Mon, 19 Dec 2011
A diversified portfolio including MLP, trust preferred, and mortgage-backed securities can return a decent yield in a market where traditional income sources are lacking, says Sanibel Captiva Investment Advisers' Pat Dorsey.
Jason Stipp: I'm Jason Stipp for Morningstar. With bond yields continuing to be at such low levels, income investors have to ask themselves some tough questions lately. Here with me to help investors work through the tough yield environment is Pat Dorsey, he's President of Sanibel Captiva Investment Advisers.
Thanks for joining me, Pat.
Pat Dorsey: Anytime, Jason.
Stipp: So, it has been a tough environment for income investors. We see that yields are persistently low on fixed income, yet we know that a lot of investors are moving into retirement, and income is on their minds.
What are some of the key broader questions that investors should be asking themselves when they're trying to build an income portfolio, given this tough environment today?
Dorsey: I would say one thing is ... think hard about how you view safety and risk, because the risk that your income stream from, say, a Treasury at 2% or a J&J bond at 2.5%, doesn't keep up with the cost of goods, doesn't keep up with inflation over 10 years, that is just as real a risk as the higher volatility risk you might take owning say Abbott Labs equity or Johnson & Johnson equity, for example.
Day-to-day volatility is how risk is commonly defined in the academic literature, but the reality is that if the dollars you get from those bonds are worth less in 10 years than they are today, that's a risk to you as well.
Stipp: So, I think, that's more of a longer-term risk, maybe harder for folks to conceptualize versus the risk I might lose some money tomorrow or next week. But I think that one of the issues that they have right now is these areas that they normally would go into just aren’t really doing it for them as far as fixed income, and so we have fixed-income yields that aren't very good, but then we also have investors that are looking out in traditional areas that they consider safe like utilities, but you tell me that maybe this isn't exactly the best place to be in, either?
Dorsey: No, not at all. I mean, utilities have had a wonderful run over the past two, three years, as this search for yield has really driven up their valuations. And of course, we have to remember that for every security, you get return from three places: the dividend, the earnings growth, and in the change in valuation. And a big chunk of the return on utilities over the past few years has come from rising valuations.
You have companies like say Southern and Duke Energy, which are wonderful utilities, very well-run businesses, still with good yields, but trading at sometimes 14 and 16 times earnings, which is a premium to the market, and these are businesses that will never grow at more than maybe a mid-single digit rate. So it's not nosebleed, this isn't Cisco at a 100 times earnings, but it certainly introduces an element of risk, that I don't think most utility investors are comfortable taking.
Stipp: So, Pat, what about high yield. I know in the quest for yields some investors are looking out on that credit quality and maybe going down in the credit quality a little bit to try to pick up a few basis points--what do you feel about that area now?
Dorsey: You have to be very comfortable with volatility. If you bought high yield, say, in April or so, when the economy was kind of peaking a little bit on a near-term basis, during the worries about a double-dip recession in late August, you had lost almost 8%-9% of your portfolio. I mean, that's a pretty serious level of volatility for "bonds," for a supposedly lower-risk asset class.
So if you're thinking about high yield, think about it more like an equity, don't think about it as a bond. And of course, I would say being opportunistic makes a lot of sense. High yield tends to be quite a volatile area, so I would say when you start seeing headlines about double-dip inflation, that's the time to start thinking about looking at the high-yield [sector] opportunistically probably more so than something that you can expect steady-eddy returns from.
Stipp: So, Pat, we've talked about some areas where investors might want to think twice before investing, but can you help me out here? I'm trying to build an income portfolio. What are some of the places where I might be looking?
Dorsey: I can give you some love, Jason.
So, obviously, at Sanibel Captiva, we have a lot of retired clients who are looking for income, so we've been trying to solve this problem ourselves, and what we've tried to look at is kind of alternatives, sort of, alternative income sources, and one way to do it is by building a portfolio of slightly more exotic securities, a little bit more off the beaten path, but that are all liquid and which all trade publicly. Things like master limited partnerships, which I'm sure many Morningstar viewers are quite familiar with, with good yields, a little bit of tax complications, but you are well paid for that in terms of the rise of those distributions and good underlying economics.
Trust preferred securities, which are hybrid securities issued by banks; they are basically junior to debt, but senior to common and preferred. And they are yielding in many cases between 7% and 8% right now. And because of a regulatory change in Dodd Frank over the past few years, odds are very good that they are going to get called at par, and so many are trading at [par value of] 21-22, that's a good total return.
And then finally, mortgage-backed securities, for example, Annaly Capital, which is a very high-quality mortgage REIT, or Jeff Gundlach's portfolio at DoubleLine, which are essentially just mortgage-backed securities with kind of a barbell structure to them.
Again, these are all areas with their own unique risks, but you put them together in a portfolio, and the risks that Bank of America can't pay its trust preferreds, the risk that a huge pipeline can't pay its distributions, and the risk that the entire mortgage-backed market goes kablooey again--those three risks are, I would argue, somewhat uncorrelated, so you put together a portfolio of those, it's yielding about 7%, and in today's environment, we'd consider that pretty attractive.
