Cabot Income Advisor 921 - Cabot Wealth Network

Cabot Income Advisor 921

In This Issue

    A Wobbly Market Gets Worse
    A teetering market just got a weight thrown on the negative side of the see-saw.

    The market had the worst day in months Monday on news that Chinese real estate giant Evergrande may default on $300 billion in debt. There is fear that such an event could cause contagion and ripple through the financial markets.

    The real estate sector accounts for 28% of China’s economy. Many companies are regarded as over-leveraged and could have serious problems if a major player like Evergrande defaults. At worst, the default could trigger a global financial event that sends markets reeling. At best, the problem will be contained for now. At the least, it is another sign of weakness in the Chinese economy that will have negative implications for global growth.

    The market didn’t need this. It was already bleeding down because of other issues. The delta variant continues to be a problem and threaten economic growth. There is still persistent inflation. Markets are high-priced and due for a correction as we sail through the historically worst months of the year. Plus, there are worries that the Fed will announce a tapering of their bond buying program.

    All those issues make a market correction very possible in the near term. I’m not saying there will be one. No one ever knows for sure. I’m just saying that the risks are higher than normal right now.

    Of course, a correction wouldn’t be the end of the world. Periodic corrections in bull markets are healthy. Plus, any market pullback is likely to be short-lived because money still has no place else to go but stocks to fetch a decent return. Fear always wanes. When it does, investors will come back to stocks.

    Despite the current situation, there are pockets of opportunity. In this month’s issue, I highlight two portfolio positions that are likely to trend higher over the course of the year because of a steepening yield curve.

    What to Do Now
    The dicey market prognosis creates two issues for the portfolio. One is that it isn’t a great time to buy anything. Stocks aren’t down much yet and the near future looks bleak. The other issue is that the recent downward bias has shrunken call premiums, as less investors are willing to bet on higher prices.

    The pending call trade for U.S. Bancorp (USB) is being removed. The 57.50 October 15th call was targeted at 2 per call. Although the stock price has held steady, the calls have lost two weeks of time value. They currently sell well below the target. I still believe in USB and there will likely be call writing opportunities in the future.

    Energy positions Enterprise Product Partners (EPD) and ONEOK (OKE) continue to underperform. I believe that, despite the current weakness, they are worth buying at the current price if you don’t own them already. The sector is being weighed down by the virus spread and ensuing growth concerns.

    However, both companies should have a strong second half in terms of earnings. They also sell at dirt-cheap valuations and pay high and safe dividends. When the virus wanes, they should get moving again.

    Although I’ve expressed caution about the near-term direction of the market, nothing is being sold. The reason is that I believe any selloff won’t be that severe and the market should rebound quickly. Plus, there may not be a significant downturn just because the risks are greater. It doesn’t make sense to trade in and out of the market and interrupt the dividend flow.

    The current positions are worth holding. If there is a correction, it will likely present buying opportunities that will be highlighted in an update or a “trade alert.”

    Monthly Recap
    August 20th
    AGNC August 20th $17 calls at $0.50 – Expired
    OKE August 20th $57.50 calls at $1.65 – Expired

    August 25th
    Purchase KKR & Co., Inc. (KKR) $64.31

    September 1st
    Sold BIP October 15th $55 calls at $2.00

    September 8th
    Sell USB October 15th $57.50 calls at $1.70 or better – Pending

    September 17th
    NEE September 17th $80 calls at $3.50 – Expired
    NextEra Energy, Inc. (NEE) stock – Called

    September 22nd
    Sell USB October 15th $57.50 calls at $1.70 or better – Remove

    Featured Actions

    Buy AGNC Investment Corp. (AGNC) and U.S. Bancorp (USB)
    It may seem like a contradiction. I spent the issue so far bad-mouthing the market. Now, I’m turning around and saying buy these two stocks. Sure, a market correction would pull the prices down somewhat from here. But these stocks have already been pulled down by other factors and there is a strong prognosis for the rest of the year even if there is a correction (which may not even occur).

