Investing for Income in a Down Economy
Alternative Investment Strategies for the Recession
As equity markets fall and a recession develops, investors are faced with the “What do I do now?” question. At this point in the business cycle, it is common for investors to move all their resources into cash and cash-equivalent investments while other investors who desire higher rates of return without exposure to equity markets turn to income-generating securities, like bonds, and suffer the low yields. Still others, who seek to minimize the risk of loss, turn to blue-chip-type equities with high-dividend yields and some potential for capital appreciation. However, there are other alternatives that share characteristics with these strategies and may provide better long-term portfolio performance through high-dividend yields and favorable diversification characteristics.
Traditionally, investing for income means investing in fixed-income securities such as treasury securities (T-bills and T-bonds), agency debt, municipal bonds, corporate debt, annuities, money market accounts, and CDs or simply allocating resources to interest-bearing bank accounts. While this is one way to preserve capital, these fixed-income securities currently offer very little in the way of yield or long-term capital appreciation. Moreover, when deflation ends and inflation reignites the market, interest rates will head higher, which means the real value of bonds and other fixed interest-bearing securities will fall. Investors in these securities will run the risk of significant loss of purchasing power, due to inflation and material resource shortfalls, when it is time to retire. Annuity investors also face these risks and may feel somewhat secure knowing that top-rated insurance companies have their backs. However, a bankrupt insurance company means that its annuity holders are likely to get much less than they had planned. 
Alternatively, investors with higher risk tolerances and with goals of generating high rates of return may consider common stock with high-dividend yields. Currently, it is uncommon for the yields on Fortune 500-type companies to be in the 3 to 4 percent range or higher, and to receive these dividends, investors need to be able to bear the turbulence of the markets and the possibility that the dividends will be cut. Since the beginning of 2008, many publicly traded companies in the United States, Europe, and the Far East have cut their dividends and more cuts are expected. Furthermore, some analysts have observed that if we go into a prolonged recession, a depression, stagflation, or just an extended period of equity markets moving sideways, then buy-and-hold equity investors may experience little, if any, capital appreciation.
So, what are the securities that offer an alternative to fixed-income securities and common stock? They include real estate investment trusts, master limited partnerships, closed-end mutual funds, business development companies, royalty trusts, and shippers.
These securities often include equity claims on assets like real estate, gas and oil wells, pipelines, mines, timberland, and tankers and dry-bulk shippers or may be funds that hold a portfolio of debt and equity claims of companies operating in related industries. While these securities are subject to the same volatility as common equities (particularly those with low-volume trading and market capitalizations below $250 million), they typically offer large dividend payouts that help cushion an often bumpy ride through the downturn and subsequent recovery. Alternatively, these investments offer a superior return relative to fixed-income investments because of the potential for capital appreciation. A brief discussion on each of these investment opportunities follows.
Real Estate Investment Trusts (REITs)
Real estate has come into its own as an asset class, and REITs are probably the best known and most popular way to get exposure to the real estate market outside of owning a personal residence. Since 1960, when the U.S. Congress created REITs to make investing in income-producing real estate available to all investors, the market capitalization of these publicly traded partnerships has reached $300 billion.
REITs come in three general types:
- Equity (owns and manages commercial, office, industrial, storage, medical, and multi-family properties)
- Mortgage (facilitates real estate ownership by investing in mortgages and mortgage-backed securities)
- Hybrid (invests in both property and mortgages)
Because much of a REIT’s return is in the form of a dividend that is taxed in the year in which it is received, the ability to defer taxes is somewhat diminished, when compared to a long-term investment in non-dividend paying equities.
