Adventures in High-Yield Investing

On a different topic than the usual science-and-faith…Over the New Year’s holiday I reflected on how ten years from now I will likely be retired and living largely off the returns of whatever I have been able to invest by then. So I decided to do some reading on investing.

The data I have seen indicates that if you don’t need to draw down your investment for fifteen years or more, you are usually best off to put it all in stock funds and just leave it alone. Studies show a long term average return (including reinvested dividends) in the stock market of 9.6%, or 6.2% after adjusting for the effects of inflation.

However, for later phases of life, financial advisors typically counsel investors to allocate some portion of their portfolio to fixed-income securities that generate cash to spend.  Also, after a 30% runup in stocks last year, the market may well muddle along flatter in 2014, making other investments more attractive this year.

For some time now, short-term money market funds have yielded essentially zero. Currently a one-year CD yields a little over 1%, a five-year CD about 2%, and a ten-year U.S Treasury note yields just under 3%. These are viewed as essentially risk-free yields.  These rates are near historic lows, so presumably they will be higher in coming year. Nevertheless, I’d like to get higher yields than the minimum. Therefore, I have been reading up to understand what types of higher-yielding investments exist out there. Naturally, with higher yields come higher risks. But I found a couple of investments that seem to have attractive fundamentals, and have made some small purchases to put some skin in the game.

Yahoo Finance  is a good starting place to check on basic data for a security, and gives links to recent articles. A lot of people spend a lot of time studying investments, and many of them share their learning on the internet. For instance, Bruce Saunders has presented a compact discussion of a number of income-generating investments, with great charts and links.

I have found the Seeking Alpha site to be very educational. Contributors are always posting short articles sharing information and touting some stock or fund; what really adds value is the comments on these articles. If the article’s thesis is bad, usually some reader will point it out.

Here I will note a resource I found particularly helpful for identifying investments that yield high income. A private investor named Tim McPartland, who has some finance background, has studied lots of high-yielding securities and put together a preferred list of them. His full list is here.

I have taken his master table, and trimmed away many rows and columns, and copied the remainder below. I removed several whole categories (e.g. Exchange Traded Debt and Master Limited Partnerships) to make it more digestible.

High Yield Table

The first category here is Preferred Stocks. Without going into all the details, a preferred stock should pay out a fixed dollar amount of dividend each year. Unlike with common stock, the dividends on preferreds do not rise from year to year. Thus, they usually perform much like long-term bonds.  If interest rates rise (which is likely to happen in 2014), the value of preferred stocks will drop. This may not matter to you if you plan to just hold them forever and collect their dividends.

However, the Dividend Hunter site pointed out several preferreds which have a special characteristic: the issuing company has committed to buy these shares back at fixed price, at a fixed date in the future. That removes much of the interest rate-related fluctuations in market price.

For instance, Oxford Lane Capital has issued two series of preferreds, one of which will be redeemed in 2023 (and is listed in the table above), and one in 2017. I checked the historical price of the 2017 issue and found it has traded in a range of about 26.0-26.4 for the last year. I bought some of this last week and now have a locked-in 8% yield for the next three years.  There is a low probability/high impact risk here of having Oxford Lane Capital’s earnings tank, making it unable to pay the dividend.

Instead of you personally buying an apartment complex and renting out, you can buy shares in an enterprise doing just that. A Real Estate Investment Trust (REIT) can buy and rent out properties, and is required to distribute nearly all the taxable income back to shareholders. A REIT (in general) does not pay tax at the corporate level, which is a huge advantage.

I looked at some of the REITs listed above, and decided to buy some shares of Realty Income (symbol “O”).  At 5.9% its yield was not the highest, but it is a very well established company and is likely to continue raising the dividend. Its share price has flopped around similar to a long bond.

The common stocks listed include some familiar names like AT&T, Proctor and Gamble, and the utility Southern Company. I got intrigued by the 9.25% dividend on Seadrill, read up on the company (they contract off-shore oil-drilling platforms), and decided to buy some shares. It’s riskier than some of the other choices in the list above, but offers a chance at capital growth in addition to plain income.

Closed end funds (CEFs) can trade higher or lower than the net asset value (NAV) of their holdings. The pros advise waiting to buy until the discount to NAV is deeper than whatever is the historic average for that fund, since the discount will likely later revert back to its long-term average. Four CEFs are listed above, which have various investing strategies.