    The yield curve has flattened and two stocks in the portfolio, AGNC and USB, have pulled back as a result. I believe this interest rate dynamic is temporary and these stocks are good buys ahead of a likely reversal. Let me explain.

    A yield curve is the difference between long- and short-term interest rates. Certain companies profit from the difference between the two. They borrow at short-term rates and lend at longer-term rates, profiting from the spread.

    Short-term rates, largely defined by the benchmark Fed Funds rate, are currently between 0% and 0.25% and has been since the pandemic hit. The Fed has announced it does not intend to raise that rate until 2023. Longer-term rates, gauged by the benchmark 10-year Treasury rate, have fallen from 1.75% in March to below 1.2% in early August (currently 1.31%), thus flattening the yield curve.

    But the economy is strong. Companies just posted the strongest earnings growth in decades. Interest rates historically rise under such circumstances. Why have they fallen?

    There are a few reasons. One, the market anticipates beyond this pandemic recovery to a more normalized environment. Two, the delta variant is stoking fears about economic growth. Three, the Fed’s current $120-billion-per-month bond buying program puts downward pressure on interest rates.

    But I believe rates have moved far too low. Sure, the economy will normalize. But rates are still well below what has been defined as normal for the last decade. The 10-year rate is still well below the pre-pandemic level. Plus, the benchmark rate averaged between 2% and 3% during both the Obama and Trump Administrations.

    The other issues are temporary. The virus will abate eventually. And then economic growth will likely make up for lost time and last longer. And the Fed bond buying program will have to end. In fact, the Fed is near announcing a date for tapering either later this year or next. The downward pressure on rates will be removed.

    Plus, there is still persistent inflation. Of course, the current thinking is that this inflation won’t last long. But it is still another force that should put upward pressure on rates in the near term.

    In short, I believe interest rates have fallen too far and are likely to trend higher in the months ahead. This will benefit these two current portfolio positions.

    AGNC Investment Corp. (AGNC)
    Yield 9.0%
    AGNC is a mortgage real estate investment trust that invests predominantly in U.S. Government-backed residential mortgages. It pays a very high dividend yield and makes payments on a monthly basis.

    While typical REITs own actual physical real estate properties, charge rent, and pass that income on to shareholders, mortgage REITs are a different animal. They buy mortgages and generate income from monthly mortgage payments. A mortgage REIT borrows money at low short-term rates and uses that money to buy mortgages that pay higher long-term interest rates, making a profit on the difference, or the net interest spread.

    AGNC invests almost entirely in mortgages backed by Fannie Mae and Freddie Mac, so there is virtually zero credit risk. However, there is certainly interest rate risk. It’s all about the spread. If the difference between the short-term rates at which it borrows money and the mortgage interest paid increases, so do profits. When the spread decreases profits fall.

    AGNC had been thriving in the market recovery as the economy recovered and interest rates rose. The stock rose from under 10 per share in the pandemic bear market to almost 19 by the end of May this year. Since then, AGNC has pulled back to the current 16 per share as the flattening yield curve has weighed on profits.

    But despite the lower rates, business is solid in the booming economy as mortgage demand is high. The REIT is earning more than enough to at least maintain the current dividend. So, you’re getting a safe 9.0% yield on a stock that is likely to appreciate if rates trend higher.

    U.S. Bancorp (USB)
    Yield 3.3%
    U.S. Bancorp (USB) is the fifth largest bank in the United States and the country’s largest regional bank with over 3,000 bank branches in 25 states in the western and northern U.S. The Minneapolis bank was founded in 1863 and now has more than 70,000 employees and $543 billion in assets.

    The bank offers a wide range of services. There are four main divisions including consumer and business real estate banking, corporate and commercial banking, wealth management services and payment services. That probably sounds more complicated than it is.

    Like most regional banks, revenues are generated primarily from net interest income (NII), which is the rate spread between the cost of money and the loan interest charged to customers. Half of the loan volume is to businesses with the rest primarily to residential mortgages and personal loans. The rest of the revenue is derived from banking fees.

