When is 3 percent better than 6 percent? Yeah, we all know the answer, but only until
the prices of the securities we already own begin to fall. Then, logic and
mathematical acumen disappear and we become susceptible to all kinds of special
cures for the periodic onset of higher interest rates. We'll be told to sit in
cash until rates stop rising, or to sell the securities we own now, before they
lose even more of their precious Market Value. Other gurus will suggest the
purchase of shorter-term bonds or CDs (ugh) to stem the tide of the perceived
erosion in portfolio values.
There are two important things that your mother never
told you about Income Investing: (1) Higher Interest Rates are good for
investors, even better than lower rates, and (2) Selecting the right securities
to take advantage of the interest rate cycle is not particularly difficult.
Higher
Interest Rates are the result of the Government's efforts to slow a growing
economy in hopes of preventing an appearance of the three headed inflation
monster. A quick glance over your shoulder might remind you of recent times
when the government was trying to heal the wounds of a misguided Wall Street
attack on traditional investment principles by lowering interest rates. The
strategy worked, the economy rebounded, and Wall Street is trying to scramble
back to where it was nearly six years ago.
Think about the impact of changing interest rates on your
Income Securities during the past five years. Bonds and Preferred Stocks;
Government and Municipal Securities; they all moved higher in Market Value.
Sure you felt wealthier, but the increase in your Annual Spendable Income got
smaller and smaller. Your total income could well have decreased during the
period as higher interest rate holdings were called away (at face value), and
reinvestments were made at lower yields!
How many of you have mental bruises from the realization
that you could have taken profits during the downward trajectory of the cycle,
on the very securities that you now lament over. The nerve; falling below the
price you paid for them years ago. But the income on these turncoats is the
same as it was in 2004, when their prices were ten or twenty percent higher.
This is the work of Mother Nature's financial twin sister. It's like acorns,
snowfalls, and crocuses. You need to dress properly for seasonal changes and
invest properly for cyclical changes. Remember the days of Bearer Bonds?
There was never a whisper about Market Value erosian. Was
it the IRS or Institutional Wall Street that took them away?
Higher rates are good for investors, particularly when
retirement is a factor in your investment decisions. The more you receive for
your reinvestment dollars, the more likely it is that you won't need a second
job to maintain your standard of living. I know of no retail entity, from
grocery store to cruise line that will accept the Market Value of your portfolio
as payment for goods or services. Income pays the bills, more is always better
than less, and only increased income levels can protect you from inflation! So,
you say, how does a person take advantage of the cyclical nature of interest
rates to garner the best possible income on investment quality securities? You
might also ask why Wall Street makes such a fuss about the dismal bond market
and offers more of their patented Sell Low, Buy High advisories, but that
should be fairly obvious. An unhappy investor is Wall Streets best customer.
Selecting the right securities to take advantage of the
interest rate cycle is not particularly difficult, but it does require a change
in focus from the statement bottom line. and the use of a few security types
that you may not be 100% comfortable with. I'm going to assume that you are
familiar with these investments, each of which could be considered (from time
to time) for a spot in the well diversified Income Portion of your Asset
Allocation: (1) The traditional individual Municipal and Corporate Bonds,
Treasuries, Government Agency Securities, and Preferred Stocks. (2) The eyebrow
raising Unit Trust varietals, Closed End Funds, Royalty Trusts, and REITs.
[Purposely excluded: CDs and Money Funds, which are not
investments by definition; CMOs and Zeros, mutations developed by some sicko
MBAs; and Open End Mutual Funds, which just can't work because they are really
"managed by the mob". i.e., investors.]
The market rules that apply to all of these are fairly predictable, but the ability
to create a safer, higher yielding, and flexible portfolio varies considerably
within the security types. For example, most people who invest in Individual
bonds wind up with a laundry list of odd lot positions, with short durations
and low yields, designed for the benefit of that smiling guy in the big corner
office. There is a better way, but you have to focus on income and be willing
to trade occasionally.