Over the last three decades, REITs have offered returns and diversification benefits not available from traditional equity and equity index investing. Currently, there are over 150 publicly traded REITs on U.S. exchanges, and according to the National Association of Real Estate Investment Trusts (NAREIT), the total return on these REITs is superior to that of all the major stock indexes for the period March 1978 to March 2008. They also note that the annual dividend growth rate for REITs from 1993 to 2007 averaged just below 6 percent, with a high of 8 percent in 1998 and a low of just less than 2 percent in 2002. In 2005, Michael C. Henkel, president of Ibbotson Associates, observed, “because of their declining correlations with other types of investments, REITs offer a significant source of portfolio diversification.”
However, recent REIT performance indicates they offer little diversification benefit in the face of the current credit crisis. The latest returns on REIT indexes indicate one-year and three-year rates of return of approximately -50 percent and -22 percent, respectively. Returns on the S&P 500 over the same periods were approximately -38 percent and -27 percent, respectively.
So does this mean that the diversification benefit has evaporated? Not exactly. Over the short run, various asset classes can be highly correlated; however, over longer periods, these correlations will decline and the diversification benefits will return. This is likely the case for REITs. Also, note that the REIT sector is an important factor in determining relative performance. For example, REITs that invest in industrial, office, and retail space are likely to continue to suffer in the near-term, while REITs that invest in healthcare-related assets may have less exposure to the current economic difficulties.
REIT investors have the option of investing directly in partnerships or investing in Exchange Traded Funds (ETFs). An ETF is similar to a mutual fund, with a couple of notable exceptions. First, ETFs are traded just like stocks throughout the day, so they offer a liquidity advantage over mutual funds. Second, ETFs are passively managed, unlike most mutual funds. This means that, once ETFs are created, the portfolios do not change very often. Some notable ETFs offering the benefits of a diversified REIT portfolio include Vanguard’s REIT Vipers (VNQ), iShares Dow Jones U.S. Real Estate Index Fund (IYR), and streetTRACKS Wilshire REIT Index Fund (RWR).
Master Limited Partnerships (MLPs)
The United States has a natural gas pipeline network stretching almost 300,000 miles; its crude oil pipeline network runs approximately 100,000 miles. These networks move over 60 billion cubic feet of natural gas and 20 million barrels of crude daily. Some 50 exchange-traded MLPs control 25 percent and 70 percent of the ownership of these networks, respectively. Ownership is traded in the form of “units” rather than shares, to reflect the nature of the business’ legal structure investors are essentially limited partners when they acquire ownership. While most MLPs are in natural gas and oil-related businesses, there are other MLPs operating in the real estate, mining, and coal and timber industries.
The limited partner status will result in an investor’s receiving a form K-1 for tax purposes. The form K-1 indicates how much of the earnings and depreciation are passed through to unit holders. It also indicates how much of the total distribution to unit holders is return of capital as opposed to return on capital (i.e., dividends) which is not taxable. Because unit holders are taxed as partners rather than as shareholders, the depreciation and return of capital result in lower current taxes and allow unit holders to effectively defer some of their tax obligations into the future. Finally, if an MLP is held in a tax-sheltered account, such as an IRA, the portion of the distribution designated as income may be subject to unrelated business tax income (UBTI). If an investor has UBTI of less than $1,000, then the income from the MLP is not subject to the tax. However, if UBTI exceeds $1,000, then the income from the MLP is subject to the tax as well in effect, it becomes part of the UBTI measure.
Another way to take advantage of the rich yields offered by MLPs and avoid all the tax issues associated with K-1s is to hold an exchange-traded fund (ETF) or a closed-end fund (CEF). Kayne Anderson MLP Investment Company (KYN) is an example of a CEF that converts K-1 income into dividend income and provides some diversification across the North American natural gas and oil infrastructure. Kinder Morgan Energy Partners (KMP) is another way to invest in pipelines and receive mostly dividend income. Currently, these securities offer yields of 8 to 10 percent.
Closed-End Funds (CEFs)
A closed-end fund is similar to a mutual fund, but with some notable differences: CEFs issue a fixed number of shares in their IPOs, can be bought and sold throughout the trading day, do not require minimum investments, and have market prices that can deviate from their net asset values (i.e., CEFs trade at discounts and premiums).
