Income CEF Price Volatility… No Problem at All

Market Cycle Investment Management portfolios are different from any others you may be analyzing, and all investors analyze their portfolios most intently when their “bottom line” market values begin to crumble. This focus on market value is part of Wall Street’s Brainwashing of the American Investor.

MCIM investing is more realistic. It recognizes that investment markets (both equity and income) are cyclical. Rarely do portfolio market values trend upward as long as they have since March of 2009, and most equity investors have forgotten the five month, 22%, mini-correction that ran from May through September 2011. When will we experience the real deal?

MCIM focuses on “working capital”, a measure of the total cost basis of the securities and cash contained in an investment portfolio. Managed properly, this measure should grow in all market, economic, and interest rate environments, irrespective of changes in “market value”… really.

MCIM portfolios include 30% Income Purpose securities (based on Working Capital), and never own non Investment Grade Value Stock equities. This translates into portfolios of high quality securities, each contributing to higher realized base income than that contained in market averages and blended Mutual Funds.

Embracing the cycles, MCIM portfolios strive to grow both total Working Capital and portfolio “Base Income”steadily, regardless of what is going on in the investment markets, in either direction.

MCIM portfolio “Working Capital” will be higher now than on January 1st; and “base income” will have risen in all portfolios where cash flow has remained positive… in spite of lower CEF market values. Long term, this is the single most important of all portfolio management issues.

Income Closed End Fund (CEF) prices have been moving lower since November 2012; the decline accelerated in May — but with barely any change in total income generated. In November 2012, you’ll recall, many CEFs were selling at premiums to NAV. The premiums are now gone, taking a whole lot of market value with them… but, again, with little or no change in income.

Stock market numbers have also weakened recently, and this 2.5 year divergence between equity and income security prices is quite normal; accelerated weakness in income security prices often signals an upcoming stock market correction, as it did in 2007..

The vast majority of income CEFs are now selling at significant discounts to the Net Asset Value of the security portfolios inside. The vast majority of income CEFs are selling at significant discounts to the market value of the securities they contain. (repetition intended)

Wall Street wants you to believe that higher prices and lower yields are better… how does that make any sense with no change in the portfolio content?

A selection universe of about one hundred taxable income CEFs and seventy tax free income CEFs is used in constructing MCIM portfolios. In the six plus years since the depths of the financial crisis, and in spite of the lowest interest rate environment in history, the vast majority of these CEFs have maintained their regular payouts to shareholders.

Lower prices now are as much a result of FED tinkering as threatened rate hikes.

Historically, in more “normal” interest rate environments, income increases have been more prevalent than income reductions. Overall, income CEF managers coped well with the lowest interest rates ever…. how have they been dealing with the specter of higher rates? Keep in mind that no actual interest rate change has yet occurred.

After six years of artificially low interest rates, many have been forced to reduce their payouts… very few have made significant dividend cuts.

Now the interesting part: at current prices, the average dividend yield on 57 taxable CEFs paying over 7.0% is approximately 8.5%; the average on 53 tax free CEFs paying over 6% is about 6.7%

The vast majority of all CEFs made their regular scheduled distributions throughout the financial crisis; more actually raised their payouts than reduced them; after six years of close-to-zero rates, higher “coupons” will eventually increase CEF dividend payouts to normal, pre-financial crisis, levels.

The current yield on the MCIM CEF Universe is well above 6% for tax free income and above 8% for taxable. Why is this bad news? Only, yes only, because professional bond traders have to realize losses when they trade… income investors do not have to sell at all…. they can take advantage of “discounts” to increase their spending money.

What’s lnside the CEFs:

• Each CEF portfolio contains hundreds of individual issues with varying qualities, maturities, call provisions, etc. The average duration is between 7 and 8 years

• Managers use short term borrowing to purchase additional securities; nothing forces them to borrow at higher rates if they can’t still invest profitably

• Managers capitalize on profit-taking opportunities; and are not forced to sell at losses.

• CEF share prices are completely “uncoupled” from NAV; shareholders are investing in the investment company as opposed to owning a piece of the investment portfolio itself.

As I see it, and this is no prediction or recommendation of any specific course of action, CEFs provide investors with the opportunity to take advantage of irrational price dislocations in the income securities market — an opportunity that is difficult for the average investor to capitalize upon using individual securities.

