Seeking Alpha

10% Yield: Why I 'Sleep Well At Night' With A 100% High-Yield Portfolio - Part 2

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Includes: ACRE, AGNC, AINV, ARCC, ARI, ARR, BXMT, CGBD, CHMI, CIM, CSWC, DX, GBDC, GSBD, HTGC, IVR, LADR, MAIN, MFA, MITT, MORL, NEWT, NLY, NMFC, NRZ, ORCC, OXLC, PCI, PFLT, PMT, SAR, SCM, SLRC, STWD, TCPC, TPVG, TSLX, TWO
by: High Yield Investor
High Yield Investor
Long only, portfolio strategy, REITs, BDCs
Summary

10% yield portfolio SWAN depends on basic principles to reduce risk.

Portfolio income sustainability based on bull/bear hedging strategy.

Yield vs. capital income allocation analysis chart (new visual display).

Introduction

This is Part 2 describing my experience with a SWAN “Sleep Well At Night” 100% high-yield portfolio. Price is not the focus of my investment strategy since price is controlled by market sentiment. Essentially, price is manipulated at times by emotion, based on short-term predictions. I don’t know about you, but price is something I’m not going to hang my hat on. Apparently, Santa thinks I’m on the right path; concentrate on the tangible cash flow and let price follow along at its own pace.

Source: Shutterstock, Words of Wisdom; Santa

I designed this portfolio for 10% yield back in 2014 and it continues today near 10%. This translates into higher cash flow, in effect producing both balance and income growth. This portfolio has six years of performance data along with taking a distribution in 2018 and 2019.

In my previous article, I touched on the concept of SWAN and how it relates to my current high-yield portfolio. When I first started building my income recession-proof portfolio, I believed analysts at the time, a recession was just around the corner and began purchasing agency mREITs (mortgage Real Estate Investment Trust) backed by the U.S. government.

With the same line of thinking concerning a recession around the corner, an interesting article published November 22, 2019 by Ben Carlson recently came out describing that fear-mongering has picked up since 2008.

“This group used to be more on the fringe but 2008 drove lots of investors over the edge. So now we get people who aren’t just bearish but basically root for the markets to go down to make themselves look better for being wrong all these years.

Perma-bears of the past used to put out research that gave you the other side of the argument. Now this group is full of tinfoil hat-wearing maniacs who simply predict a crash no matter what’s happening in the markets.

Just remember, even if this group pretends to be “right” when the next crash hits, they will never get you back into the market because there will always be room for another leg down in their minds.

They are not selling predictions, they are selling fear.”

With hindsight the valuations were elevated for my purchases, but I believed a recession was imminent. Needless to say, I overpaid for most of my mREITs back then, but something interesting happened through the years.

I noticed high dividends were swamping out my mispriced assets. Their accumulated high dividends were creating a positive total return for most holdings. This revelation solidified the SWAN concept for investing in high yield since the capital exposed in the market was being reduced at a faster clip. Receiving a tangible cashback with each purchase provided a positive feedback loop reaffirming my exposure in the high-yield environment.

Note: I publish an article once a year in February reporting how accumulated dividends overwhelm cost to produce positive total return. My last article “2019 Price, Dividend, Time Charts; Deceptive Price And 10% High Yield Income Revealed” is a good reference of the type of returns high yield actually produces in a short period of time; years not decades.

From my last SWAN article “10% Yield; Why I 'Sleep Well At Night' With A 100% High Yield Portfolio” I stated:

“We are constantly exposed to the acronym SWAN “Sleep Well At Night” all the time when analysts talk about individual investments. I want to touch on this same concept pertaining to building an income focused portfolio. From the start, building my own retirement SWAN portfolio I took steps upfront to deliver excess income exceeding my expenses. The focus on building a SWAN portfolio does not depend on a few individual investments, but from the totality of all the individual moving parts working together.”

I want to continue with this line of thinking by exposing readers to additional steps taken to safeguard an important aspect in retirement, namely income.

SWAN Depends On Principles To Reduce Risk

My portfolio design began while still working and I needed a plan to replace my paycheck when I retired. A number of common-sense factors were assessed upfront. They were developed for high yield, but can be used for any portfolio in or near retirement.

