The Quest for Income

 | May 06, 2013 | 2:30 PM EDT  | Comments
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Stock quotes in this article:

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kfn

As the rest of the value world was tweeting and streaming the Omaha carnival this weekend, I specifically ignored it until Sunday. When I finally sat down with some coffee to read the reports, I found some of Buffett's comments to be of great interest. In particular, he said that when the Federal Reserve signals that it will raise rates, it will be the shot heard 'round the world that rocks the financial markets. In a related remark, he said that bonds are horrible investments and contained the possibility for substantial losses. While this is all very true, it has been true for a couple of years and leaves investors in search of income in more of a quandary than ever.

One technique that has worked very well for investors seeking income over the past few years is owning a diversified portfolio of high-yielding alternative investments. A portfolio of high-yield real estate investment trusts, business development companies and mortgage REITs has offered strong cash flow, and most of them have appreciated quite a bit. The iShares FTSE NAREIT Mortgage PLUS Capped Index Fund (REM) has a total return of more than 30% over the past year and has paid out huge dividends. Even after solid appreciation, it still yields more than 11%. We have been able to improve on that a little bit by only buying the high-yielding securities when the entities traded below asset value and owning a diversified portfolio of securities.

When I ran a screen this morning for high-yielding income alternatives, I found the same condition in every segment of the value world right now. The list of entities trading below asset value is shrinking. Many of them have appreciated substantially and, of course, yield-seeking investors have bid the price up while expressing a lot of concern about valuation. Anytime we see this happening, it is a sign to use caution.

ARMOUR Residential REIT (ARR) looks good at this level. The shares have been weak of late, down less than 1% to $6.32 at midday, but it is still trading below net asset value and it yields 13.2%. Insiders have been consistent buyers and we should be as well. They have the same problem with their portfolio of agency-backed mortgage securities as others with prepayments and lowering spreads squeezing margins. It will be a bumpy ride with the potential for additional lowering of the dividends, but long-term holders should do well.

I would like to see a little pullback in shares of Apollo Commercial Real Estate Finance (ARI) but the REIT still trades below asset value and has a 9.2% yield. Commercial real estate has not had as big a bounce as residential, but I love the long-term prospects of this sector. The company has been making loans in first mortgage loan and mezzanine financing and has a total portfolio of $688 million with an average yield of 12.9%. Adding the commercial side of the real estate business to an income alternative makes sense to me and I would be a buyer of the stock on decline in the broader market.

KKR Financial (KFN) has been a steady performer in the alternative income universe over the years. The company invests in high-yield bonds, real estate financing, bank debt, oil and gas royalty interest and other select income-producing assets. I like what I see going on with this company. It has been taking advantage of what the managing director called exuberance for risk assets to take profits in its high-yield bond and bank loan portfolio. At the same time, it is increasing commitments and exposure in the commercial real estate markets. The shares are trading at a slight discount to asset value and currently yield 7.7%.

There are fewer opportunities to get money to work in the income alternative segment right now. Patience and discipline are called for. The key to a successful portfolio of these higher-yielding securities is to stay small, move slowly and own lots of them. Ultimately, you want to own 20 or more securities in an income-alternative portfolio with as much diversification in nature and purpose as possible. It takes a lot more research and effort than buying a bond or packaged investment product but over the long run, it should be a lot more rewarding.

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