Seeking Alpha

Alternate Investments For Income-Seeking Investors

by: Mark Ferry
Summary

This is an investment philosophy designed for people who, either now or in the future, will find yields on government bonds too low to meet their needs.

It is a follow up to my most recent article on Seeking Alpha titled "The U.S. Bond Market Has Only 10 Years Left."

This article is intended for buy-and-hold bond investors and for non-bond investors who are looking for income from their investments in a low interest rate environment.

In this article, I will list 25 funds and stocks that I personally own that I expect will provide a solid income stream for many years to come.

Here are my thoughts on the hot topics in the current economic environment:

I do not think that we will have negative interest rates at any point on the yield curve for US Treasuries for at least 10 years. I think the yields bottom out at 0.5-1% on the 10-year Treasury and then the Fed starts selling its Treasuries to keep the yield from moving lower. For years The Fed has wanted to unwind its balance sheet of US Treasuries down to 500 billion (or maybe even lower) and eventually they'll be able to do so without the risk of higher rates making the debt service on the national debt too burdensome on the budget or doing damage to the economy. Our economy can thrive with low, but positive rates.

If the minimum wage goes up to $15.00 nationally it will have a domino effect on all pay scales at many businesses and prices of goods and services will have to be raised. Wage inflation is the single biggest component of inflation and we have not had this type of jump in the minimum wage ever. It may take a few years to play out but I think it is definitely inflationary. I don't want to get into any political debate whether $15.00 is a good or bad idea or fair or unfair; I am simply making a statement on how I think it will affect inflation.

I think that the flat or inverted yield curve is a function of such low rates more than because of an impending recession. If eventually all rates on the curve will be below 1.0% (which is where I think we are headed), then how steep can the curve be and have that scenario in place? Eventually we'll have all rates between 0.25%-0.5% and of course the yield curve won't be a curve any more but rather a yield horizontal line. That's what will be needed to finance our debt and eventually it will come to pass.

I think the low interest rates, as long as they are not negative across the board, are bullish for stocks and investments that offer good yields without excessive risks. Asset classes such as preferreds, REITs, quality BDCs, corporate bond funds and multi-income funds should do well. As such, I am long all of these asset classes. I expect PE multiples to expand on stocks and as long as the yield on the S&P 500 is comparable to the 10-year US Treasury yield then stocks will look more attractive to many US investors than bonds.

The continued trend towards lower interest rates is great news for the states, counties and municipalities who can continue to refinance their debt every few years with lower rates. This will keep many local governments solvent when they otherwise might not be. While the yields on AA rated municipals will move lower from 3% towards 2% over the coming years, the default rate will drop as debt service becomes more manageable throughout the U.S. in all municipal sectors.

Background

First let me state that for the past 20 years or so I have been mainly a bond guy. I love bonds, namely municipals and US Treasuries. For some of that 20 years, my portfolio was 100% bonds! I was running two businesses in New Jersey and didn't want to be bothered with following the stock market. Now my portfolio is mostly bonds with some carefully selected other issues I will discuss in this article.

Around 20 years ago, the yield on AA rated 20-year tax-free muni paper was about 5.0%. Around 10 years ago, that yield was 4.0%. Today it's about 3.0%. Treasuries, which lead the movement in yields, have also fallen and now the 10-year yield is 1.6%. We're in a low interest-rate environment. You don't need me to tell you that I'm sure.

During the past 20 years, yields were sufficiently high for me to employ the following simple strategy:

  1. For munis, it was mainly buy and hold. As my cash flow allowed, I would buy mostly state-issued bonds (always investment grade) with the intent that I would hold them until they are called or mature. This is a typical strategy for most muni investors.
  2. For US Treasuries, the strategy was twofold. I only bought when yields spiked up. Then I would collect the coupons until yields spiked down, at which time I would sell large chunks (or even all) for capital gains. I would repeat that cycle again and again and because of the trend towards lower rates the past 20 years, that strategy worked well.

But I sense we're coming to end of that cycle. Over the past 8 months I have sold one-third of my long term bond holdings and dumped most the proceeds into short-term treasuries. I am waiting and hoping for the 30-year yield (currently at 2.1%) to move back up to 3.0%, at which time I will buy aggressively. That may never happen.

But the writing is on the wall. 20 years ago, yields were high enough to employ my strategy safely and with a very high chance of success. Nowadays, with yields much lower, this strategy is far less viable, so much so that I now spend much of my time looking for what I call alternate investments for the buy-and-hold bond investor.