    Banks took it on the chin in the pandemic as loan activity dried up during the lockdowns and interest rates crashed. They didn’t participate in the recovery until last fall when the vaccines came within sight. From September to May USB stock soared 77% as business recovered with the economy.

    Last quarter’s earnings were stellar as loan volume and fee business soared. But net interest income fell amidst the falling rates. The stock has floundered since early May because of the flattening yield curve. And, despite the booming economy, USB is still priced below where it was before the pandemic.

    The huge recovery in USB was interrupted by falling longer-term interest rates. That recovery should be reignited if rates trend higher.

    Portfolio Updates
    CIA STOCK PORTFOLIO
    Open Recommendations Ticker Symbol Entry Date Entry Price Price on
    9/20/21
    Buy at or
    Under Price
    Yield Total Return
    AGNC Investment Corp. AGNC 01/13/21 15.52 15.91 17.00 9.01% 8.54%
    Brookfield Infrastructure BIP 01/13/21 50.63 54.31 53.00 3.76% 10.34%
    Enterprise Product Partners EPD 3/17/21 23.21 21.43 25.00 8.40% -3.71%
    U.S. Bancorp USB 3/24/21 53.47 55.68 55.00 3.30% 5.69%
    Qualcomm Inc. QCOM 5/5/21 134.65 132.76 140.00 2.05% -0.44%
    ONEOK, Inc. OKE 5/26/21 52.51 52.99 60.00 7.06% 2.73%
    One Liberty Properties, inc. OLP 7/28/21 30.37 30.68 33.00 5.87% 1.02%
    KKR & Co., Inc. KKR 8/25/21 64.52 62.45 68.00 0.93% -3.21%
    EXISTING CALL TRADES
    Open Recommendations Ticker Symbol Intial
    Action
    Entry Date Entry
    Price
    Price on
    9/20/21
    Sell To Price
    or Better
    Total Return
    BIP Oct 15 $55 call BIP211015C00055000 Sell 9/1/21 2.00 0.70 2.00 3.95%
    SOLD STOCKS
    Security Ticker Symbol Action Entry Date Entry
    Price
    Sale Date Sale Price Total Return
    Innovative Industrial Props. IIPR Called 6/2/20 87.82 9/18/20 100.00 15.08%
    Qualcomm QCOM Called 6/24/20 89.14 9/18/20 95.00 7.30%
    U.S. Bancorp USB Called 7/22/20 36.26 9/18/20 38.00 3.42%
    Brookfield Infras. Ptnrs. BIP Called 6/24/20 41.92 10/16/20 45.00 8.49%
    Starbucks Corp. SBUX Called 8/26/20 82.41 10/16/20 88.00 6.18%
    Visa Corporation V Called 9/22/20 200.56 11/20/20 200.00 0.00%
    AbbVie Inc. ABBV Called 6/2/20 91.04 12/31/20 100.00 12.43%
    Enterprise Prod. Prtnrs. EPD Called 6/24/20 18.14 1/15/21 20.00 15.16%
    Altria Group MO Called 6/2/20 39.66 1/15/21 40.00 7.31%
    U.S. Bancorp USB Called 11/25/20 44.68 1/15/21 45.00 1.66%
    B&G Foods Inc, BGS Called 10/28/20 26.79 2/19/21 28.00 4.42%
    Valero Energy Inc. VLO Called 8/26/20 53.70 3/26/21 60.00 11.73%
    Chevron Corp. CVX Called 12/23/20 85.69 4/1/21 96.00 12.95%
    KKR & Co. KKR Called 3/24/21 47.98 6/18/21 55.00 14.92%
    Digital Realty Trust DLR Called 1/27/21 149.17 7/16/21 155.00 5.50%
    NextEra Energy, Inc. NEE Called 2/24/21 73.76 9/17/21 80.00 10.00%
    EXPIRED OPTIONS
    Security In/out money Sell Date Sell Price Exp. Date $ Return Total % Return
    IIPR Jul 17 $95 call out-of money 6/3/20 3.00 7/17/20 3.00 3.40%
    MO Jul 31 $42 call out-of-money 6/17/20 1.60 7/31/20 1.60 4.03%
    ABBV Sep 18 $100 call out-of-money 7/15/20 4.60 9/18/20 4.60 5.05%
    IIPR Sep 18 $100 call in-the-money 7/22/20 5.00 9/18/20 5.00 5.69%
    QCOM Sep 18 $95 call in-the-money 6/24/20 4.30 9/18/20 4.30 4.82%
    USB Sep 18 $37.50 call in-the-money 7/22/20 2.00 9/18/20 2.00 5.52%
    BIP Oct 16 $45 call in-the-money 9/2/20 1.95 10/16/20 1.95 4.65%
    SBUX Oct 16 $87.50 call in-the-money 10/16/20 3.30 10/16/20 3.30 4.00%
    V Nov 20 $200 call in-the-money 9/22/20 10.00 11/20/20 10.00 4.99%
    ABBV Dec 31 $100 call in-the-money 11/18/20 3.30 12/31/20 3.30 3.62%
    EPD Jan 15 $20 call in-the-money 11/23/20 0.80 1/15/21 0.80 4.41%
    MO Jan 15 $40 call in-the-money 11/25/20 1.90 1/15/21 1.90 4.79%
    USB Jan 15 $45 call in-the-money 11/25/20 2.00 1/15/21 2.00 4.48%
    BGS Feb 19 $27.50 call in-the-money 12/11/20 2.40 2/19/21 2.40 8.96%
    VLO Mar 26 $60 call in-the-money 2/10/21 6.50 3/26/21 6.50 12.10%
    CVX Apr 1 $95.50 call in-the-money 2/19/21 4.30 4/1/21 4.30 5.02%
    AGNC Jun 18 $17 call out-of-money 4/13/21 0.50 6/18/21 0.50 3.21%
    KKR Jun 18 $55 call in-the-money 4/28/21 3.00 6/18/21 3.00 6.25%
    USB Jun 16 $57.50 call out-of-money 4/28/21 2.80 6/18/21 2.80 5.24%
    DLR Jul 16 $155 call in-the-money 6/16/21 8.00 7/16/21 8.00 5.36%
    AGNC Aug 20 $17 call out-of-money 6/23/21 $0.50 8/20/21 $0.50 3.00%
    OKE Aug 20 $57.50 call out-of-money 6/23/21 $3.50 8/20/21 $3.50 6.67%
    NEE Sep 17 $80 call in-the-money 8/11/21 $3.50 9/17/21 $3.50 4.75%

