Dividend Growth Investor inspired me with his recent [important!] post about his plans for a fixed income allocation after reaching the dividend crossover point. Show some love and give him a read.
music selection: “Aime” — Pure Prairie League
DGI rightfully recognizes that having a fixed income component to a portfolio 1) lowers risk 2) smooths out returns 3) provide resilience in dividend cutting environments. My only bone to pick is in the comments he mentioned he didn’t consider his yield on fixed income as a boost to income. Fixed income investors often earn within a few hundred basis points of the long term average for the broad indexes with much less volatility and risk. And in some environments, fixed income actually outperforms equity for as long as a decade at a time. Maybe I’m biased because I need to spend my interest income to pay the bills.
I’m going to discuss my thoughts on closed end funds, municipal bonds, preferred shares, international debt, and variable rate debt. My personal asset allocation is currently at 18.6% (at cost) for the sum of these categories. The income is a substantial component of my budget and I sleep better at night regarding this component than I do for DGI or high yield companies. My favorite, of course, is writing options for short term cash. And there is always my highest conviction idea to short UVXY with long dated out of the money long puts. But fixed income investing is the most overlooked critical part of an early retirement in the blogoverse. This is why I frequently have posts about individual investments in this category.
About Closed End Funds
It is no secret I love the closed end funds for fixed income investments. See, there is an additional risk to fixed income investing versus stock investing that is often overlooked. That is liquidity risk. Bonds of various types are frequently (and rightfully so!) often held to maturity by the owners. So very few of them trade in the open market on a given day. When there is negative news, a Fed change in interest rates, or just increased interest in a issue, you often can’t buy the bonds at any price. It can take a couple weeks. For a buy and hold investment, this shouldn’t frighten you. But some people spook and that causes a danger for ETFs or mutual funds that hold bonds. They have to provide something approaching immediate liquidity to meet redemptions when things are going south and people are pulling their money out of the fund. There can be forced selling at distressed prices, locking in steep losses.
Closed end funds *never* have to meet redemption claims. It is a simple matter for them to hold the bonds to maturity. The price of the bonds may fall by half in the interim but they will almost all pay full par at maturity. Closed end funds also provide a great deal of diversification. They often have hundreds of underlying securities in the portfolio, with a mix of durations, and a mix of credit ratings. It would be very time consuming to build out a similar fixed income portfolio on your own. Finally, closed end funds provide modest leverage at a low cost. Typically, a closed end fixed income issue uses thirty to forty percent leverage to boost returns. Leverage can kill a fund that has to meet redemptions but a closed end fund that holds bonds to maturity can safely employ a small amount. You get thirty to forty percent higher returns without risking a margin call in your brokerage account. Win!
About Municipal Bonds
I hold four municipal bond funds, all in the closed end fund format. I add an average of $800 a month (roughly the average amount of slush in my budget) in new purchases in this category to grow my post work income safely. Don’t buy a muni mutual fund, by law they must be able to provide seven day liquidity. And it can take longer than seven days to get a fair price for a municipal bond. Municipal bonds have a special feature in that they are exempt from federal income taxes. For me, that means effectively 25% of bonus yield. Some munis are also exempt from state income taxes but we have no such beast in Texas.
Municipals are very safe bonds. Historical default rates are lower than two percent. What is often not known is that munis in default usually still pay back par…eventually. Even the huge Orange County California default eventually paid back every penny of capital. See, governments need to borrow and they can’t get favorable rates if there is no trust. They are highly motivated to make good on their promises because they have long lifetimes and uncertain revenue streams. Holding a fund, especially a closed end fund of munis lets you additionally spread your risk of default across many issuers. I spread mine even further by using four closed end funds: IIM, IQI, NEA, and NIO.
My average yield on cost for these is about 6.2% or 7.75% after tax equivalent. This approaches the yields in my high yield MLP, REIT, and BDC holdings, with far less risk and volatility. You can see why I am so high on holding munis in closed end funds. A quick note about taxes, some closed end funds will do a small amount of buying and selling before maturity to massage credit exposure and manage allocations. Capital gains from this activity (which represent a very small sliver of your return) are subject to Alternative Minimum Tax. You may have to file the form but the hit will be trivial. Obviously, the tax benefits are even better for high income individuals in higher marginal tax brackets – bully to you if that applies!
About Preferred Shares
Preferred shares are a hybrid security that have some bond like characteristics even though they are technically capital stock. In the event of a bankruptcy liquidation, they have seniority over common stock but come after bond holders, pension, and payroll needs. They typically pay a fat coupon and often have a feature that allows the company to convert them to common shares at some predefined rate of exchange. I buy them for income with the intent to hold forever. The only fund I have found I really like in this space is JPS. I earn 8.14% at cost (there has been about 6% price appreciation since purchase), which beats even my after tax return on municipals. This makes sense as there is more risk of loss of capital here.
About International Income
Interest rates tend to be higher overseas. There are plenty of safe companies that simply have to pay more for their bonds because they are not big enough to raise capital in the United States. Curiously, many of these bonds are denominated in US Dollars (else, British Pounds) anyway. Exchange rate risk is usually very low and often hedged away. I dabble in two buckets for international debt: GIM, and ESD. GIM is a short duration international bond fund, which I picked to partially hedge against rising rates. ESD is an emerging markets (heavily weighted to Mexico) debt fund. Both pay about 7.5% yield. This is less than what I get from preferreds but I think the risk is lower and I like the international diversification to lower my Beta.
About Variable Rate Debt
You can gain some exposure to variable rate debt with BDC investing as a lot of the loans these companies make are variable. But I don’t count them as part of my fixed income allocation as they also use equity, convertibles, and sometimes exotic instruments. My favorite play in this space is JRO. This fund is entirely in senior variable rate notes. That is, in the event of a bankruptcy liquidation, these notes have to be paid from proceeds first. Often times, the loan is for a specific facility or piece of equipment which is also listed as collateral on the debt covenant. JRO provides for very safe debt investing this way. It currently yields 7.5% percent and has upside when and if the Fed finally starts raising interest rates.
There isn’t much room for income growth or capital appreciation in fixed income. But there is security and good current income. Everything I listed here pays (after tax) over seven percent. As a proxy for dividend growth investing, I propose we look at VIG – the Vanguard Dividend Achievers Index – which currently yields 2.29%. I mean sure, that yield will grow about seven percent a year but it will be a decade before the yield catches up to the fixed income options I showed today. To beat total cash distributions will take decades. I like being retired now instead of a decade in the future so having a healthy and growing fixed income allocation is for me. Your Mileage May Vary. Thanks to DGI for posting an important and though provoking article.
Devour your prey raptors!