These funds can employ leverage, e.g. Nuveen Preferred and Income (JPI) borrows low-interest short-term money to buy higher-yielding longer-term preferred stocks.  This gives a higher return for the fund, but also magnifies its value swings up and down.  JPI currently trades at about a 6% discount to its NAV, probably because investors are anticipating that the NAV will fall if interest rates continue to rise. For a non-leveraged, non-CEF play on high yield bonds, a highly-regarded high yield (“junk ”) bond fund is AdvisorShares Peritus High Yield ETF (HYLD). It yields around 7%, and has relatively low interest rate volatility since the average duration (time left till maturity) of its bond holdings is only about 3 years.

The Blackrock Global Opportunities (BOE) closed end fund listed above buys stocks, then sells (“writes”) call options on them. This is a pretty reliable way to generate 8-9% returns, though you have to ride out drops in share prices if the stock market dips. The fund values here do seem to come back after a correction.  I bought some ETV which is a buy-write fund like BOE but with better price stability, which yields around 9% and makes its distributions in tax-advantaged ways.

Instead of trying to choose among the hundreds of CEF’s out there, you could buy shares in an ETF which has selected a basket of CEF’s. You pay an extra 0.5%  or so in expenses for these ETF’s, but get expert picks and diversification. YieldShares High Income ETF   (YYY) and PowerShares CEF Income Composite Portfolio (PCEF) each yield about 8%.  YYY’s holdings are tilted towards stock CEF’s, including call-write funds, while PCEF holds more bonds than stocks. Cohen & Steers Closed End Opportunity Fund (FOF) is a CEF which, like YYY and PCEF, selects and hold a wide variety of CEFs. FOF typically trades at a discount to its own holdings, which results in a boost in your yields.

One common high yield security is missing from this list. The REITs listed above are equity REITs, which buy and rent out physical properties. A different animal is the mortgage REIT, which borrows fistfuls of low-interest, short-term money to buy higher-interest mortgage loans. Annaly Capital Management (NLY) is a classic mREIT. It typically yields well over 10%, but with rising interest rates and other factors, its stock price is down to about half of what it was 18 months ago. Ouch. Most commentators agree that the worst is over for NLY and similar pure mREITs, but they may drop another 10% in 2014 if interest rates spike.

Two Harbors (TWO) is a hybrid mREIT, which has diversified and taken special steps to protect against the effects of rising interest rates. I am not competent to run the financials myself, but essentially every article I read agreed that TWO is pretty safe (unless we get another 2008-style meltdown), so I bought some. It currently yields 10.7%.

Another class of income securities that does not appear in this list is adjustable rate loans, which banks have made to companies.  Because the interest rates on these loans tend to ratchet up if general interest rates rise, their value does not gyrate as much as for bonds. (There is some complexity here involving the “LIBOR floor” which I won’t go into).  Also, secured bank loans have a higher priority on the assets of a bankrupt company than do bonds, so they are less at risk if a company fails.  Nevertheless, we can expect the prices here to dip during an economic slowdown as fears rise over loan repayments, leading to equity-like risks for these funds.

I am trying to decide whether to dip into this space. A leading exchange traded fund (ETF) in this area is PowerShares Senior Loan Portfolio (BKLN), currently yielding around 4.5%. As an ETF, its shares tend to track along with its NAV.  Invesco Senior Income Common (VVR) is a leveraged bank loan fund which yields about 6.5%. The higher yield is attractive here, but because this is a closed end fund as opposed to an ETF, the market share price can go considerably higher or lower than the NAV. This makes VVR about twice as volatile as BKLN. The Fidelity Floating Rate High Income (FFRHX) fund, currently yielding 3%, is renowned for low volatility. This is a regular Fidelity fund, which has a minimum purchase amount of $2500 and a redemption fee of 1% if held less than 60 days. I think it can be purchased through a stockbroker account. Ridgeworth Seix Floating Rate High Income Fund  (SAMBX) has volatility similar to FFRHX, with a slightly junkier portfolio and a yield of about 4%.

A reality check on this sort of high-yield investing is offered by Seeking Alpha contributor Steven Bavaria. He invests in a portfolio of mainly closed-end funds for his IRA, which he periodically reports on, most recently in April, 2015 .  Most of these funds borrow cheap short-term money and buy higher-yielding bonds and preferred stocks. His portfolio succeeds in yielding about 9% in cash dividends and distributions. So this is doable. Because of his long-term perspective, he does not worry if the share prices of his funds fluctuate. Since this for an IRA, he is not concerned with tax-advantaged strategies.

