div EXG 9.63% -2.9% 1.26% 1.75% -0.49% Equity/Option
UBS ETRACS Lev BDC BDCL 17.00% - 1.24% 0% 1.24% BDC
Reaves Utility Income UTG 6.87% -2.10% 1.12% 1.08% 0.04% Utilities
First Trust Energy Inc & Gro FEN 11.75% 1.21% 0.87% 0.86% 0.01% MLP
Wells Fargo Income Opp EAD 9.63% -11.58% 0.87% 0.0% 0.87% High Yield
Cohen & Steers Global Inc INB 10.65% -12.71% 0.41% 0.0% 0.41% Equity/Option
Nuveen Real Estate Inc JRS 9.81% -11.81% 0.28% 0.42% -0.13% Real Estate
BlackRock Multi-Sector Inc BIT 8.91% -12.54% 0.00% 1.07% -1.07% Multi-Sector
Aberdeen Income Credit ACP 13.30% -11.90% 0.00% 2.06% -2.06% High Yield
Virtus Global Multi Sector Inc VGI 13.30% -11.60% 0.00% 1.03% -1.03% Multi-Sector

That's pretty much it for 2018. Without sounding over-confident, I believe the past few months have been somewhat of a validation of our Income Factory philosophy. Watching our current income increase, as we re-invested and compounded higher and higher yields through mid to late December, even as our portfolios' market prices dropped, took some of the sting out of the downturn. Had I been sitting on a portfolio only paying me 3 or 4% instead of 12%, I know I would have been far more worried and tempted to want to "do something" about it; even if "doing something" might likely have ended up costing me in money or opportunity further down the road.

Further to my article of almost two weeks ago mentioned earlier where I said bargains abound in this market, I wish to emphasize that the funds I mention are just the tip of the "opportunity iceberg" in closed-end funds and other asset classes driven to absurdly low levels despite little or no real deterioration in their "economic" value (including their ability to make distribution and dividend payments). To find other candidates not in my portfolio, but deserving of your consideration, you might wish to read some of the fine articles by Stanford Chemist, Nick Ackerman, Arbitrage Trader and others.

Disclosure: I am/we are long CEN, EMO, FEN, JMLP, KYN, DSE, FMO, AMZA, VVR, CHW, EAD, FGB, BDCL, OXLC, ECC. 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 own all the securities listed in the Income Factory.