FSK - Cash Flow You Can Keep (Growing Your Income Through Bear Markets)

2023-03-23 04:40:59 ET

Summary

• Many investors (like me) don't care whether the "Total Return" from our investments comes from cash dividends or growth.
• After all, "math is math" and total returns of 10% can be earned equally well from a 10% dividend yield and 0% growth, or from 10% growth and 0% yield.
• But in bad times, like bear markets and downturns, when growth is hard to come by, high-yielding income strategies really show their stuff.
• That's why the past 15 months have been a great time to own credit and other high-yielding investments, especially if you're focused on growing your income.
• Even if your portfolio drops in market value (just like equity), you're able to collect, reinvest, compound, and grow your income stream while waiting for the market to recover.

Cash Flow You Can Keep, During Market Downturns

Most investors (especially readers of Seeking Alpha) know that "Total Return is Total Return" regardless of whether it consists of cash distributions generated by a particular asset, or appreciation (or depreciation) in the value of the asset.

In other words, an asset that generates a 10% yield and 0% appreciation during a year (or other time period) has the same total return as an asset that generates a 0% yield and appreciates by 10% during that period.

Understanding this is key to being able to compare and evaluate various investment strategies, some of which, like my Income Factory® and other income methods of various types, rely heavily on high cash yields for their total return, and rely less or not on all on market price growth. Other strategies, like traditional equity strategies, rely on relatively small dividend yields (like the S&P 500's current 2%) and depend on market price appreciation to bring their total returns up to their long term average of 9 or 10%.

Total Return vs Rate of Growth

What often causes confusion is the difference between the "total return" an asset or portfolio generates, and the "rate of growth" (sometimes called the compound annual growth rate or "CAGR") in an asset's income or value. The two can be closely related, but are two distinctly different measures.

As described already, the "total return" of an asset is how much income it produces during a specific period (can be a day, a week, a month, a quarter or a year, etc.). It's pretty simple. You take the cash distribution(s) an asset pays its investor during the period, and you add (or subtract) the gain (or loss) in market price during that same period, and the sum of the two is the total return. If you take that sum and divide it by the value of the asset at the beginning of the period, it will give you the rate of total return.

For example, if you have a security that starts the year at $100, and during the year pays a distribution to shareholders of $5, and also appreciates in value by $5 so it is worth $105 at the end of the year, its total return is $5 plus $5, or $10; and its rate of return for the year was $10/$100, or 10%.

Where this get complicated for many readers I've encountered here on Seeking Alpha is when you begin to talk about growth rates. In general, the rate of growth of your investment will be a function of BOTH the total return of the asset (as described above) AND what you decide to do with that total return (i.e. whether you consume it, or re-invest it).

For example, two investors might each have a portfolio generating a 10% annual total return. One investor might consume the entire total return each year (i.e. keep and spend all of it if it's a distribution, or sell off the portion of the portfolio that represents the capital gain, and keep and spend that). Either way, after they consume the total return the end-of-the-year portfolio value will be the same as it was at the beginning of the year. If they did this year after year, the total return would be 10% per annum, but the growth rate would be zero.

The other investor might be at a different stage of their investing life and be interested in maximizing growth for the future. They might take the entire 10% total return each year and reinvest it in their portfolio. That would mean, in the case of the distribution, actually reinvesting and compounding it. In the case of capital gains, it would generally mean doing nothing and leaving the appreciated assets to just grow organically. Unlike the previous investor who was consuming his/her total return each period, and whose core assets were thus remaining essentially static to continue producing the same total return (but no more) period after period, this investor should see his/her total return compounding and growing at roughly 10% per annum (which means they would, under the "Rule of 72", double and redouble every 7 years). That sort of performance would make any long-term investor very proud and happy. I say "roughly 10% per annum" because how fast an investment actually compounds and grows over time depends on how frequently the compounding occurs. So if you reinvested your accumulated return every week or month it would compound faster than if you reinvested and compounded every quarter, or semi-annually, or annually.

Total Return During Downturns (Here is where it gets interesting!)

Once we understand that total return includes BOTH elements - cash received plus gain or loss in market price - then we can get into some of the finer points and advantages and disadvantages of each element.

For investors who reinvest and compound their total return, it doesn't really matter whether you're reinvesting cash you've received as distributions, or just letting the asset continue to grow "organically" (i.e. through earnings and dividend growth, or whatever it is doing that is causing the market to value it more than before).