Seeking Alpha author Left Banker has (September, 2015) put together a diversified model portfolio of mainly closed-end funds for a non-IRA account, where taxes are more of a concern. His yields on tax-exempt municipal funds are about 5%. For taxable funds he gets about 8% yield, much in the form of tax-advantaged qualified dividends.

Other useful sites for checking on various securities include QuantumMorningstar, CEFChannel (for closed-end funds), and PreferredStockChannel for preferreds.

Technical trading note: Some CEF’s and preferreds are thinly traded issues (maybe just a couple trades per day), which means the spread between bid (the price at which someone is currently offering to buy) and ask (the price that someone on the stock exchange is offering to sell for) can be large. Thus, it is recommended to place limit orders, rather than market orders, to buy or sell these securities at reasonable prices.

On taxes (U.S. federal; details omitted): Most dividends, and capital gains on assets held more than a year, are taxed at a special low rate of 15%, or even 0% for the lowest income brackets. Short-term capital gains, interest, and most dividends from REITs are taxed as ordinary income, at tax rates which can be over 30%.  The interest from most municipal bonds is not taxed, so for someone in a 28% tax bracket, a 5% yield on a muni is like 6.9% regular interest.

For my description of the overall workings of the modern monetary system, see here.  Happy investing…

[Boilerplate Disclaimer: This page should not be taken as advice to buy or sell anything].

POST SCRIPT

It has been nearly two years since I posted the article above. Most of the content has stood the test of time, but I have since learned a few things that are worth noting.

The limited-term preferreds I bought (OXLCP and a similar instrument GLADP from Gladstone Capital) performed just as expected – – their value floated around $25/share, and they paid 7-8% dividends. The only perturbation was that the companies redeemed both of these issues earlier than required (at $25/share, which was OK), so to replace them I had to go buy similar shares from more-recent issues (e.g. OXLCO, listed above, and GLADO). No harm. The plain (perpetual) preferred stock from NLY, and the buy-write fund ETV and common stock T (AT&T) I bought in early 2014 have all pretty well held their values, and kept pumping out dividends.  The equity REIT O has continued its long-term solid performance.

The high yield bond fund HYLD had been remarkably stable for several years previous. In late 2014, this sector fell into into disfavor, and the share price of HYLD started going down. I was alerted by numerous Seeking Alpha articles that high yield (“junk”) bonds were going to be in trouble, so I sold out, roughly breaking even before the share price cliff-dived.

My holding in the mortgage REIT TWO was good for nearly two years, then its price started to slide. When I read a Seeking Alpha article speculating that TWO might have to cut its dividend, I bailed out, just in time before its price dropped 10%.  Lesson learned: mortage REITs are trickier vehicles than most, with dependence on yield spreads, leverage, and asset values. Their share prices and dividends have shown a tendency to erode with time. The reason they sport such high current yields (10-12%) is because the market believes that their dividends and share prices are not sustainable. So handle with care.

My investment at about $40/share in SDRL (Seadrill, which buys and rents out oil well drilling ships) did not turn out so well. This stock started sliding as the price of oil dropped in 2014. There were some dire warning articles in Seeking Alpha, but there were just as many articles arguing forcefully that Seadrill was going to be just fine. Also, the company pronouncements seemed to say that they would maintain their dividend payments all through 2015, so I was not too worried.  I sold half of my holdings at a moderate loss, and held onto the rest, hoping for a rebound. In a surprise announcement, the company completely eliminated the dividend in late 2014, and the stock instantly plunged from 21 to 12, and has since dribbled down to 6. Lesson learned: if there are strong reasons to doubt a company fundamentals, get out sooner rather than later, and put your money to better use elsewhere. Also, if an investment seems particularly risky, only devote a small percentage of your portfolio to it.

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About ScottBuchanan

Ph D chemical engineer, interested in intersection of science with my evangelical Christian faith. This intersection includes creation(ism) and miracles. I also write on random topics of interest, such as economics, folding scooters, and composting toilets. Background: B.A. in Near Eastern Studies, a year at Gordon-Conwell Theological Seminary and a year working as a plumber and a lab technician. Then a B.S.E. and a Ph.D. in chemical engineering. Since then, conducted research in an industrial laboratory. Published a number of papers on heterogeneous catalysis, and an inventor on over 80 U.S. patents in diverse technical areas.
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5 Responses to Adventures in High-Yield Investing

  1. Anonymous says:

    Wow, fancy finding this on your site! I was actually on your site looking for other material, but was very pleased to find this, as I am also interested in investing! I am curious as to what your thoughts are on your findings a year ago?