CEFs are also similar to ETFs; however, CEFs are actively managed and have higher management and expense ratios. Current CEF offerings break down into the following asset classes:
- Tax-exempt bond funds (42 percent)
- Domestic equity funds (25 percent)
- Domestic taxable bonds funds (20 percent)
- World equity funds (9 percent)
- World bond funds (4 percent)
The Closed-End Fund Association provides a website that allows for searches by asset class and offers news related to the CEFs and advisors they follow. 
Of particular interest in this business cycle are CEFs that invest in convertible securities and preferred stock. Convertible security CEFs will offer investors a small yield with upside potential, once the stock market resumes its climb. This is because convertible securities are debt instruments until they convert, so the investor “gets paid to wait” until conversion.
Due to the recent market decline, it is likely that most existing convertible securities will not convert for some time. However, with yields ranging from 2.5 to over 11 percent, these investments are a reasonable alternative to other fixed-income securities, with the bonus of a claim to the upside potential of the firms in the portfolio. However, because there is no such thing as a free lunch in financial markets, the values of these securities are more volatile than their non-convertible counterparts.
Preferred stock CEFs are another possibility for generating income. Preferred stock is typically issued by financial concerns and utilities, but can be issued by firms from all industries. Preferred shares are often called hybrid securities, because even though they are equity securities, they behave like fixed-income securities due to their high yields. Currently, there are approximately 30 CEFs that include preferred stock in their portfolios. When selecting a CEF with preferred stock, one must pay careful attention to the contents of the portfolio and avoid those with exposure to companies that are financially distressed or may become financially distressed, as we move further into the recession. For example, firms likely to be able to meet preferred dividend obligations include banking concerns that are supported by regulators and the government, such as J.P. Morgan, Bank of America, Wells Fargo, Freddie Mac, and Fannie Mae. Most other banks are in a more precarious position. Utility issues are also another subset of preferred stock likely to avoid default. A good example of a fund with minimal exposure to the banking crisis is the DNP Select Income Fund (DNP), which is 75 percent invested in interest-bearing securities issued by utilities and currently yields over 10 percent.
BDCs offer individual investors the opportunity to enter the private equity markets, with all the potential returns and risks facing professional private equity firms and venture capitalist. However, BDC investors do not have to worry about capital calls and minimum income or net worth requirements and their shares are quite liquid.
The Small Business Investment Incentive Act of 1980 facilitated the establishment of BDCs, which are closed-end funds that provide financing to small- and middle-market companies that are often not large enough, or obscured by too much uncertainty, for larger financial institutions’ tastes. They also receive tax-preferred treatment that is, there are no taxes levied on the entity because BDCs are regulated investment companies (RICs) and are required to distribute a minimum of 90 percent of investment company taxable income to shareholders by the end of each tax year.
BDCs investment strategies can be focused on:
- Growth (majority of capital allocated to start-ups or smaller companies with high growth opportunities),
- Value (majority of capital allocated to established and less speculative companies), or
- Income production (majority of capital allocated to established and less speculative companies).
Typically, publicly traded BDCs will allocate capital to all of these opportunities using various financial instruments, including secured debt, unsecured debt, convertible notes and bonds, preferred stock, common stock, and warrants.
Because BDCs invest in small companies with subordinated positions, the investment risk in these entities can be substantial. This risk is somewhat mitigated by regulations that limit leverage to a one-to-one ratio that is, for every dollar borrowed by the BDC, they have to raise at least one dollar in equity. Furthermore, BDCs must also be diversified no more than 25 percent of a BDCs assets may be invested in a single issuer. The upside to this significant risk is that small companies tend to do well once a new expansion begins, so well-managed and well-positioned BDCs will also do well.