If you are an income investor, like so many retirees are, it does matter how you earn your total return, if only for the inconvenience of converting capital gains into cash, if you choose to use a low-yielding, growth oriented equity portfolio as your source of cash income. If, for example, your equity portfolio earns 10% total returns (during good times, like most of the years between 2009 and 2022), and you needed an income of 6% to live on, you may have had 1 or 2% in dividend yields and had to sell off 4 or 5% of your stock portfolio each year in order to generate the remaining cash. That would be fine if your overall portfolio were appreciating by 8 or 9%, so that selling 4 or 5% to raise cash left half of your capital gain intact to earn additional money in future years.

Unfortunately, in a period like the past 15 months, when the equity market was on a steady downward path, an income investor who needed 6% to live on had to sell perhaps 4 or 5% of their portfolio at depressed, possibly market-bottom prices, in order to supplement the 1 or 2% dividend yield they were receiving. I have described this as " eating your seed corn " because by having to monetize (i.e. sell) core portfolio assets in order to keep up income distributions, over time an investor will have fewer and fewer of their original "core" assets to benefit later when the market starts to recover.

Investors in credit and other fixed income assets, don't have that problem. For example, my personal portfolio, at currently depressed prices (just like equities) is generating a distribution yield of about 11% per annum. By reinvesting and compounding that, I can grow my income at 11% per year, which means my cash income is 11% higher than it was a year ago, despite the fact that my "paper value" is depressed, just like other investors.

And when I do need to take some of my cash distributions to live on, or to transfer out of my IRA for tax reasons, because the core portfolio is generating this 11% "river of cash", I never have to touch the core principal; the way I would have to if I were largely in equities earning only 2%.

Like every investor I know, I'd love to see markets turn around so our "paper losses" eventually lessen and turn into paper profits.

But until that happens, I am happy and sleeping well at night knowing that my Income Factory® philosophy has continued to vindicate and prove itself, as it steadily builds "economic wealth," in the form of higher and higher income streams, even as fickle market prices continue their volatility.

"Buy When There's Blood In The Streets"

Baron Rothschild made a fortune investing during the panic that followed Napoleon's loss at the Battle of Waterloo. Fortunately none of our recent financial challenges approach the problems besetting Napoleon, but there has been enough to create generous discounts and high yields on many of the credit investments that we favor, like corporate loans, high yield bonds and specialized investment vehicles like collateralized loan obligations ("CLOs").

As a result, we are seeing senior loan funds like Apollo Senior Floating Rate ( AFT ) , at a 13% discount and paying a yield of 10.8%, its sibling Apollo Tactical Income ( AIF ), at a 14% discount and paying 12%, Nuveen Credit Strategies ( JQC ), at a 13% discount and paying 11.4%, and Ares Dynamic Credit Allocation ( ARDC ) , at a 12% discount and 10.9% yield.

Business Development Companies (BDCs), which make senior, secured, floating rate corporate loans, also offer some good opportunities, like Barings BDC ( BBDC ), selling at a 30% discount and yielding 12.9%; FS KKR Capital ( FSK ) , selling at a 26% discount and yielding 15%; or Carlyle Secured Lending ( CGBD ), selling at an 18% discount and yielding 10.7%.

Finally, for a taste of a more complex, exotic but high performing asset class, investors might want to check out XAI Octagon Floating Rate & Alternative Income Term Trust ( XFLT ) , which currently yields 13.8% and holds a mixture of senior loans and CLO debt and equity; or the Janus Henderson B- BBB CLO ETF ( JBBB ) , a relatively new ETF that is focused on the "sweet spot" of middle-level CLO debt, where market conditions have driven current yields up to nosebleed low and mid-teen levels. JBBB has slowly been bringing its yield up to where it currently is about 7%, but I expect it will go higher.

I hold all of these names in either my personal portfolio or our Inside the Income Factory® model portfolios, or in most cases, both. While anything is possible from a macroeconomic and financial outlook point-of-view, I continue to believe that if I can earn equity-type returns of 10%+, from credit investments (i.e. merely betting on companies to stay alive and solvent, even if their stocks go nowhere), that is the more prudent strategy, than betting on equities, and trading cash yields of 10%+ for equity yields of 2% or so, just for the chance that I'll get capital gains sometime later on this year.

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