    AGNC Investment Corp. (AGNC)
    Yield 9.0%
    The thing ailing this mortgage REIT is the flattened yield curve. It makes profits on the difference between long and short rates. But the benchmark 10-year Treasury rate has fallen from 1.75% in February to the current 1.31%. I believe that rate is likely to climb. It may fall a little first amidst the current market worries. But that rate is still below the pre-pandemic level while the economy is strong and inflation is persistent. You can be patient with AGNC because it yields 9% and pays dividends every month. BUY

    AGNC-092021

    Brookfield Infrastructure Partners (BIP)
    Yield 3.8%
    Business is good at this infrastructure partnership. Earnings were already poised to grow nicely as its transportation assets rebound and new projects come online. The Inter Pipeline acquisition will be accretive right away and take earnings growth still higher. The stock is behaving true to historical precedent. It made new highs and now it’s pulling back and consolidating. BIP closed below the 55 strike price for the calls on Monday. I like the stock longer term. We’ll see what it does over the next month. HOLD

    BIP-092021

    Enterprise Product Partners (EPD)
    Yield 8.4%
    Operationally, things are solid for this midstream energy partnership. Business should continue to improve in the recovery over the rest of the year and that huge dividend is safe. But the stock has been a dog with fleas for months now. Cyclical stocks have been on the outs. I believe the primary culprit is the delta variant. The virus is dampening investor optimism for the Main Street recovery and energy demand. EPD probably won’t move substantially higher until there is improvement in the virus news. But you get 8.4% while you wait. BUY

