The Path to Cash for Income Investors

 | Jul 19, 2013 | 4:00 PM EDT  | Comments
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HYG

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spg

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cdr

While on vacation recently I had a chance to spend time with an old friend, Jeff Rollert, a managing director of ALM Advisors, a firm dedicated to providing what they call sustainable income. Rollert is fond of saying that if it produces cash, he is interested in it. Over the years, I have had many informative discussions with him about income markets and he has a great grasp of the finer points of income investing and a unique perspective that finds value in unlikely places.

One of my obvious questions was where to invest now. Rollert pointed out that many of the traditional sources of income have been bid up as yield-chasing investors have flocked into the market. He expressed real concerns about the high-yield market because of exchange-traded fund distortions. Given that the two largest ETFs for high yield bonds, SPDR Barclays High Yield Bond Fund (JNK) and iShares iBoxx $ High Yield Corporate Bond Fund (HYG), between them control something like $27 billion of junk bonds, there is a real danger if investors begin to liquidate. Should investor selling reduce the share count of these large funds, billions of dollars' worth of bonds could be dumped on the market in a short time. He pointed out that the high-yield market is exhibiting classic signs of a top, with covenant lite bonds being the order of the day and inexperienced buyers flooding the market.

What is working, according to Rollert, is illiquidity, which is not necessarily your enemy, contrary to the old adage. As listed alternatives have been bid up to unreasonable prices, he has seen income investors increasingly turn to things like private mortgages on commercial and residential properties and direct financing of business-related assets. He pointed to things like solar panel leaseback transaction as an example of private financing that is producing sustainable income for individual and smaller institutional investors. This is great news for the bank regulators, as it gets unconventional loans out of the banking system and into the hands of speculative income investors and lenders.

I have seen this principle at work in the markets as well. The larger income-oriented investments such as real estate investment trusts, business development companies and other higher-yielding securities have been bid up to very high, if not unreasonable valuations. Look at the value distortions just in shopping center REITs. Simon Property Group (SPG) has a $50 billion market cap and trades for more than 8x book value. Cedar Realty Trust (CDR) has a $319 million market cap and trades for just 1.1x book value of its shopping center assets. Liquidity is carrying a huge valuation premium because of institutional money searching desperately for yield.

On the subject of real estate, Rollert told me that his research partners at JRW Investments had found a way to exploit the differential. The gap between private market value and the price being paid by the public REITs and other large institutions has become so great that there is actually a real property arbitrage opportunity. Investors can buy residential or commercial rental property and collect the income while marketing the property to a large public fund that is usually willing to pay quite a premium over the value to a private buyer. I suspect this would also work with small private REITs and localized real estate private partnership projects in commercial and multi-family housing. We are even starting to see this in individual homes as new funds for rental properties are popping up almost daily.

As always, talking with Rollert was an eye-opening experience. The Federal Reserve has told us that zero interest rate policy will be with us for some time. The yield chasing has pushed many traditional income investments to silly prices and investors have to be far more selective in their search for sustainable income that does not carry excessive principal risk. Going along with the crowd in the more popular and liquid income securities could expose you to substantial losses, as over-valuations are inevitably corrected by the marketplace.

I have maintained for some time that most investors are best served owning companies that are not in the heavily traded indices and ETFs. This applies to income-seeking investors as well. I find very little in the large-cap dividend space that I would buy, but a quick screen of small and micro-cap issues show about 100 names that, with dividends north of 5%, are not unreasonably valued. Looking for smaller, less-liquid securities and thinking outside the box is going to be the path to cash for income investors for the next several years.

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