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 erosion. 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.
About the author:
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"
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