So what's the plan?

I will not address asset allocation. How much of one's assets should be in any asset class is a function of that person's age, income, net worth, risk tolerance, income needs, years to retirement and other such factors. Since all of that is so individualized, it is outside the scope of this article. That's where one-on-one financial planning comes in.

The main purpose of this article is solely to list some alternate investments for the ex-buy-and-hold bond investor or yield-seeking investor in the form of various other asset classes. That's it in a nutshell.

There are 5 alternate asset classes for the buy-and-hold bond investor, which I will refer to as BAHBI. If you pronounced BAHBI it would sound like the name Bobby, so I will call guys like me Bobby for the purposes of this article!

I will use the term funds interchangeably for ETFs (which follow an index) or CEFs (whose holdings are instead bought and sold at the discretion of the fund manager) because if a fund meets our goals it doesn't matter whether it is an ETF or a CEF. I also don't get too hung up on expense ratios. If the fund makes money and helps me meet my goals, I can live with the higher expense ratio and not worry about it. I am also not too concerned about how much leverage the fund uses, as I trust the fund managers to use debt judiciously.

What's the criteria?

I consider the following 4 parameters:

1. Yield. Yields vary and the higher yielding issues tend to have less price appreciation than the lower yielding ones. As companies and funds pay dividends it lowers their share price so I look to own some issues falling into both categories and achieve at least 5% aggregate yield for each asset class, except corporate bonds where investment grade funds will yield less than 5%.

2. Share price track record. I look at 1-year, 5-year and 10-year charts. In general, the issue must show price appreciation in at least 2 of these 3 time frames, with appreciation in all 3 preferred. If it has a very high yield, then as long as the price has remained essentially flat over a 10-year period then that makes it worth owning. I know that past performance is no guarantee of future results, but I figure if a company or fund has had a successful track record then that usually suggests such performance will continue.

3. Share price volatility. I look at the charts and gauge what types of price swings can be expected. I tend to buy smaller amounts of the more volatile issues.

4. Future prospects. I ask myself if this issue will continue to do well in a very low interest rate environment because I am convinced that bond yields will continue to move lower over the next decade and beyond.

What are the asset classes?

I have constructed a portfolio of issues that generates income in a variety of different ways to spread out risk. These are not growth issues, they are income issues (although some have shown good growth).

I am not recommending any issue; I am merely listing the issues that I own. Do your own due diligence before buying anything.

I have identified the following 5 asset classes for Bobby:

  1. preferred securities funds
  2. REIT funds
  3. multi-income funds
  4. BDCs (Business Development Companies)
  5. corporate bond funds

You'll note that there is no mention of common stock funds. I am long several common stock funds but those are not Bobby investments since I consider them growth investments, even though some have decent yields.

My commodity (precious metals, actually) funds don't pay dividends so they are not bond substitutes at all, but they serve as a hedge against inflation and on the basis of that merit inclusion in my portfolio. I do not like government bond funds - like the iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) and iShares National Muni Bond ETF (NYSEARCA:MUB) - so anyone seeking ideas for that asset class will need to look elsewhere. That's not to say that those types of bond funds are bad investments, it's just that I own so many individual government bonds I am, in essence, a government bond fund.

Notes: Funds are being assigned to one of the 5 categories even though they may not hold 100% of their assets in that category.

These issues all have some level of risk. There are 4 ultra-safe asset classes in my view: US Treasuries, AA or higher state issued municipal bonds, GSE (government sponsored entity) bonds and FDIC insured CDs. None of the issues mentioned in this article are as low risk as those 4 asset classes.

I own considerable amounts of the first 3 asset classes. I don't like CDs and own none. All of my risk assets only account for about 10% of my entire portfolio. The other 90% are in the ultra-safe category. But as yields continue to drop it's possible that a higher and higher percentage of my portfolio will be risk assets, much to my chagrin.

Since these investments have been chosen for yield, any increase in price is a bonus. The higher the yield, the lower my expectation is for price appreciation. So, if a high yielding issue only moves up a few percent, I consider that good because it would be a good investment with no price appreciation so the price appreciation is the icing on the cake, as it were.

For funds, I am not going to go into any details of its holdings. For individual stocks, I'm not even going to discuss its business model or any financials. If you see a stock or fund that you like, its up to you to do your own research. The purpose of this article is merely to suggest possibilities.