Principle #1

  • Pre-Retirement: I wanted to perform a lateral transition from a working paycheck to retirement paycheck, without reducing my current expenses. Social Security along with some IRA withdraw should pay my current expenses.

Principle #2

  • Pre-Retirement: With all the deductions taken out of my working paycheck, including Social Security, Medicare, High Deductible Health Care, 401(k) 10% contribution, State and Federal taxes, etc., I realized my take-home pay would be a good starting number. Household expenses were paid from my take-home pay. I now had a working number as a goal in mind.

Principle #3

  • I wanted to design a portfolio that generated twice the required dividend income needed for my distribution. The reason for this was the margin of safety with unexpected income variability. This concept is very important since I’m using high-yield assets that may eventually reduce their dividends. This amount of distribution along with Social Security pays my current expenses.

Principle #4

  • The excess dividends in the IRA portfolio are used to reinvest and grow the income cash flow. In retirement, I wanted to be in the accumulation phase like I was when employed. Nothing has changed except the amount of reinvestment capital is now three times that of my 401(k) contribution while working.

Principle #5

  • Another important aspect to my design was to never sell shares for income. This one is self-explanatory where selling shares reduces income. My only trading activity is to buy more income-producing shares, always in the accumulation phase.

Principle #6

  • After my initial assertion concerning my design, a Shmoo plot evaluation (Excel software application I developed) indicated I needed a 10% yield design. This level of yield satisfied both my distribution (to pay expenses) and reinvest surplus dividends to grow future income.

Principle #7

  • The next step was to find out which stocks generated high-yield dividends ranging between 8 and 12% yield. It’s not that hard in the CEF, ETF, BDC, REIT, etc., sector of the economy. Seeking Alpha is an excellent source to begin searching out possible candidates.

Principle #8

  • During my search for high-yield stocks, I determined to purchase assets that will perform well during both a bull or bear market. Thus, the 50/50 (BDC, mREIT) portfolio was created. Two asset classes where I can chart and track them against each other. See Hedging Strategy, Principle #8 section for additional detail.

Principle #9

  • The next element in keeping up with the SWAN concept is to rely on a reasonable number of income contributors. I started with 30 holdings back in 2014, currently at 38. When building a portfolio, individual company management is very important in providing reasonable expectations for dividend sustainability. As we all know sometimes an under-performer will enter the portfolio and needs to be replaced. See YTD Price/Dividend Performance, Principle #9 section for additional detail concerning dividend increases/decreases.

Principle #10

  • Another strategy I use is income allocation. This method provides more capital exposure to lower-yielding investments that are generally safer, and lower capital to higher-yield investments generally at higher risk. For an example, let’s say there are two stocks, one yielding 7% and the second yielding 14%. With this method the second stock with the higher yield will have half the capital exposure than the first stock with lower yield. The principle behind this method comes from the presumption that lower yielding stocks are safer than higher yielding stocks. See Income/Capital Exposure, Principle #10 section Table-1 and Chart-3.

Hedging Strategy, Principle #8

My portfolio is unique and designed to reduce income volatility during a bull or bear market. I use two asset classes in my IRA portfolio: BDCs (Business Development Company) for a bull market and mREITs for a bear market with the focus on income. This is what hedging looks like taking out insurance protection from catastrophic income loss during any market cycle. The only major difference is collecting the massive dividend income while waiting.

The following quote from my original article “High Yield 50/50 Portfolio Strategy Built With BDCs And MREITs” describes my hedging strategy:

"(1) BDCs, in general, outperformed when markets were flat to up, while (2) Agency Mortgage REITs, in general, outperformed when markets were flat to down." In the process the investor "collects a meaningful amount of dividends throughout the process as both vehicles provide above-average yields, i.e., 8+%".

"BDCs' performance is tied to the underlying borrower's ability to borrow or repay. In times of economic stress, borrowers' willingness and ability to lend and/or repay declines, negatively affecting BDC performance."