By adding to existing CEF positions, investors increase overall portfolio yield, increase yield on specific holdings, and reduce per share cost basis.

Thus, even if some reduced payouts are experienced, the overall level of income is likely to be at least stable, and possibly higher. Right now, the expectation of higher interest rates is probably the main force driving Closed End Fund prices lower.

BUT, particularly if the stock market corrects, higher interest rates and higher demand for safety may cause investors to seek out higher yielding and safer investments.

Never forget, all companies must pay their bond, note, and preferred stock investors BEFORE a penny goes to their Equity investors… income CEFs contain no equities, even though your (purposely) confusing Wall Street account statement tells you that they are equities…. hmmm

To Rollover 401k Plan Assets or Not To… That Is The Question

The major purveyors of 401k products, and those who benefit from using them remind me of politicians… they press the party line, and use their power to demonize the competition.

Their position and deep pockets allow them to get their message out while we who have neither can only shake our heads and whimper about the sacred purpose of retirement income programs.

But, in the simplest of terms, since when has 2% been better than 6% (both after expenses)? The DOL, fiduciaries, and plan sponsors are staring back at me, eyes wide shut.

LinkedIn discussion groups have been talking about the pros and cons of 401k rollovers to private IRA portfolios. Most of the articles, and not by a slim margin, are institutionally biased advertisements for low cost Mutual Funds and ETFs, despite the fact that have absolutely no “preparation for retirement income bones” in their mass marketed bodies.

When the market corrects, the results will be what they have always been for market-value-growth-only programs. This time though, the DOL will fine the Plan Sponsors (i.e., the corporations so bitterly hated by our government), for allowing plan participants to make investment judgment errors with their own money plus the matching contributions…. let hindsight reign in the 401k space!

The 401k “space” as they call it, has become a lucrative product shopping mall, totally out of touch with what should be the long run purpose of these “quasi” retirement programs: it’s the monthly retirement income that pays the bills, Charlie Brown, not the market value.

If a person were a conspiracy theorist, he or she could make a case for institutional/congressional manipulation of interest rates… keeping them near zero so that gurus will continue to predict that stock market “returns” will outpace those of income purpose securities. Hmmm.

None, absolutely none, of the products provided by the top institutional peddlers produce nearly as much after “expense-ratio” income as Closed End Income Funds. These outstanding (and income paying far longer than any income ETF) managed portfolios are never, ever, found in 401k Plans… except the Self Directed, “safe harbor” variety.

Interestingly, all the major 401k product providers, also manage Closed End Fund product lines that generate generous income, even after higher fees. These fees, so important to regulators and politicians, are never paid by the recipients of the much higher income.

CEFS paying 6% to 9% after expenses are commonplace, but not available in 401k plans. Similarly, there are no restrictions on speculation in the equity markets, where similar high quality managed equity portfolios have been available for decades.

The retirement plan (401k) community has gotten so paranoid over goose-stepping DOL auditors and other regulators armed with crystal clear hindsight, that they have completely lost site of “spending money” as the be all and end all purpose of retirement portfolios. They must “outperform” half their brethren, and be dirt cheap to boot.

Yeah, I know that 401k Plans are not retirement portfolios, but neither the regulators, plan sponsors, congressional leaders, POTUSs, fiduciaries, or plan participants seem able or willing to accept that reality… why should they?

Looking inside the multi-billion dollar Vanguard 2020 TDF, we find 60% invested in equities (no less than 7000 individual positions) and income of about 1.5%. Wake up regulators… the “unfairness” is in the “emperor’s new clothes” products provided to the plan sponsors for inclusion in employee product menus.

You the fiduciaries, you the regulators, you the witch hunters, and you the do-gooders need to look at the product providers instead of their victims.

If you insist upon looking at investment plans as retirement programs (ERISA = Employee Retirement Income Act), perhaps you need to mandate that an outside-the-mainstream, “Self Directed”, income program be a major part programs you supervise. Until the focus changes from market value and expense control to after expenses income, these plans cannot provide what is expected of them… retirement readiness.

So in answering the “To rollover the 401k or not to rollover the 401k” question, I would say: “Run like _ _ _ _, just as fast as you can, to get out of that 401k and never ever buy a low income or no income security in the Rollover IRA you move to.

