‘Cold Hard Cash,’ Paper Losses, And Sleeping Better At Night

An Investor’s Best Sleeping Pill: “Cold Hard Cash”

It’s hard not to be anxious as we review the state of the world – geopolitically, economically, financially – and, especially, watch the daily gyration in the prices of our investments.

Of of course we all know from history that staying fully invested through periods like this – not losing our nerve and doing “defensive” things like moving to cash, or buying so-called “stable” assets like long-term bonds paying 2% that only lock in sub-standard returns – is the key to investment success.

But we also know (many of us from personal experience) how that is easier said than done when we’re watching our investments drop in price and our “paper losses” are piling up. As they have so far this year for the major indices:

• Dow Jones Industrial Average (DIA) – 9.8%
• S&P 500 (SPY) – 13%
• Nasdaq Composite (ONEQ) – 21%

It’s even harder if you are a retiree or other investor who is counting on your investment portfolios for regular income, since traditional growth or even so-called “dividend growth” stocks typically only pay current yields in the 1% to 3% range. So anyone who needs more than that to live on (ie most of us), and who has a traditional equity portfolio, may be forced to liquidate part of their principal, at current depressed prices, to fill the gap.

Not So For High-Yield Investors

High-yield investors, whether they call their strategy an Income Factory® or merely use some other more generic income method of investing, have several important things in common:

• With high-yielding portfolios generating 8% to 10% income streams, they continue to receive a high “river of cash” on a regular basis every month or quarter, regardless of what market prices do
• Moreover, when market prices fall, as their own portfolios drop in value (which admittedly, is painful to watch), high yield investors can reinvest and compound their distributions at bargain prices and higher than normal yields. So while they may be experiencing “paper losses” in terms of their portfolio’s market value, they are increasing their actual income stream from month-to-month at a faster rate than ever.
• Retireees or anyone who needs to spend all or part of their portfolio’s income doesn’t have to worry about selling assets while their prices are depressed. Thus they avoid locking in permanently what will otherwise most likely be only temporary paper losses.
• Since their strategy is to generate what has historically been an “equity return” of 8%-10%, but to do so primarily or even exclusively through cash yields, and not rely on growth to achieve it, these investors have additional “non- equity” investment options. Many of which are less volatile and more predictable than “regular equity.”

From Heresy to Mainstream

With a personal background in banking, I learned about credit and how to analyze and make money from taking credit risk long before I learned about investing generally. I also saw how banks and other institutions, for decades, even generations, have been able to create more complex and sometimes leveraged credit instruments and vehicles that allowed sophisticated investors to earn “equity returns” while taking risks that were easier to project and model.

This was demonstrated to me clearly in the 2008/2009 crash, when corporate credits experienced default rates that hit a record high of about 10% (which after recoveries averaging about 50% resulted in a typical portfolio hit of 50% of 10%, or a net 5%; serious but hardly existentially threatening). Meanwhile the remaining healthy 90% of typical healthy credits that did not default was being marked down on the secondary market to 60 and 70 cents on the dollar. This meant investors in high yield bonds, senior corporate loans, or structured vehicles like collateralized loan obligations (CLOs), who were routinely receiving principal and interest payments from their healthy borrowers, could turn around and buy replacement loans on the secondary market at deep discounts which would later repay at par when they matured. As a result, credit investors who focused on their cash flows and not on the temporary price gyrations of their portfolios did very well.

This taught me not only what a versatile and durable asset class credit was. It also demonstrated to me that, when it comes to achieving “total return” as an investor, “math is math” and total return doesn’t care how you earn it. By this I mean that any investment’s total return is the sum of two things: (1) how much cash you receive as dividends or distributions during the period, and (2) how much the market price of the security appreciates or depreciates during the period . That means a 10% distribution yield and 0% growth equals a 10% total return just as much as a 0% distribution yield and 10% growth, or 5% and 5%, etc.

Once you accept that idea, particularly that “growth” doesn’t need to be the main component of your investment strategy, it opens up a whole range of additional high-yielding investments, many of a credit or fixed-income nature, and generally more stable and predictable.

This idea that you could produce long-term equity returns without “growth” and, ultimately without even equity, was treated as heresy when I first introduced it about a decade ago here on Seeing Alpha. Since then it has become more mainstream and I’ve even named and trademarked it as the Income Factory®, while more and more contributors, readers and investors here on Seeking Alpha have embraced it or similar versions.

Recent Experience: 2022 Year-to-Date

As mentioned above, mainstream investments like the Dow, the S&P 500 and the NASDAQ, have lost between about 10% and 20% so far this year. My own personal portfolio has a negative total return year-to-date of 7.5%, and is currently yielding 10% per annum. Our two Inside the Income Factory core model portfolios have total returns so far this year of:

• -6.5% (market price) and -3.7% (on net asset value) for our most conservative “Hunker Down” portfolio, which yields 8.7% currently, and
• -5.7% (market value) and -4.1% (on net asset value) for our slightly less conservative and whimsically named “Widow & Orphan” portfolio, which currently yields 9.8%.