    • Well, a year later I can say that the fixed income holdings (various preferreds) have worked out well, as has TWO. Pretty much held their values, and gushed income (8-10%). I have also bought some MORL, which is like a2X leveraged mREIT fund (technically not a fund, but Exchange Traded Note or ETN). It yields about 20% (!) but is a bit volatile.
      I bought O but sold too soon — it’s price went up a lot as interest rates fell. ETV (closed end buy-write fund) has done OK — yields about 9%. It’s value climbed (as discount to NAV shrank) over the past year, then retraced with the market angst that has prevailed off and on since October.

      Bought some HYLD, got several months of ~ 7% interest out of it, then its value started to tank as low oil prices affected indebted shale oil drillers, casting a shadow over high-yield (junk) bonds. I got out after it dropped about 10%, which is good b/c it then dropped another 10%. Odd, b/c its value had been rock-steady for about a year previous.
      Big heartburn has been SDRL. This has been successful, high-growth leassor of deep sea drilling rigs. But fast growth is b/c they borrowed a ton of money to build, which (as it turns out now) puts them in long-term danger of bankruptcy. I bought in around 38, sold half after it dropped to about 25. At that point the dividend was up to 13%. I held on to the other half because mgt pronounced that the dividend was safe into 2016 — so how bad could this be? Also, I read article after article on Seeking Alpha about how SRDL had nearly all its rigs contracted for, so there was no need to worry. The, blam, out of the blue mgt not just cut, but completely eliminated the dividend. Stock dropped in half overnight.
      At that point, I was too demoralized to lock in such a huge loss by selling my shares, so I am holding on to my miserable remnant, in case there is a war or something to drive the price of oil back up this year. Which is not really a good example of rational, disciplined investing, but I am learning from my mistakes by having skin in the game. Takeaway from SDRL debacle: try to decide ahead of time a reasonable stop-loss point. Which is what all the pros say — if you lose a big chunk of your capital, you are kind of out of the game. I do not have a good selling discipline – yet.

      I did not write about Business Development Companies a year ago, since I did not understand them. I have since read more about them. They lend money directly to startup type companies, and often yield 8-9%. They should be safe as long as the business environment in the US is healthy.
      After another year of reading and doing, perhaps the best advice I can give now in this area is to follow the articles of Steve Bavaria and “Left Banker” on Seeking Alpha. They seem to be savvy and well-balanced, not perma bull or perma bear, but able to adjust to changing circumstances.
      Best of luck to you…

      • Anonymous says:

        Thanks, Scott, for your detailed response.

        I don’t live in the US, so I don’t understand all the options you talk about, but the ideas are useful nevertheless. I, too, got caught by not having stop-losses and am just sitting and hoping for recovery on oil stocks. Then again, who would’ve thought all that would have happened? Still, if you are in it for the long term, good stocks do recover and hopefully, outcomes from good choices trump the ones from nasty surprises.

        I am still in the midst of reading some of your other posts, so you may see a comment here and there as I find something interesting!

  2. Chris Falter says:

    Hi Scott – In the 90’s I was a financial consultant at Merrill Lynch. I always encouraged my investors to put the bulk of their funds in the least expensive, broad market (preferably index funds) available. Investing in single issues or narrow funds is fun, but rarely beats the market. My brokerage peers were incredulous; they were quite sure that I could outsmart the market. But I had read Malkiel’s “Random Walk Down Wall Street,” so I was under no illusion that the recommendations of Motley Fool and Bloomberg and Kiplingers were worth following.

    My career did not last very long, but I was able to leave the field with a clear conscience. Since then I have put all my retirement savings in no-load stock market index funds, slept soundly, and made a killing–with vanishingly small effort.

    This article from the NY Times “Upshot” section pretty much says it all:

    “It’s Time to Ignore Advice About Which Stocks to Buy in 2017”

    http://www.nytimes.com/2017/01/04/upshot/its-time-to-ignore-advice-about-which-stocks-to-buy-in-2017.htm

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