Carving Out an Income Stream

 | Oct 07, 2013 | 2:30 PM EDT
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Over the weekend, I was asked by a longtime reader to comment on the outlook for income-seeking investors. Specifically, he asked about closed-end funds and other vehicles that pay monthly dividends.

That is a challenge in this environment. The whole income sector has been pretty well picked over as investors have rushed to snap up anything that looks like it may have an adequate payoff to help them meet their specific income needs. Those featuring monthly payouts have received particularly strong attraction from people who are used to bank products that pay monthly, and who like that the regular check basically replaces the paycheck they got during their working years.

Wall Street has rushed to fill that void with closed-end offerings and other products that feature monthly payouts. I can say with a high degree of certainty that a lot these products should be avoided. You are always paying a premium to the value of the assets as expenses and commissions are deducted from the offering price. The money takes months to get fully invested, so the promised payout frequently does not materialize for six months or more with many of these offerings.

I am not a huge fan of the closed-end bond funds 90% of the time. The only time they seem to offer real value is in the aftermath of a good smashing in the bond market, when you can buy them a steep discount to the underlying value of the paper held by the fund. That is not the case right now, as bond yields have remained very low. Convertible bond funds can work very well after the stock market takes a beating -- but, once again, that is not the case right now, as the stock market has climbed the wall of worry the past four years like a sacred kitten fleeing the hounds.

There has been a lot of recent chatter about municipal closed-end funds, with the muni market having weakened amid news that places like Detroit and Puerto Rico are raising risk levels in this market. The problem with most of these funds is that the vast majority of them use some form of leverage, usually in the form of preferred stock. I have never been comfortable using leverage to raise the yield when most of the buyers of these securities are risk-averse and, I suspect, do not really understand the exposure to interest-rate risk these funds offer.

When I look though the portfolios of most of these funds, I see they are doing a bit of yield-chasing and that they own a lot of lower-rated securities. The funds that are not leveraged and own mostly high-quality paper, like Nuveen Select Maturities (NIM), are only yielding around 3.5% and trade at small discounts to the net asset value.

If you must have monthly income, the business-development companies are probably your best bet. I have owned shares of Prospect Capital (PSEC) in income-oriented accounts for so long that seeing it on the sheets is like the sun coming up in the morning. Management has done an excellent job of navigating differing and difficult market conditions over the past six or seven years, and it has rewarded patient investors with an outstanding flow of dividends over the years. When we get a market decline that pushes the price down, I just buy a little more. The stock is yielding at 12% right now, and it is a decent buy for disciplined long-term income investors.

Fifth Street Finance (FSC) also pays a monthly dividend and has performed well over the past several years. These shares are yielding at more than 11%. Gladstone Financial (GLAD) has been around for some time and pays more than 9% at the current price. KCAP Financial (KCAP) offers a monthly payout and yields at 11.5% right now. Its association with Kohlberg Kravis and Roberts (KKR) gives me a high comfort level with the manager of this offering.

The caveat with these higher-yielding securities is that, as saw in 2008, they can get absolutely crushed in a steep bear market. A high comfort level with management, and a trust in their ability to navigate the waters of a bad market, are absolutely necessary for owning these income investments. I suggest owning a small amount of several of the better ones, and buying them during market pullbacks in order to reduce the overall risk of the portfolio. Owning business-development companies has worked very well for my income accounts, but I only buy on declines below tangible asset value and have a high tolerance for market volatility.

I am not sure that focusing on just monthly pay vehicles is the way to go, as it limits your universe of securities. There are only a small handful of monthly payers I would consider anywhere near suitable for purchase. Investors probably need to expand their horizon and focus on the total level of annual cash flows and structure the monthly payout based on dividends collected over the entire year.

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