"Agency MREITs (by design) are negatively correlated to the health of the U.S economy. Stated another way, when the U.S. economy is performing poorly, Agency MREITs tend to outperform.", "Agency MREITs are simply leveraged portfolios of U.S. mortgage backed securities, and these securities carry an implied government guarantee, which means that if there is a principal loss on a home loan, the government will back the credit loss. Thus, in periods of economic stress, investors generally seek the safety and security of U.S. government backed papers (like Treasuries and MBS pools) and this leads to strong performance in times of financial distress."

During the past 6 years, my total portfolio return has continually grown along with increased cash flow based on surplus dividends reinvested. Judge for yourself if high-yield investing is as dangerous as pundits continually try to portray. Understanding how both asset types work together makes all the difference in becoming a successful 10% High Yield Investor in retirement.

As a side note, both types of stocks are pass-thru investments established under the 1940 Regulated Investment Company Law that avoids double taxation. They are special income investments that are required to pay out 90% of their earnings as dividends. The investor is responsible to pay taxes as ordinary income and best held in an IRA or ROTH account.

YTD Price/Dividend Performance, Principle #9

The following two charts detail year-to-date price/dividend changes. This shows the importance in building a high-yield portfolio with many individual investments. We can’t know for certain which individual company will have problems, but the rest of the holdings will come through and make up the difference.

Chart-1: YTD 2019 price performance

Needless to say, Chart-1 stock performance is typical for most investors this year since the beginning valuations were quite low. The left side of the chart contains 19 BDC stock types and the right side contains 19 mREIT types. Notice the mREITs had difficulty this year (price declines, red bars) from the rapidly declining Treasury rates.

The yield spread for the 3-month and 10-year inverted for quite some time before the Fed began reducing the overnight lending rate 3 times in 2019. Rapid rate changes create problems with mREIT hedging strategies and 7 of them cut their dividends, see Chart-2.

Chart-2: YTD 2019 Dividend changes

Chart-2 is a simple display of all the dividend increases and decreases during 2019. As I said previously, seven mREITs cut their dividends, red negative bars. Also notice the green bars where this year the portfolio had 10 dividend increases. This is one example I consider a SWAN advantage by having many individual stocks to absorb a few dividend reductions and not having much effect on the income stream.

Even with the dividend reductions and withdrawing a distribution, I’m estimating 2019 total income growth to come in at 7.0%. Reinvesting surplus dividends plays an important role in both balance and income growth as my final 2019 report will demonstrate. The report will come out the first week of January 2020, please select follow and prepare to be amazed at the performance.

A note on special dividends - they have given a boost to total yearly income this year. Since all high yield stocks in this portfolio are RIC (Regulated Investment Company) stocks, they must pay out at least 90% of their earnings as dividends. Most high-yield stocks will pass any extra earnings to the investor to prevent paying corporate tax and continue to be considered tax-exempt.

Yield/Capital Exposure, Principle #10

The following chart demonstrates income allocation and capital at risk based on yield. This method reduces the possibility of having too much capital at risk in very high-yield assets.

Chart-3: Capital vs. Yield

I’ve talked about this method many times, but finally figured out how to visually demonstrate its effectiveness. Notice in Chart-3, the inverse relationship between capital exposure to yield for stocks with the same level of yearly total dividends. The black arrows in “Grp-1” show the inverse relationship between capital allocation and yield. The higher the yield, the less capital is exposed in the market.

Take a look at “Grp-6” stocks, ARES Capital Corp.'s (ARCC) yield of 8.6% with capital exposure of 4.2% while UBS AG ETRACS Monthly ETN's (MORL) yield of 23.2% is 1.6%. They both generate the same income, but I have about 1/3 less capital in MORL than ARCC.

This is income allocation based on yield. This method provides capital preservation based on income and not equal asset allocation. This is a very important concept when investing in high yield that indirectly stabilizes portfolio volatility.

Table-1 listed below are the groups of stocks plotted in Chart-3.