As long as plain vanilla portfolios of high quality equity (IGVSI companies) and Income CEFs yielding an experienced average, net/net 6% or more, are banned from participating in the 401k marketplace by (possibly) illegal monopolistic practices, rollovers to IRAs should be a requirement, not an option.

See how they run: https://www.dropbox.com/s/b4i8b5nnq3hafaq/2015-02-24%2011.30%20Income%20Investing_%20The%206_%20Solution.wmv?dl=0

As long as regulators are blaming generous employers for the investment mistakes of their employees, self-directed, income purpose, 401k plans are a much less scary, “almost a retirement plan”, option.

The Extremely Good News About Higher Interest Rates

What!

Yes, market values of existing income purpose securities will certainly move lower… BUT, the income you’ve contracted for will likely remain the same, AND, you will be able to invest in new paper at higher yields.

This is a good thing, and you should not be so easily convinced that it is not. Even if your “guaranteed” paper falls in price, there need never be a loss of “principal”.

If I’m borrowing money, higher rates are bad news; for investors, higher rates mean more spending money while lower market values just mean lower market values.

The purpose of income securities is income, and a reasonably safe “more” has always been better than any “less”. The problem is simply the negative perception of a lower portfolio “total market value”. OMG!

In our financial lives, what we can spend or reinvest is the important detail, and when dealing with income-purpose investments, 99% of the time, change in market value has no impact on income received.

This was most clearly demonstrated during the financial crisis:

More than 90% of borrowers remained current on their mortgages, yet all mortgage backed securities were deemed nearly valueless under absurd “mark to market” regulations.

Even with monthly payments pouring in, many financial institutions failed to meet regulatory “market value” reserve requirements and were forced to close their doors.

At the same time, even at lower market values, virtually all non-mortgage securities, particularly managed Closed End Funds, continued to pay the same levels of interest like clockwork, while a “clockwork orange-esque” nightmare played out in financial institutions.

This focus on market value is a financially inappropriate attempt to equate the nature of debt securities to that of equities… one that could never, ever, have happened without multiple levels of ill conceived and misguided regulation.

It’s like time, tide, and gravity; you just don’t mess with Mother Nature. Price varies inversely with interest rate expectations, and this is a good thing… end of discussion.

By using Closed End Income Funds, investors can benefit from lower rates on older holdings, even as market values tumble… and this should be exciting , not scary at all.

Buying additional shares of existing bond portfolios at lower prices. Eureka!

As Yogi would say, 95% of income investing is half mental.

LinkedIn financial group members debate the impact of higher interest rates… but to income investors, there should be no debate at all. Both higher and lower rates are good for investors.

Here’s an example of where this is coming from.

I’m intimately familiar with many closed end income funds, diversified in every conceivable way, over 100 issues, with varying durations, etc. The “purpose” of the funds is twofold: (1) grow the income generated by the portfolio, while at the same time (2) distributing what individuals need to pay their monthly bills.

Income CEFs (both tax free and taxable) moved down in market value during the financial crisis, back up again (at a faster pace than stocks, actually) through November 2012, down again through the end of 2013, and now up again at a pace about the same as the S & P 500, or a bit better, through May.

During this seven years of market value direction change and short term volatility, there has been: (1) an upward move in total portfolio income, due to reinvestment of excess income; (2) never an instance of dipping into principal for a properly planned payment; (3) and hundreds of opportunities for “one-year’s-interest-in-advance” profit taking.

During seven years of historically low interest rates, income Closed End Funds have produced multiples more spending money than any other comparably safe source of income…. taxable funds are in the 7% range (net of fund expenses including interest) right now.

What negative impact has the change in market value had on the monthly income produced for Closed End Fund Investors throughout the past seven years? A resounding… NONE!

What positive impacts? Growth in income produced, growth in portfolio yield, and growth in “Working Capital” (the amount invested in the total portfolio), and not only in the income “bucket” when cost-based asset allocation is used.

Meanwhile, how have investors fared in shorter duration, stable value paper? What’s better for the economy, retirees receiving 6% tax free or less than 2%, taxable?

When investing for income, go long, emphasize experience and quality, diversify properly, and focus ( I mean really focus) only on the income you receive.

Ask your advisor:  Why is 2% better than 7%?