2023-11-27 09:30:00 ET
Summary
- Stop worrying; get paid to live your life, your way.
- The biggest worry in a recession is a loss of portfolio value, leading to a declining income. We have a solution for that.
- I recommend blazing a new trail to revolutionize your portfolio.
Co-authored by Treading Softly
Long before there was a car or a basketball team that really laid claim on the name "trailblazer", trailblazers had long been in existence. They were people who could blaze a trail and make a unique path through dense wild countryside. They were the ones who were pioneers or inventors in a field discovering new terrain. While the idea of a trailblazer has become muddied with the idea of a comfortable SUV to ride down the highway in, or a basketball team that has middling performance year to year, the world continues to need people who are willing to push the frontiers of what is known to make new discoveries, new inventions, or to make stands that are no longer popular and retread terrain that has not been seen in quite some time.
When it comes to the market and investing, many people scoffed at my focus on being an immediate income investor. Much of the academic world, as well as the established financial or investment advisory world, largely disregards dividends. There are multiple reasons as to why this is occurring - we'd have enough material for a whole other article on a whole other day. What I have seen repeatedly is evidence from various retirees and from our own portfolio's performance that being an income investor can provide you with a radically higher level of income and reduced stress. You don't have to worry about whether the economy is going to completely collapse if your income stream remains stable and steady, providing you with an abundance of income that overwhelms your expenses.
Today, we'll look at two great funds that can be used as a cornerstone of an income portfolio and will benefit greatly when interest rates begin to fall. You can rest easy on not only having a strong income stream but also a large capital gains cushion.
Let's dive in!
Pick #1: RNP - Yield 8.9%
Cohen & Steers REIT & Preferred Income Fund ( RNP ) is a CEF (Closed-End Fund) that is exposed to two sectors that have been heavily impacted by rising interest rates. RNP follows a strategy of investing roughly half in REITs and half in preferred shares.
On the REIT side of its portfolio, RNP has exposure to some of the largest and most well-known REITs. Its top 10 individual holdings are all REITs and make up 30.8% of its total portfolio - that is more than 60% of its REIT portfolio. Source
RNP Fact Sheet
If you follow REITs, I'm sure you recognize all of these names. All of them are names that many argue are best in their respective sectors. If you look up most REIT funds, you're likely to see many of these names. RNP isn't looking to make big bets on small, unknown REITs; it is holding big, well-established REITs that dominate in their respective sectors.
The other half of the portfolio is the preferred portfolio. While many REITs do issue preferred shares, RNP prefers to seek diversification, and most of the portfolio is invested in banking and insurance preferred.
RNP Fact Sheet
This creates a very diverse portfolio, ensuring that RNP can provide investors with a healthy income.
One thing that REITs and preferred shares have in common is that both tend to see prices decline when interest rates are rising. REITs are companies that use leverage, and the shares are often bought by investors who are looking for income. This makes them somewhat interest rate-sensitive. Preferred shares are fixed-income, which means that the price of preferred equity competes directly with the prices of bonds and Treasuries. So, as rates rise, that is a headwind to preferred prices.
As a result, both halves of RNP's portfolio are down in price as interest rates peak. On top of NAV declining, RNP is also trading at a discount. We frequently see this as investor sentiment toward funds tends to be negative when NAV is down.
So, while RNP's NAV has come down, we have seen RNP's discount to NAV get steeper as well.
This provides an opportunity for us to benefit from the recovery of RNP's NAV and to see additional upside as the discount disappears.
Pick #2: PFFA - Yield 10.5%
Virtus InfraCap U.S. Preferred Stock ETF ( PFFA ) is a preferred stock ETF that operates with a CEF style. Two things set PFFA apart from its peers:
- PFFA uses leverage, usually at 20-30% of assets. Leverage amplifies returns in both directions.
- PFFA is actively managed. Most ETFs blindly follow an index. Occasionally, they might mix in some rules that set them apart, but generally, management isn't making any decisions about what to buy or sell. PFFA is different. Management is actively making decisions about what to buy or sell.
These two differences have made a meaningful difference for shareholders. We all know that rising interest rates are "bad" for preferred shares - rates go up, and preferred share prices come down. So, if I tell you that iShares Preferred and Income Securities ETF ( PFF ) has been down over the past three years, you probably aren't surprised. Interest rates have gone up a lot. Bond funds have been hit hard, preferred prices are down, and the news media has been awash with stories about the "historic" declines throughout fixed-income.
It has been about as tough a market for fixed-income as we've ever seen for an extended amount of time. How did PFFA hold up in comparison?
Where an ETF that follows an index is down over 3 years, PFFA has a positive total return of 14%. How can there be such a huge difference? PFFA is actively managed, and management accurately identified low-yielding preferred shares in the financial sector as a huge risk back in 2021. Back in 2021, many preferred shares in investment-grade-rated banks were trading at premiums to par, often with very low or even negative yields to call. PFFA avoided low coupon, overpriced preferred - choosing instead to focus its portfolio on higher-yielding sectors.
Here is a look at PFFA's current sector allocation: Source
PFFA Q3 2023 Fact Sheet
Note that Financials make up 11.4% of PFFA's exposure. Meanwhile, financials make up 73% of PFF's exposure. Source
PFF Fact Sheet
Why does PFF have so much in financials? Because the financial sector issues more preferred than all other sectors combined. PFF's mission statement is:
"The iShares Preferred and Income Securities ETF seeks to track the investment results of an index composed of U.S. dollar-denominated preferred and hybrid securities."
PFF is going to own preferred shares of a company simply because it is in the index and meets certain size and liquidity requirements. That's the goal, and that is what investors are buying.
Why does PFFA have its highest allocations in real estate and mortgage REITs? Because that is where management currently sees the best value opportunity. You can ask management at PFFA about any particular stock in their portfolio, and they will be able to tell you why they bought it and their outlook for the company. Every holding is bought for a reason.
Are they always going to be right? Of course not. The harsh reality of investing is that all of us will have great investment ideas that don't pan out. However, since its inception, PFFA has managed to outperform the index and peers. Managing through a black swan with COVID and now one of the worst bond markets in history. For a fund that is only a little over five years old, that is a lot of historic events to navigate. PFFA navigated them with flying colors.
We can't wait to see what PFFA can do in a market that is good for preferreds!
Conclusion
With PFFA and RNP, we can take advantage of the market fleeing fixed income and REITs. While others are hitting the exit, we can scoop up outstandingly high yields and enjoy massive monthly distributions. The market often works like the ocean tides - as rates rise, the market flows out of fixed-income or bond alternatives; when rates fall, the market flows back into them. As a professional income investor, I can buy up outstanding opportunities that others leave behind chasing after the crowd-thinking, instead of being willing to blaze a unique path. How can I afford to keep on buying more and more? Simple - the market pays me, so I have plenty of extra cash regularly flowing into my coffers.
When it comes to retirement, I don't want you chasing after what others think is "best." I want you to enjoy your retirement your way. That means you need the income to afford your retirement, and I disagree with the common thought of storing up savings only to burn through it in your golden years. Who owns a house and sells a door to buy bread? If you wouldn't but plan to sell off your life savings to buy bread - you're doing the same thing. Instead, get paid by the market and enjoy the ringing sound as cash dollars are dropped into your account month after month. It's a beautiful sound.
That's the beauty of my Income Method. That's the beauty of income investing.
For further details see:
2 Magnificent 9% Yields In A World Of Uncertainty: PFFA, RNP