These investments work best in IRAs because that way you don't have to keep track of basis when you have funds that return capital and if your CEFs have foreign holdings you don't have to worry about foreign tax. If you want to hold them in a retail account, find out the tax implications of holding all funds. This applies to the funds mentioned in this article and all other funds mentioned in all other SA articles.

Now, let's name names: 5 asset classes, 25 issues total. That should give you plenty from which to choose.

1. Preferred Securities Funds (5 total)

  • Invesco Preferred Portfolio ETF (NYSEARCA:PGX)
  • SPDR Wells Fargo Preferred Stock ETF (NYSEARCA:PSK)
  • Cohen & Steers REIT & Preferred Income Fund (NYSE:RNP)
  • VanEck Vectors Preferred Securities (Ex-Financials) ETF (NYSEARCA:PFXF)
  • Nuveen Preferred & Income Securities Fund (NYSE:JPS)

Discussion:

These 5 give me good exposure to preferred securities in a variety of sectors. These funds aren't spectacular, but they churn out an aggregate 6.0% yield. PGX and PSK hold mostly financials and yield about 5.4%. RNP is about 50-50 between preferreds and REITs. It has a 6.4% yield and has shown excellent price appreciation through all 3 time frames. PFXF's share price hasn't performed as well as the others and has only been in existence for about 7 years and is included because it does not contain any financial company preferred securities and thus adds some balance and diversity. JPS has a yield near 7.0% and has also shown price appreciation through all 3 time frames. As an asset class, preferreds also tend to be less volatile than most other asset classes.

2. REIT Funds (6 total)

  • iShares Residential Real Estate Capped ETF (NYSEARCA:REZ)
  • Cohen & Steers Total Return Realty Fund (NYSE:RFI)
  • Cohen & Steers Quality Income Realty Fund (NYSE:RQI)
  • IQ U.S. Real Estate Small Cap ETF (NYSEARCA:ROOF)
  • Invesco Active U.S. Real Estate ETF (NYSEARCA:PSR)
  • Neuberger Berman Real Estate Securities Income Fund (NYSEMKT:NRO)

Discussion:

REZ has a low yield but has performed well over the past 10 years. I prefer residential equity REITs over other types of REITs because my reasoning is that people will always need housing and storage space no matter what the economy is doing. RFI yields over 6% and has shown price appreciation is all 3 time frames. In addition to holding real estate, it holds some communication stocks and corporate bonds. Note that another fund RQI, is quite similar to RFI in its holdings and performance. ROOF is a small-cap REIT with a 6.3% yield. It has been around only for 8 years and its price has stayed stable during that time. This one doesn't have the track record of the others so it's what I call a flyer. PSR holds some communication stocks in addition to real estate, yields only 2.3% but like REZ has performed well over the past 10 years with a nice uptrend throughout. NRO has a hefty 8.5% yield and has shown nice appreciation over the past 10 years.

I believe at some point we will get inflation and this group's performance should be even better than over the past 10 years. With this group you get income, growth and a hedge against inflation.

3. Multi-income funds (4 total)

  • Eaton Vance Tax-Managed Diversified Equity Income Fund (NYSE:ETY)
  • BlackRock Enhanced Capital & Income Fund (NYSE:CII)
  • Cohen & Steers Infrastructure Fund (NYSE:UTF)
  • John Hancock Tax-Advantaged Dividend Income Fund (NYSE:HTD)

Discussion:

Two of the funds, CII and ETY, employ the same basic strategy: They own dividend producing stocks and sell calls. CII has a yield of 6.4% and has shown only modest appreciation in price over 10 years. Selling calls by nature limits upside movement, but it's a good way of generating income. ETY has a healthy yield of 8.6% but has actually declined slightly in price over 10 years. Thus, both CII and ETY have annual returns of about 7-8% for the 10-year stretch.

UTF is an interesting multi-income fund. It yields 7.1% and invests primarily in stocks of infrastructure companies and as such has holdings in utilities, industrials, energy, REITs, communications and corporate bonds. It also has shown price appreciation in all 3 time frames. I think rebuilding the American infrastructure will have to be a priority over the coming decades so I expect this fund to continue to do well.

HTD has a yield over 6% and has also shown nice appreciation over all 3 time frames. Its portfolio is about 55% stocks (mostly utilities and energy issues) and 45% corporate bonds.

