“Tapering” Wallops Income Investments

Last month was a lousy month for most yield-focused investments, including both fixed-income securities like bonds and high-yield instruments like MLPs and REITs. The ostensible reason was the Fed’s suggestion that it might start “tapering” off its asset purchases and allow interest rates to rise. The possible implications of that reverberated around the echo chamber of Wall Street long enough to impact a stunningly wide variety of investments that were deemed “interest-rate sensitive.”

Last weekend, New York Times Columnist James Stewart summed up the collapse’s effects on a range of fixed-income assets, writing: ‘If there was an index for fixed income with the status of the Dow Jones industrial average or Standard & Poor’s 500 index for stocks, the carnage in fixed-income markets would have been a big story and we’d all be talking about a bear market in bonds.

“Consider the damage: mutual funds that invest in long-term United States Treasury bonds lost an average 6.8% in May, according to Morningstar, with the loss in principal wiping out years of interest payments. But that’s not the worst-hit sector. Higher-yielding bonds and fixed-income securities, to which investors have turned in droves in recent years, have suffered even more, especially mortgage-backed securities and emerging market debt, as well as just about anything that uses borrowing to increase returns.”

While bonds and fixed-income securities are directly affected by interest rates and thus were hardest hit, many other types of investments saw some ripple effect. Stewart notes that companies that use leverage or deal with mortgages were adversely affected because higher interest rates would squeeze their profits. And some high-yielding investments like MLPs and REITs were dumped on the premise that higher interest rates would induce their yield-seeking holders to turn back to fixed income investments.

And Systems & Forecats Editors Marvin and Gerald Appel noted the effect on defensive sectors and dividend paying stocks in their June 7 issue, writing: “For the past six weeks, relative strength has shifted from areas that led the market higher during the first quarter, such as consumer staples and low-volatility and high-dividend stocks generally. These are areas that have usually been defensive—holding up better than the broad market during corrections in the past. However, from May 21-June 5 as the S&P 500 SPDR (SPY) lost 3.5%, these areas did even worse.

“There are a number of possible contributing causes. First is the rise in interest rates during May. (Defensive stocks as a group have higher dividend yields than the overall market and are therefore more sensitive to rising interest rates.) Indeed, May was a disaster for investment-grade bonds, with the Barclay’s U.S. Aggregate Bond Index down 1.7% and the iShares 7-10 Year Treasury Note Index ETF (IEF) down more than 3% (total returns). Year-to-date total returns for these bond investments remains slightly negative, and the iShares Treasury Inflation-Protected Securities ETF (TIP) has lost 3.8% this year as inflation concerns are receding.

“Second, these defensive areas had outperformed the market by wide margins during the first quarter. Last month’s reversal simply restored the relative strength with which defensive / low-volatility / high yielding stocks started the year. … Now that the outperformance of the first quarter has been reversed [by] May’s upheavals, relative strength relationships and interest rates should stabilize in June.”

The Appels hit on an interesting theory in their commentary, suggesting that much of the poor performance was attributable to rotation in the market, not the interest rate effect. I suspect that may also be true for many of the other non-fixed-income asset types, like high yield investments, that saw losses last month.

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Regardless of the “reason” for the weakness, the losses have still caused quite a bit of concern among income investors.

As I mentioned above, some high-yield investments like MLPs and REITs were caught up in the selling, and I’ve seen a lot of questions about these investments rolling in from Dick Davis Dividend Digest subscribers. Suspecting that other readers may be concerned about the same investments, I thought I’d share some of my answers here today.

Several of the inquiries concerned Linn Energy (LINE), a non-pipeline MLP that has been recommended in the Dividend Digest many times over the years. LINE pays a great dividend—currently it yields 8.7%—but has run into some trouble recently following a negative story in Barron’s. Here’s my response to one of the recent questions:

“LINE is a great income-generating MLP. Its cash flow and payout ratio are both good, so the income is and should remain steady. Of course, you do have to deal with MLP tax issues.

“Recently, Linn has taken some flak related to less-than-stellar quarterly results, the pending acquisition of Berry Petroleum and possible accounting irregularities. The last charge was made in a recent Barrons article that garnered several responses. One I liked came from MLP Profits Editor Igor Greenwald, who wrote this about the sources cited in the article: ‘These are not names patient Linn investors need to sweat. The proprietor of the bearishly disposed hedge fund cited started this shop only in November, reportedly with just $50 million in assets. Among those on the other end of this trade is the investing legend Leon Cooperman, whose Omega Advisors fund held $150 million worth of Linn at year-end. Reputation and size aren’t everything in the investing game, of course, But they can provide important clues. We’re sticking with our call to buy LINE below $40.’

“In short, LINE comes with known risks and higher-than-average volatility, but the income is probably worth it for aggressive income investors.”

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Another recent question came from a subscriber named Duane, who wrote: “Something has been bothering me about a purchase I made based on info you provided via Dick Davis Dividend Digest. Specifically Sandridge Permian Trust (PER). My question is why isn’t everyone in the world purchasing this stock because it’s providing a 17% dividend and its value is rising in the face of a down market. What am I missing something obvious or is there a downside I don’t understand?”

Here’s what I wrote back to Duane:

“Good question! As they say on Wall Street, there’s no such thing as a free lunch.

“In the case of Sandridge Permian Trust (PER), I can think of a few factors that might turn some investors off.

“1) The trust’s distribution is tied to its cash flow. So the distribution can shrink when cash flow does. It can be affected by the price of oil or the output of the wells Sandridge collects royalties on.

“For example, in the fourth quarter of 2012, the trust paid a lower-than-projected distribution because fewer development wells were drilled that quarter and so production was lower than expected. That caused many analysts consternation and some downgraded the trust. One of our contributors recommended selling at the time.

“Another contributor theorized that the unpredictability of PER’s distributions ‘was not well understood by many who jumped on the IPO… judging from the volatility in its unit price.’ That suggests to me that PER is unpopular in part because it doesn’t provide what income-focused investors are accostomed to: reliable, predictable dividends quarter after quarter.

“2) Many investors also have concerns about Sandridge Energy (SD), PER’s parent company. PER’s distributions come from royalties on SD-owned wells. You can look up news stories about the company for more juicy details, but in short, SD is highly leveraged and its management has made some mistakes.

“3) Finally, I think some investors might be put off by the complications of owning a trust. PER sends unitholders a K-1 form for tax purposes, which some investors might be unfamiliar with. In addition, the royalty trust structure will have some odd effects on PER’s distribution in the future. Here’s an explanation from The Wealth Advisory, which originally recommended PER in the Dividend Digest: ‘It’s expected to grow payouts through September 2014, and then they are expected to shrink 9% a year. Ultimately, the Permian Basin Trust is expected to pay out $34.26 per unit. The big variable here is oil prices. The trust is hedged through April 2015 at around $96 a barrel. Our investment thesis here assumes that oil will be higher than $96 in 2015, maybe much higher.’

“I hope that explains why every investor on earth isn’t piling into PER. But, even with these complications and risks, I think the yield in the high teens makes it a great investment for investors who want high income and are willing to actively manage their portfolios and are okay with some uncertainty in income levels.”

This seems like as good a place as any to remind you that if you want more high-yielding ideas like Linn Energy and Sandridge Permian Trust, an annual subscription to Dick Davis Dividend Digest starts at just $97 per year and comes with a money-back guarantee. Plus, subscribers get to email me all their investing questions and get personalized advice like Duane did. I think it’s a fantastic deal, personally.

Click here to find out more on Dividend Digest.

Wishing you success in your investing and beyond,

Chloe Lutts Jensen

Editor of Investment of the Week

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