    EPD-092021

    KKR & Co., Inc. (KKR)
    Yield 1.0%
    This alternative asset wealth manager stock was down 6% on Monday over concern about the likely Evergrande default. Markets sold off as fear of contagion from the Chinese real estate problems spread. KKR has real estate investments that would be negatively affected if the issue escalates into a bigger crisis. As of now, it looks like the issue will most likely be contained, and KKR moved up on Tuesday. For now, KKR will remain a buy on a likely rebound from Monday’s panic. But if the issue persists or gets worse, I will reduce the rating. BUY

    KKR-092021

    One Liberty Properties, Inc. (OLP)
    Yield 5.9%
    This diversified industrial REIT remained strong during the selloff this week. It’s a snail that is trending in the right direction. It also remained strong when the REIT sector sold off earlier this month. Lesser REITs have had a tough time in recent weeks. But OLP is hanging tough. That’s a good sign and I remain positive on the stock for the months ahead. BUY

    OLP-092021

    ONEOK, Inc. (OKE)
    Yield 7.1%
    Business is good for this midstream energy company in the recovery. The stock is still cheap. The dividend is safe. And the stock can move relatively fast when it’s in favor. But it’s not in favor. Energy sector stocks are likely to wallow in oblivion until the virus news gets better. I don’t know when that will be. But it should subside before long. In the meantime, the yield is huge, and the stock shouldn’t have much downside from here. BUY

    OKE-092021

    Qualcomm (QCOM)
    Yield 2.1%
    The performance of this low-yielding tech stock continues to be disappointing. It took another hit this week on China concerns, as it does a lot of business there. But the stock is cheap while earnings are growing like crazy and will likely continue to do so for several more quarters. Semiconductor stocks are cyclical and can meander for a long time. But when they move up, they move higher fast and make up for lost time. BUY

    QCOM-092021

    U.S. Bancorp (USB)
    Yield 3.3%
    This regional bank is a great recovery stock interrupted by the flattening yield curve. Business is strong in every area except net interest income. The flattening yield curve is limiting profits by reducing the spread U.S. Bancorp earnings on loans. But if that part of the business improves, the bank should be firing on all cylinders. I don’t see a lot of downside in the stock and if rates move higher USB could get another nice run. HOLD

    USB-092021

    Existing Call Trades
    Sell NEE September 17th $80 calls at $3.50 – Expired
    While it’s disappointing to lose the stock, it provided a solid return since being in the portfolio. The stock moved a lot higher after we wrote the calls as the delta variant gained traction and investors gravitated away from cyclical stocks toward safe investments. But NEE isn’t far above the strike price and the call forces us to take some profits in a very uncertain market.

    Call premium: $3.50
    Dividends: $1.155 (3-15, 6-15, and 9-15)
    Appreciation: $6.24 ($80.00 strike price minus $73.76 purchase price)

    Total: $10.90 (total return of 14.8% in seven months)

    Sell BIP October 15th $55 calls at $2.00 or better
    The company is doing well. But the stock has a history of pulling back after making new highs. We wrote the calls near the high and the stock has since been true to form and pulled back. BIP is currently below the strike price even though the calls were several dollars in-the-money when sold. We’ll see where the stock goes over the next month. But either way, we’ll lock in a terrific income return.

    Income Calendar
    Ex-Dividend Dates are in RED and italics. Dividend Payments Dates are in GREEN. Confirmed dates are in bold, all other dates are estimated. See the Guide to Cabot Income Advisor for an explanation of how dates are estimated.

    CIA October Calendar

    CIA Calendar November


    The next Cabot Income Advisor issue will be published on October 27, 2021.

    Cabot Wealth Network
    Publishing independent investment advice since 1970.

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    Chief Investment Strategist: Timothy Lutts
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