In all three cases, my own personal portfolio and our two core models, our total return losses have been less than the losses of the major market indices. But more important is the fact that our cash yields are stronger than ever and have actually increased as market prices have dropped, providing us with higher than ever reinvestment and compounding rates. That means as each month (or quarter) ends and we collect that period’s “river of cash,” we’ve been able to reinvest it at lower prices and higher yields than the previous month/quarter. So we literally can track and project the growth of our cash income, even as our paper losses, along with everyone else’s, have increased.

This doesn’t make the current environment any less scary for investors. But by giving us control over the growth of our income stream, which is what really provides the “economic value” to our investment (read this if that interests you), it makes it psychologically easier to forget about the market price and focus on growing our income. And not be tempted to do something “defensive” that we would regret later.

I’ll confess right up front that if I had a typical equity growth or index portfolio that only yielded 2% or so, and I had to just watch its price move up and down every day (mostly down recently), I don’t know if I’d have the iron will required to just hang on tight and wait for it to eventually recover, even though history tells us it will. That’s why I evolved to an income strategy, embraced it and eventually wrote a book about it. It won’t necessarily earn a higher return over time than a growth or index strategy, for those stalwart investors who have the courage to stick to such a strategy through thick and thin. Rather, the strategy is for those who, like me, want to know we can continue to grow our income, and therefore our wealth, through all kinds of markets no matter what market prices do in the short term.

Final Thought: “Heroic” vs “Non-Heroic” Investments

We are paid to take risk. At least that’s the theory. So if I can make the same rate of return taking less risk than clearly I’d prefer to do that.

That’s what substituting credit risk for equity risk is all about, especially if we can figure out how to make the same return with less risk. Many investors never think about this, but when you take credit risk you are merely betting that the issuer will stay alive and pay its bills, including its debt. Even if the company makes hardly any money or fails to grow and its stock plummets or goes nowhere, as creditors we don’t care. So if I can make 8, 9 or 10% investing in funds or other vehicles that just buy credit instruments (loans, bonds or similar fixed income issues), then why should I bother to take the additional equity risk of a company failing to grow its earnings and its stock price, unless of course I think I can make a lot more than 8%-10%?

I call the basic credit risk, that a company will merely stay alive and pay its bills, the “existential” risk. The additional risk that equity owners take, that the company will not only stay alive but that it will thrive and grow, and the stock market will recognize that and increase its stock price (a lot of risks), that I call the “entrepreneurial” risk.

To me the entrepreneurial risk, which of course also includes the existential risk (ie the company can’t thrive and grow if it doesn’t first stay alive and pay its bills), is a “heroic” investment. The duller, more boring investment – the existential one that the company will merely stay alive – that’s a “non-heroic” investment.

I compare the two – equity bets versus credit bets – as like going to a track and betting on a horse to win, place or show (equity), versus betting on a horse to merely make it around the track and finish the race (credit ). It’s obviously much easier to win the second bet.

In today’s environment, with all the uncertainties we face, I have positioned our Income Factory strategy to rely mostly on credit and credit-like assets. In so doing, we are betting more on major corporations to merely “muddle through” whatever lies ahead, to stay alive and pay their bills; so our incomes will continue growing even if the issuers don’t win their respective races and stock markets remain in the doldrums.

And A Few Ideas To Leave You With

Here are my ten largest personal holdings, which you will see are mostly credit-focused investments, or other securities that emphasize high-yields over market growth:

• Eagle Point Credit (ECC), CLO equity, 12.8% yield (curious about CLOs? read this)
• Eagle Point Income (EIC), CLO debt and equity, 9.4%
• Kayne Anderson Energy Infrastructure (KYN), energy/pipelines, 8.1%
• XAI Octagon Floating Rate Alternative Income (XFLT), CLO equity, high yield debt, 10.3%
• Oxford Lane Capital (OXLC), CLO equity, 13.2%
• Aberdeen Australia Equity (IAF), Australian stocks, held in part as an inflation hedge, given the nature of the Australian economy, 10.5%
• PIMCO StockPlus Long Duration (PSLDX), stock/bond blend, yield varies
• Special Opportunities Fund (SPE), closed-end “fund of funds,” 9.5%
• Eaton Vance Tax Managed Global Diversified Equity Income (EXG), covered call fund, 9.3%
• Barings BDC (BBDC), business development company (senior secured lender), 9%

One note. I know we will get readers who look at this list and say: “Oh my God!! These are ‘high yield bonds.’ That’s ‘junk.’ Too risky. I’d never touch it.”

I would urge those readers to check their own stock portfolios. In most cases they will find small-cap and mid-cap stocks. Those small-caps and mid-caps are invariably non-investment grade companies; the same cohort of companies that issue the high-yield bonds those investors swear they’d never buy. Of course the bonds are far safer than the stock, since the stock is worthless if the companies fail to pay their bonds (or loans) and thus go bankrupt. Whereas the debt pays off in full even if the companies fail to grow and their stock drops or goes nowhere.

Thanks to all the readers and other contributors who have supported and/or embraced our Income Factory strategy and philosophy, or similar ones, over the years.