Monday, May 6, 2013

Income Options (Part 1)

It is a tough time for the income investor. That would be us retired folks. The most important consideration for those of us who have passed our prime earning years is stated rather succinctly in the Tao of Warren Buffet, “Rule No. 1: never lose money; rule No. 2: don’t forget rule No. 1″ After safety, a steady reliable stream of income is the highest priority for us old folks. After retirement growth is still a consideration, as the threat of inflation is very real, but preservation of capital and income are of paramount importance. Traditionally bonds were the safe harbor for retired folks. With very little risk it was easy to generate a 5% income stream to support a lifestyle simplified after children left the home. For those willing to take a little more risk, widow and orphans stocks, like Ma Bell, Johnson & Johnson, and solid responsible bank shares paid somewhere around a 4% dividend with the opportunity for at least some growth. Inflation was running around 2%. Life was good.

Today Government inflation numbers no longer include energy or food. This makes Government estimates of inflation quite worthless. It is pretty easy to see where this is leading. Those worthless numbers are fed back into cost of living calculations for Social Security, allowing inflation to eat away at our $55 Trillion problem with unfunded liabilities. The real rate of inflation in 2012 is given at 8% rather than the 3.1% figure provided by Government economists. The Federal Reserve has destroyed interest rates. Today the benchmark Ten Year Treasury yields a paltry 1.75%. The Standard and Poor’s 500 index dividend yield is floating around 2.0% rather than the historic norm of 3.5%. In this dreadful situation, older investors are reaching for better returns to provide the income they need in retirement. All these options contain greater risks than those investments found in conventional models. Options such as retail annuities that limit risk are so expensive they are of little value to the small investor.

We are forced by these circumstances to undertake more risk by investing a larger potion of our retirement savings in stocks. For new readers, the traditional rule of thumb was your age in bonds. Hence at age 60 you would hold 60% of your retirement investments in bonds and 40% in stocks. More recently the new conventional wisdom suggests that you kick up your stock holdings by 15%, hence at age 60 you would have 55% in stocks and only 45% in bonds.

If the Treasury and the Federal Reserve Bank persists in their ZIRP (Zero Interest Rate Policy) that relentlessly punishes savers and conservative investors the percentage that retirees should hold in equity positions may continue to increase. Siegel’s Constant teaches us that the U.S. stock market generates a remarkably consist return of 6.5% to 7.0% after inflation over any long time period. However, as Lord Maynard Keynes observed, “In the long run we are all dead.” If the stock market suffers a 50% meltdown the day after I retire, while I am holding 100% of my retirement investments in stocks, I would need to double my money just to break even. Even if Siegel’s proves to be true over the course of the next thirty years, it won’t do me any good. I saw this happen to a number of formally rich old people in both my mother-in-law’s senior high rise and my parent’s retirement community. Now they are poor old people living with their Baby Boomer children who need to use their money to prepare for retirement not take care of their very elderly parents.

Particularly at this time when the market is at or near historic highs, bargains are hard to find. Older investors seeking better returns have driven up the price of boring old dividend producers like Chevron (CVX) past historic valuations. Now we are turning to somewhat more exotic instruments in the never ending quest for a return that can support a dignified retirement.

Preferred shares provide a higher return, somewhere around 6.8%. Preferred stock is neither this nor that. It isn’t a voting share in the company and it is not a bond. It is a debt instrument that pays a set dividend that does not change. There are a number of risks associated with preferred shares. Typically these shares are issued at a par value, often $25.00. The company has the option of recalling these shares at any time for the par value. In the current environment that is likely to be less than you paid for your shares. If you held those shares for several years, this is not a problem. If the company recalls those shares at par the day after you paid $36.75 per share, you lose.

The bond holders get first shot at interest, then the holders of preferred shares get their cut, finally those who own common stock get their dividends. Some preferred shares can allow the company to defer payment. Sometimes if the company can’t make their dividend payment to holders of preferred shares, they just lose that promised money. In bankruptcy the bond holders get first crack at any asset leftovers after the creditors have been made whole. Preferred shares become worthless. In actual practice it is hard to say how the courts will carve up the carcass of a dead company. When General Motors went into bankruptcy the bond holders, including the pension funds of a number of states were left holding the bag.

The real risk with most preferred shares issued by responsible corporations is inflation. If you are holding a preferred issue that pays 6% of par, you are looking pretty good in today’s bizarre ZIRP world. If suddenly the rates on Ten Year Treasuries jumps from 1.75% to 3.5% because the Chinese get tired of taking our debt or the Federal Reserve Bank slows down its purchase of surplus debt issued by the Treasury that could cut the value of your preferred share in half. Overnight! If the company that issued those shares is unwilling to recall them when Treasuries are yielding 1.75%, they sure won’t recall them when Treasuries are yielding twice that figure.

REITs (Real Estate Investment Trusts) are another option for the investors in search of better yields. “Under U.S. Federal income tax law, a real estate investment trust (REIT) is "any corporation, trust or association that acts as an investment agent specializing in real estate and real estate mortgages" under Internal Revenue Code section 856.” (Wikipedia) By law a REIT must distribute 90% of taxable income in the form of dividends. If a company is organized as a REIT the shareholders avoid paying double taxes on its profits, corporate income tax on the profits; then individual taxes on dividends.

Before exploring REITs as an investment let me add a word of warning. What the taxman giveth, the taxman can taketh away. Back in the day, I bought a nice little dividend machine named Fording Canadian Coal Trust. This company and others like it took advantage of a loophole in Canadian tax law that turned into a bonanza for shareholders. The Canadian Government decided that enough was enough and closed that loophole, dropping the value of my holding to about ½ of what I paid for it. Also the dividend returned from the stratosphere to something more reasonable for a coal company. This story did have a happy ending. I decided that the Chinese would continue to buy high quality metallurgical coal from Fording to fuel their growing steel industry. Coal doesn’t go bad sitting in the ground, so I kept a stiff upper lip and held onto my shares. Eventually something called Teck Cominco bought up all of Fording’s assets at a very high price. I made a nice profit.

REITs buy and manage real estate. There are REITs for just about everything from storage units to skyscrapers. The price of these shares rise and fall with value of the underlying properties. When the real estate bubble popped in 2006 the value of many of these shares dropped between 40% and 70%. Today the total REIT index is paying somewhere around 3.4%, much better than Ten Year Treasuries at 1.75%. However, history indicates that REIT correlate to stock prices, not bond yields. Today the markets are overvalued against historic norms. Is it a good time to buy REITs….hmm? My crystal ball is foggy. The spirits aren’t telling me a thing. In fact the valuation of REITs, driven by a search for better yields, has outpaced the general market since the crash of 2008. Still REITs are a way for the small investor to share in profits generated by income producing real estate, including large commercial properties. There is also the possibility that these holdings could act as an inflation hedge—or not.

As always, Please Let’s Be Very Careful Out There Today!

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