Just the other day, I was discussing the topic of retirement readiness with a small group of people, some of whom were already retired. None of them owned or had even heard of them, either equity or income closed-end funds (CEFs)…vehicles I’ve used in professionally managed portfolios for decades.
Readers are assumed to have read the six Q&A questions covered in Part One.
7. Why do CEFs, public REITs, and master limited partnerships seem to be ignored by Wall Street, the media, and most investment advisors?
All three are income producers, and once they’re “out there” in the market, they trade like stocks…due to their own fundamental advantages and at a price solely dependent on supply and demand. Unfortunately, income programs have never garnered the attention and speculative fervor that any type of growth vehicle has.
Income mutual funds and ETFs can create shares at will, with market value equal to NAV (net asset value). But the sole purpose of each is to increase market value and achieve a stock market-like “total return” number… Yields are rarely mentioned in their product descriptions.
An income security can stay in the same price bracket for years and only spend 6% to 10% of its income to fund college education, a retirement lifestyle, and world travel. But most investment advisors, ETF passiveists, and mutual fund managers are rated on the annual “total return” that their portfolios or indexes produce… Income programs simply don’t generate year-end excursions and six-figure bonuses.
I got fired myself a few times right before the dot.com bubble burst because my 10% to 15% “yield” from high quality stocks and yield producers just couldn’t keep up with the speculation frenzy that drove the NASDAQ to 5000. ..
But when the markets crashed in 2000, the “No NASDAQ, no IPO, no mutual Medium = is not a problem” The operational creed resulted in significant growth and income.
Another problem is the brokerage/consultancy fee in Wall Street firms…which is based entirely on the sale of proprietary products and the recommendations of the “investment committee.” There’s no room for slow growth based on high-quality dividend-paying stocks and income-focused closed-end funds.
Finally, myopia of government costs and market value performance precludes any inclusion of CEFs in 401k and other employer-sponsored investment programs. Vanguard’s VTINX Bond Fund Pays Less Than 2% After A Minimal Fee; Hundreds of much better diversified CEFs pay 7% and better after 2% or more in fees. Yet the DOL, FINRA, and SEC somehow determined that 2% money is better than 7% in what they incorrectly call “retirement income programs.”
You will never see a CEF in a 401k security selection menu, not even stock or balanced portfolio CEFs. Public REITs and MLPs shouldn’t be there either.
8. How many different types of CEF are there? what do investors pay for it; and are there any penalties for frequent trading?
CEFConnect.com lists 163 tax-exempt funds, 306 taxable funds, 131 US stocks, and 204 non-US and other funds.
A non-exhaustive list of types and sectors includes: Biotechnology, Materials, Convertibles, Covered Calls, Emerging Markets, Energy, Stock Dividends, Financials, General Equities, Government Bonds, Health Care, High Yield, Term Bonds, MLP, Mortgage Bonds, Multi Sector Income, Diversified National Local Governments , preferred stocks, real estate, senior loans, 16 different state local governments, tax-deferred stocks and utilities.
CEFs are bought in the same manner and at the same cost as individual stocks or ETFs, and there are no penalties, fees, or additional fees for frequent selling…they are traded for free in managed, fee-based accounts and always pay more income than their ETFs and mutual funds.
9. What about DRIPs (Dividend Reinvestment Programs)?
There are at least four reasons why I choose not to use DRIPs.
I don’t like the idea of adding to positions above the original cost basis.
I don’t like to buy when demand is artificially high.
I prefer to pool my monthly income and select reinvestment opportunities that allow me to lower position cost basis while increasing returns.
Investors rarely add to their portfolios in falling markets; especially when I need flexibility to add new positions.
10. What are the key things investors need to understand when it comes to income investing?
In fact, an investor can become a successful income investor if they can take care of just three things:
Changes in market value do not affect the income paid and rarely increase financial risk.
Income security prices vary inversely with interest rate change expectations (IRE)
Income-related securities must be valued according to the amount and reliability of the income they generate.
Let’s say thirty years ago we bought a 4.5 percent IBM bond, a 30-year 2.2 percent Treasury bond, and 400 shares of a 5.7 percent P&G preferred stock at par and $10,000 each invested. The annual income of $1,240 was accumulated in cash.
During this period, interest rates have ranged from a high of over 12% to recent lows around 2%. They made no fewer than fifteen significant changes of direction. The market value of our three “fixed income” securities has traded dozens of times above and below the “cost basis,” while the portfolio’s “working capital” (cost basis of portfolio holdings) has grown each quarter.
And each time the prices of these securities fell, their “current yield” increased while paying the same dividend and interest payments.
So why does Wall Street make such a fuss when prices are falling? Why actually.
Over the years we’ve accumulated $37,200 in dividends and interest; the bond and treasury note each matured at $10,000 and the preferred stock is still paying $142.50 quarterly.
So our cash account is now $57,200 and our working capital has grown to $67,200 without lifting a finger or worrying for a moment about fluctuating market values. That’s the essence of income investing, and that’s exactly why it doesn’t make sense to look at it in the same way as stock investing.
Investors need to be reprogrammed to focus on income generation from income-oriented investments and to seek reasonable gains when they are generated from growth-oriented securities.
What if we reinvested earnings into similar securities each quarter? Or sold the stock when it was up 5% or so… and reinvested the proceeds into portfolios of similar securities (CEFs) rather than individual companies, for diversification and higher returns?
Assuming just $500 in earnings per year and an average interest rate of 5%, the portfolio’s “working capital” would grow to $168,700 … a gain of about 462%. The income would be $8,434…a 680% gain
I hope these conservative income numbers get you a little more excited about having some serious income allocation in your “ultimately a retirement income portfolio”…income CEFs in particular. Don’t let your advisor talk you out of this; Stock market investing isn’t designed to do the income work… reliably, throughout our retired lives.
CEFs allow anyone to invest in diversified portfolios of fixed income securities, always at inherently higher rates than individual securities.
CEFs provide a uniquely liquid entity that allows investors to benefit in both directions from IRE-driven price changes. Yes, that’s what I meant to say.
11. Why take profits when the income from a security hasn’t changed?
Compound interest is the “holy grail” of income investing. A 5% profit realized and reinvested today will work much harder than 5% realized over the next few months. Also, when interest rates are rising, opportunities for profit are slim and proceeds can be used more productively than in a falling or stable interest rate environment.
So let’s say we have a “delimited maturity” CEF bond that yields 6%. We’ve held it for 8 months, so we’ve already received 4.5% and can sell it today for a 4% profit. So we can realize a nice 8.5% in just eight months (actually a bit more since we’ve reinvested the previous earnings).
Then we can use the proceeds to search for a new CEF with a yield of 6% or more and hope to make a similar trade in another of our holdings soon.
A second reinvestment strategy is to add to several positions that are priced below the current cost basis and are yielding more than the CEF just sold. This is a great way to improve the “current yield” on existing positions while ensuring you have more ample profit-taking opportunities when interest rates fall.
12. How do you keep working capital growing?
Total working capital and income from it will continue to grow as long as income exceeds any withdrawals from the portfolio. Note that if the proceeds can be reinvested at a higher “current” rate of return, capital losses will have no impact on income…but working capital will be temporarily affected.
Portfolios are kept on track of their asset allocation with each series of monthly reinvestment decisions, but the larger the income purpose “bucket,” the easier it is to ensure steady growth in both income and working capital.
13. What is Retirement Income Readiness?
It is the ability to make this statement unequivocally:
Neither a stock market correction nor rising interest rates will have a negative impact on my retirement income. In fact, I’m more likely to be able to grow both my income and working capital even faster in both scenarios.