4. BDC companies (7 total)

Here I deviate from my core strategy of buying ETFs and CEFs simply because I could not find any BDC funds that I liked. If anyone knows one with a good track record, please post a comment and let me know.

A business development company is a company that invests in small and medium sized companies as well as distressed companies.

I looked at yields and performances of quite a few and found these 7 to be worth owning.

Note that BDCs are risky by nature. In addition, these are individual stocks, not funds. For those two reasons, I consider this group to be the riskiest of the 5 asset classes listed in this article. Thus I suggest for conservative investors like me that only a small portion of one's asset allocation be invested in these names.

Caveat: I don't like reading financial statements of individual companies and I am listing the BDCs without having done so. I know some readers may find that irresponsible on my part but I base my decisions on the criteria I listed above, not on financials. I assume that all known or knowable financial information is already factored into the price and that by reading financials I will not discover anything that every portfolio manager doesn't already know. I welcome comments from readers who are adept at reading such financials and as such may have a positive or negative view of some of the BDCs.

Gladstone Investment (NASDAQ:GAIN)

  • Gladstone Capital (NASDAQ:GLAD)
  • Main Street Capital (NYSE:MAIN)
  • Saratoga Investment Corp. (NYSE:SAR)
  • Ares Capital (NASDAQ:ARCC)
  • Capital Southwest (NASDAQ:CSWC)
  • Chimera Investment Corporation (NYSE:CIM)

Discussion:

Let's look at yields and performance in 1-year, 5-year and 10-year periods of these 7 issues:

GAIN has a 6.9% yield. It's 1-year chart is flat but both its 5 and 10-year charts show nice appreciation.

GLAD has an 8.8% yield. Its price has been essentially flat for all time periods.

MAIN, considered the class of the field, has a 5.6% yield and has shown good appreciation in all 3 time periods.

SAR is a bit of a flyer as it has had a rocky history. It has an 8.5% yield. It crashed in 2008 but since then has revamped its management team and investing strategy. Thus, I am looking at it only since 2014 where its performance has been very good. Invest in this issue only if you feel its problems from 10+ years ago are behind it and it is on the right track now.

ARCC has an 8.5% yield. It has shown just modest appreciation on the 1-year and 5-year charts but good appreciation on the 10-year chart.

CSWC has a 5.6% yield and has shown good appreciation in all 3 time periods.

CIM has a hefty 10.1% yield. It has been a roller coaster over the past 10 years with little net change in share price so be prepared for a lot of volatility.

5. Corporate Bond Funds (3)

  • Vanguard Long-Term Corporate Bond Index ETF (NASDAQ:VCLT)
  • SPDR Portfolio Long Term Corporate Bond ETF (NYSEARCA:SPLB)
  • iShares Long-Term Corporate Bond ETF (NYSEARCA:IGLB)

Discussion:

All 3 funds have comparable yields just under 4.0%. Like preferreds, these funds show relatively less volatility compared to other asset classes.

Over the past 10 years, share prices of both VCLT and IGLB are up about 33% while SPLB share price is up about 25 percent.

All 3 funds hold about 50% Baa-rated issues and 50% A or better rated issues and all 3 hold about 2,000 individual bonds. There is likely to be a lot of overlap with 2 or 3 funds holding the same individual bonds.

Final points and summary

As I said earlier, my portfolio is 90% individual bonds; the other 10% in decreasing amounts are in the following asset classes:

  1. Common stocks (not discussed in this article)
  2. REITs
  3. Preferreds
  4. Multi-income funds
  5. Corporate bond funds
  6. BDCs
  7. Precious metals (not discussed in this article)

I try to not be very correlated with the S&P 500 so I can weather the next stock market downturn with minimal damage, whenever that is.

What I have found about this portfolio is that on most days, about half the issues are up and half are down. If I have invested wisely, then the up volume will exceed the down volume most of the time, and therein lies the profit (that and the dividends I collect). Very rarely do I see all the issues up or all the issues down. Some are risk-on assets, some are risk-off assets. The betas (i.e., correlation to the S&P 500) are very diverse so the portfolio, by design, is not correlated to the S&P 500 nor are the issues correlated to each other.

This helps limit portfolio volatility, and most Bobby investors like that.

Disclosure: I am/we are long ALL 25 ISSUES LISTED IN THE 5 ASSET CLASSES. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.