The larger the portfolio, the more likely it is that you
will be able to buy round lots of a diversified group of bonds, preferred
stocks, etc. But regardless of size, individual securities of all kinds have
liquidity problems, higher risk levels than are necessary, and lower yields
spaced out over inconvenient time periods. Of the traditional types listed
above, only preferred stock holdings are easily added to during upward interest
rate movements, and cheap to take profits on when rates fall. The downside on
all of these is their callability, in best-yield-first order. Wall Street loves
these securities because they command the highest possible trading costs. costs
that need not be disclosed to the consumer, particularly at issue.
Unit Trusts are traditional securities set to music, a
tune that generally assures the investor of a higher yield than is possible
through personal portfolio creation. There are several additional advantages:
instant diversification, quality, and monthly cash
flow that may include principal (better in rising rate markets, ya follow?),
and insulation from year-end swap scams.
Unfortunately, the Unit Trusts are not managed, so there
are few capital gains distributions to smile about, and once all of the
securities are redeemed, the party is over.
Trading opportunities, the very heart and soul of successful Portfolio
Management, are practically non-existent.
What if you could own common stock in companies that
manage the traditional Income Securities and other recognized income producers
like real estate, energy production, mortgages, etc.? Closed End Funds (CEFs),
REITs, and Royalty Trusts demand your attention. and don't let the idea of
"leverage" spook you. AAA + insured corporate bonds, and Utility
Preferred Stocks are "leverage". The sacred 30-year Treasury Bond is
"leverage". Most corporations, all governments
(and most private citizens) use leverage.
Without leverage, most people would be commuting to work
on bicycles. Every CEF can be researched as part of your selection process to
determine how much leverage is involved, and the benefits. you're not going to
be happy when you realize what you've been talked out of! CEFs, and the other
Investment Company securities mentioned, are managed by professionals who are
not taking their direction form that mob (also mentioned earlier). They provide
you the opportunity to have a properly structured
portfolio with a significantly higher yield, even after the management fees
that are inside.
Certainly, a REIT or Royalty Trust is more risky than a CEF comprised of
Preferred Stocks or Corporate Bonds, but here you have a way to participate in
the widest variety of fixed and variable income alternatives in a much more
manageable form. When prices rise,
profit taking is routine in a liquid market; when prices fall, you can add to
your position, increasing your yield and reducing your cost basis at the same
time. Now don't start to salivate about the prospect of throwing all your money
into Real Estate and/or Gas and Oil Pipelines. Diversify properly as you would
with any other investments, and make sure that your living expenses (actual or
projected) are taken care of by the less risky CEFs in the portfolio. In bond
CEFs, you can get un-leveraged portfolios, state specific and/or insured
Municipal portfolios, etc. Monthly income (frequently augmented by capital
gains distributions) at a level that is most often significantly better than
your broker can obtain for you. I
told you you'd be angry!
Another
feature of Investment Company shares (and please stay away from gimmicky,
passively managed, or indexed types) is somewhat surprising and difficult to
explain. The price you pay for the shares frequently represents a discount from
the market value of the securities contained in the managed portfolio. So
instead of buying a diversified group of illiquid individual securities at a premium,
you are reaping the benefit of a portfolio of (quite possibly the same)
securities at a discount.
Additionally, and unlike regular Mutual Funds that can
issue as many shares as they like without your approval, CEFs will give you the
first shot at any additional shares they intend to distribute to investors.
Stop, put down
the phone. Move into these securities calmly, without taking unnecessary losses
on good quality holdings, and never buy a new issue. I meant to say: absolutely
never buy a new issue, for all of the usual reasons. As with individual
securities, there are reasons for unusually high or low yields, like too much
risk or poor management. No matter how well managed a junk bond portfolio is,
it's still just junk. So do a little research and spread your dollars around
the many management companies that are out there. If your advisor tells you
that all of this is risky, ill-advised foolishness. well, that's Wall Street,
and the baby needs shoes.
The final
article in this Income Investing trilogy will be on managing the Income
Portfolio using the Working Capital Model.
******************************************
Steve Selengut
http://www.sancoservices.com
Professional Portfolio Management since 1979 Author of:
"The Brainwashing of the American Investor: The Book that Wall Street Does
Not Want YOU to Read", and "A Millionaire's Secret Investment
Strategy"
