by Steve Selengut
After 45 years of investing, I’ve come to the conclusion that the equity (or growth purpose) market is a far easier medium for investors to understand than the far safer, and generally less volatile, income purpose securities market. As counter intuitive as that sounds, experience supports the premise.
“Understanding” boils down to the development of reasonable expectations: just how do you expect the market value of your income purpose securities to react to varying market, interest rate, economic, political, atmospheric, and “other” conditions”… and, does it really matter?
Few investors grow to love volatility as I do, but most expect it in the market value of their equity positions. When dealing with “income purpose” securities, however, neither they, their guru/advisors, nor market commentators are comfortable with any downward movement whatsoever.
• Not to make excuses for them, but most professional investors, and media folk, think in terms of the individual bonds, other debt securities that Wall Street markets to brokerage firms, and other large investment entities. Bond traders hate to discount their inventory due to higher interest rates. It’s bad for year end bonuses, but their bond market disaster is the individual investor’s opportunity to buy the same amount of income at a lower price.
Most investors are also more receptive to loss taking advice on income securities, than they are with respect to equities. It is always the affect of a “market value”, rather than an “income production” focus, and it is a well kept Wall Street secret.
The list below describes some important characteristics, and concepts, involved with investing in income purpose securities. Familiarization with these will aid in the development of valid “performance” expectations. Doing so will also help develop an appreciation of this important (and somehow not too often mentioned) relationship: changing market values (in either direction) rarely have any impact on the income being generated by the security.
• Confucius say: keep your eye on the ball.
You can’t buy groceries with market value or total return, only income pays the bills, without depleting sacred capital.
General attributes of income purpose securities:
• They generate a predictable stream of interest, dividend, rent, royalty or other income.
• They pay income in specific amounts on specified dates.
• Their risk of financial loss varies dependent upon security type, issuer quality, and maturity. BUT, all normal income securities are considered far less risky (financially) than the common stock of their respective issuing entities. State government paper is less risky; federal government issues carry no financial risk at all.
• The purpose of the income asset allocation of an investment portfolio is the production of income in an amount large enough to assure: annual growth of income producing capital, and annual growth of income production.
• High dividend common stocks (utilities, etc.) are not included within the income purpose security definition, although they may be less risky than other equities.
• Bonds, loans, and other interest bearing securities are issued by both corporations and government entities and have maturity dates upon which the principal is returned to investors.
• Income securities that are guaranteed as to principal and interest, or protected by “safety mechanisms” of any kind always bear a lower yield than otherwise similar securities.
• Generally, fluctuations in market value have nothing to do with the financial viability of the security issuer. Most often, they are the result of anticipated changes in the direction of interest rates, or the tax code.
• Any form of either market value or total return performance analysis in a predominantly income purpose investment portfolio is counterproductive, at best, particularly when compared with any form of equity index.
• Bonds, mortgages, notes, and other “debt” instruments are generally liquid securities with wide price “spreads”, and difficult to either sell at “statement” prices, or add to from the marketplace; income closed end fund portfolios are liquid containers for liquid securities, thus eliminating the major drawbacks of owning individual bonds, mortgages, loans, etc.
• Higher interest rates (lower prices) are good for income investors, because they produce higher yields from new (and existing) securities that are available for purchase.
• Lower interest rates (higher prices) are good for income investors, because they can provide “reasonable” profit opportunities on securities already owned.
• A reasonable trading profit on an income purpose security is anything in the neighborhood of “one year’s interest in advance”, keeping in mind that three 7s always beat two 10s.
Theoretically, income purpose securities should be the ultimate “buy and hold” security blanket within retirement income portfolios. But, if you examine the average retirement portfolio, especially 401k portfolios, you would find a remarkable low “income purpose” asset allocation. This seemingly nonsensical behavior is as much the result of government regulation, as Wall Street manipulation.
• The Vanguard Retirement Income Fund (VTINX), with nearly $17 billion in assets, is one of the most popular, and well respected, of all funds in retirement income portfolios, particularly 401ks. The five individual funds inside yield just 1.75% in actual spending money to investors, but they are dirt cheap.
• A diversified portfolio of income purpose Closed End Funds (CEFs), with payment histories stretching back more than twenty years, would yield well in excess of 7.00% after somewhat higher expenses. CEFs are never found in 401k plans, and rarely appear in IRA and other retirement portfolios created by investment professionals; please let me know if you know why.
• Confucius say: if you buy cheap, you get what you pay for
The focus of an income purpose portfolio needs to be: the amount of realized, spendable, income produced irrespective of market value fluctuations. The operative investment management objectives need to be: growing both the productive working capital and the spendable “base income” within the portfolio.
Wall Street has you believing that lower market values are always bad and that higher prices are always good. This is the conventional wisdom we’ve all had thrust upon us for decades. However, price volatility is the very nature of securities markets, it is also that reality which creates both buying and profit taking opportunities, particularly in income purpose securities.
• Higher income purpose security prices mean lower yields, but also increased realized profit potential; lower income purpose security prices mean higher yields and buying opportunities. I see no bad or good; just the opportunity created by either scenario. (The same is true, incidentally, with Investment Grade Value Stocks.)
• It is the inherent safety (i.e., lower risk of financial loss) of income purpose securities that creates this almost perfect relationship. Price volatility is always good.
“It’s OK, it’s natural, every market value fluctuation is “satisfactual” is what I’ve been singing for decades, particularly since the creation of income CEFs. Rarely, even in the three major meltdowns of the past 40 years did any high quality company, or government entity default, regardless of tremendous price fluctuations in all securities. Each time, the vast majority of CEF income payments kept rolling in, unscathed by the surrounding chaos.
Steve is a private investment manager, focusing on providing retirement income to a clients throughout the USA. Read “What Your Mother Never Told You About Income Investing”, Chapter 5 of the “Brainwashing” book.