Table-1

Symbol

Inc. Allocation

Capital At Risk

Yield

Grp-1

(TSLX)

2.5%

3.3%

7.3%

(CSWC)

2.5%

3.3%

7.5%

(PMT)

2.5%

3.0%

8.3%

(PFLT)

2.5%

2.5%

9.7%

(OTC:AINV)

2.5%

2.2%

11.0%

Symbol

Inc. Allocation

Capital At Risk

Yield

Grp-2

(BXMT)

2.6%

3.7%

6.9%

(GSBD)

2.6%

2.9%

8.9%

(NMFC)

2.6%

2.5%

10.2%

(TCPC)

2.6%

2.5%

10.2%

(MFA)

2.6%

2.5%

10.5%

(TWO)

2.6%

2.3%

11.1%

Symbol

Inc. Allocation

Capital At Risk

Yield

Grp-3

(PCI)

2.7%

3.1%

8.3%

(CIM)

2.7%

2.7%

9.9%

(IVR)

2.7%

2.4%

11.2%

(CGBD)

2.7%

2.4%

11.3%

(ARR)

2.7%

2.2%

12.0%

Symbol

Inc. Allocation

Capital At Risk

Yield

Grp-4

(SAR)

2.8%

3.1%

9.0%

(DX)

2.8%

2.5%

11.0%

(OXLC)

2.8%

1.4%

19.4%

Symbol

Inc. Allocation

Capital At Risk

Yield

Grp-5

(HTGC)

3.1%

3.3%

9.2%

(NEWT)

3.1%

3.3%

9.4%

(SCM)

3.1%

3.2%

9.6%

(TPVG)

3.1%

3.2%

9.7%

Symbol

Inc. Allocation

Capital At Risk

Yield

Grp-6

(ARCC)

3.7%

4.2%

8.6%

(AGNC)

3.6%

3.2%

11.1%

(NRZ)

3.6%

2.7%

13.0%

(MORL)

3.7%

1.6%

23.2%

Income Allocation NOT charted

Symbol

Inc. Allocation

Capital At Risk

Yield

(ACRE)

0.4%

0.5%

8.6%

(ORCC)

0.4%

0.6%

7.0%

(GBDC)

1.6%

2.2%

7.1%

(MAIN)

1.7%

2.9%

5.8%

(LADR)

1.8%

2.2%

8.0%

(STWD)

1.9%

2.3%

8.0%

(SLRC)

2.0%

2.4%

8.0%

(ARI)

3.0%

2.9%

10.3%

(MITT)

3.3%

2.7%

11.8%

(CHMI)

3.3%

2.9%

11.0%

(NLY)

3.4%

3.1%

10.9%

Note: Income allocation is simple to calculate. Take 100% and divide by the number of stocks in your portfolio. For my portfolio, 100 / 38 = 2.6%; this is the minimum allocation I want to achieve for each investment. I’m allowed to go over this percentage based on bargain-bin sales. I can’t help myself if a bargain comes my way. I then pounce and increase my future cash flow; instant gratification.

Conclusion

I have now presented my “Sleep Well At Night” principles in providing a margin of safety when investing in high yield. The main focus is income creation and not price appreciation. Like I say in my profile, “Those who live by price will dwell in the fear of price” is the reason for such volatility in the market as people try to anticipate short-term market direction. This only provides opportunity to those who know how to capitalize on price declines for investments they want to own.

I’m not advocating for any individual investments in the high-yield space. Both SWAN articles describe how I built my personal portfolio using only BDCs and mREITs or similar high-yield stocks. Other authors use different high-yield investments that get comparable results in producing high income along with balanced growth. The principles in both articles could provide the groundwork in protecting the most valuable asset for any retiree, namely income cash flow.

If you're years away from retirement, consider saving these two SWAN articles for reference. You might use some of these common sense ideas in the future when investing in high yield.

Good luck to all income seekers.

Disclosure: I am/we are long ALL STOCKS IN THIS ARTICLE. 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 not a financial adviser, but an independent investor. 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 BDCs and mREITs. Both investment vehicles are "Regulated Investment Companies" and required to distribute at least 90 percent of their earnings as dividends to investors.

This is a live active IRA portfolio that I believe will withstand the markets' bull and bear cycles 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.