Stipp: So, to dig in a little bit on some of those different ideas, MLPs, do you have any particular names that are of interest to you right now?
Dorsey: So, if you are looking a little bit more for income growth than current income, certainly Kinder Morgan Inc. and Magellan Midstream are both MLPs with lower yields than most MLPs, but growing at a very high clip. AmeriGas Partners APU is a propane partnership, a propane distributor, with a fairly high yield, slightly lower growth rate, but also very, very attractive. So, those would be probably some of my favorites I would look at right now in the MLP area.
Stipp: And trust preferred, this is probably something that a lot of investors aren't familiar with. How do you go about looking at these investments? How do you even invest in them?
Dorsey: Well, so they trade just like stocks. I mean, they trade on the market everyday just like stocks. Many of them might only trade 30,000-40,000 shares a day, but ... you can put a decent amount of dollar volume to work. If you're an individual investor, you're not putting $100 million to work after all. And what I would say is, essentially the question you'd ask yourself, because the ones trading below that par value of 25, they are Citigroup, it's Morgan Stanley, it's Bank of America and its various legacy entities like Merrill Lynch and Countrywide. And so you essentially need to ask yourself, am I comfortable not that, say, Bank of America's equity will do well, but that they will basically not fail. I mean that's kind of the question you want to ask yourself.
And if that's the case, then these are securities where their prospectuses are available, filed with the SEC. You can find a lot of information about them on Morningstar.com or other areas.
But, again, think about them as kind of hybrids between equity and debt. They are yielding more than the equity. They are yielding more than the debt in many cases, but if, for example, say Morgan Stanley were to go completely pear-shaped, and we were back to 2008-2009, the senior bondholders would get paid back before these securities would. That’s a pretty fat-tailed scenario, pretty far out the curve, and you saw with Warren Buffett's recent investment in Bank of America preferreds that he is comfortable saying, "Bank of America will survive," which is essentially the bet you are making at that level in the capital structure.
Stipp: So good to know the bet that you are making and that risk and do your own gut check, so you understand exactly what you are investing in?
Dorsey: Exactly, because if you've decided I don't want any financials in my portfolio, I've decided I don’t want to go anywhere near them, not even more senior in the capital structure, you shouldn't own them. Because they can bounce around a lot--when we had the troubles in the credit markets in August, and people were very worried, they are going to bounce around a lot. You had some of these down 10% and 15% for that month. If that kind of volatility isn’t comfortable for you, you're going to need to accept lower yields. Of course, there is no such thing as a free lunch in the equity markets. You accept higher volatility, you can get somewhat higher yields, but if you really need that smoother ride, if you're the kind of investor who is prone to selling when capital markets are distressed, you are better accepting that lower level of yield and sticking with it, because the absolute worst plan is the one you don’t stick with.
Stipp: Absolutely. So Pat, also mortgage-backed securities--you mentioned Jeffrey Gundlach's fund. Are there any other places where you are looking for exposure to that particular area?
Dorsey: Well, so Annaly Capital ... is a mortgage REIT that is one of the few to have survived the financial crisis in 2008-2009 that blew up most mortgage REITs. And ... it has about a 14% yield and people often really ... salivate at that, and plunge their money into it, but [Annaly is] really affected by things outside of their control, things like prepayment rates and the shape of the yield curve. And so ... again it's a part of this overall portfolio we put together, and I'd say for any investor, it's a part of their overall portfolio, and you really can't be seduced by that yield in saying, I'm just going to bet the farm, because at the end of the day, you can control your risk, they can do a lot of things well. Again, they obviously managed things reasonably well to be one of the few--the only one--to survive 2008-2009, but you can't really, it's not something I'd put half my portfolio into.
Stipp: What about traditional REITs, Pat? I know a lot of investors look to traditional REITs or have for income before. Are there any ideas there, or is that one that you are staying away from?
Dorsey: Generally speaking, we're not seeing very much there at all. REIT yields are not really at a level that I think compensate for the risk you are taking on in a levered capital structure that has to continuously access the capital markets.
There are a few exceptions: Realty Income, old Morningstar favorite, being probably one of the biggest exceptions right now. They tend to be very conservatively capitalized, doing a lot of fundamental balance sheet work on their own, at the individual property level. They are yielding about, I think, 5.5%, 5.6% right now. Not out of the park, but attractive, especially for a company that really has, I think, investors' interest at heart. I had the fortune of meeting with their management during one of the recent Morningstar conferences. And I think these are folks who ... the divided is as close to sacred as it gets for them. And so I think at a 5.5% yield that’s rising at a modest clip, that’s one of the few REITs I'd be looking at.
Stipp: Some very interesting income ideas, Pat. Thanks for coming in and sharing today.
Dorsey: Anytime, Jason. Happy to help.
Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.