Finally, it is important to determine whether the BDC is internally or externally managed. Externally managed BDCs may be exposed to conflicts of interest, which could have adverse consequences on shareholders. Some examples of self-managed BDCs include American Capital Strategies (ACAS), MCG Capital Corporation (MGC), and Gladstone Capital Corporation (GCC). Examples of externally managed BDCs include Apollo Investment Corporation (AINV), Technology Investment Capital Corporation (TICC), and NGP Capital Resources Company (NGPC). It is also important to note that some BDCs are broadly diversified across many sectors and industries, while others specialize within market sectors or industries.
Royalty trusts are corporations typically established to engage in natural resource extraction, such as mining and natural gas or oil production. Most are based in Canada or the United States. They are financing vehicles without management, employees, or operations of their own. They offer investors the ability to gain direct exposure to energy and commodity prices and markets. Similar to the other securities discussed in this paper, royalty trusts are currently not taxed at the corporate level, if they distribute 90 percent or more of their profits each year.
While all trusts may look similar, investors need to be aware of some important differences between Canadian and U.S. royalty trusts. For example, Canadian royalty trusts, or CanRoys, are able to replenish or perpetuate their activities through continuing investment by the same entity. In the United States, royalty trusts are established to own a specific asset or assets, and once those assets are depleted, the trust is effectively out of business and dissolved. Therefore, investors in U.S. royalty trusts can expect payouts to diminish over time, whereas investors in CanRoy trusts can expect payouts to increase.
Another important difference relates to tax status. Recently, Canada decided to tax CanRoys at the maximum corporate rate of 31.5 percent, beginning in 2011. However, political opposition is seeking to overturn the change and keep the old maximum tax rate of 10 percent. Investors seeking income through CanRoys should carefully consider the impact of the tax change on the units’ values and the future expected dividends.
Because royalty trusts incur huge depreciation and depletion charges, most of the income distributed to unit holders is not taxed in the period the dividend is received. Instead, the cost basis of the purchased units is adjusted downward, and at the time of sale, the unit holder will pay capital gains taxes on the difference between the purchase price and the reduced cost basis. A list of publicly traded royalty trusts can be found here. Examples of U.S. royalty trusts and their accompanying dividend yield include BP Prudhoe Bay RT (BPT) yielding 9.7 percent, Permian Basin RT (PBT) yielding 7.9 percent, and Sabine RT (SBR) yielding 7.4 percent. Examples of Canadian trusts include Harvest Energy Trust (HTE) yielding 38 percent, Precision Drilling Trust (PDS) yielding 10.8 percent, and Provident Energy Trust (PVX) yielding 19.2 percent. Investors should expect dividend decreases in many of these issues until oil prices firm up.
Dry-Bulk Shipping and Oil Tanker Companies
There are several exchange-listed oil tanker companies and dry-bulk carriers for investors who seek high but volatile yields and who can handle relatively volatile stock price movements. During the recent expansion in the U.S., these companies provided both high yields and handsome capital appreciation. However, in the market downturn, the capital gains quickly turned into capital losses. The meaningful gains will likely return, when China and India begin buying commodities again. This turn should be reflected when spot rates incorporated in the Baltic Index begin to rise. The signals produced by this index, which is related to market turns in shipping, tend to be more reliable than typical leading and coincident indicators used in equity markets because of the way they are constructed. There is little speculation built into shipping rates. Therefore, the time to start buying is when spot rates firm up. Current and historical shipping rates can be found on the DryShips Inc. Web site (DRY).
Currently, several shippers are offering what appear to be extraordinarily high-dividend yields. For example, at the time of writing, Nordic American Tankers (NAT), Frontline LTD. (FRO), and Diana Shipping (DSX) are yielding 15.62 percent, 37.88 percent, and 20.37 percent, respectively. But these yields reflect past shipping rates that are not available in today’s markets. The dividend yield based on next year’s profits will most assuredly be lower. While it is difficult to determine which shippers will be able to operate their fleets profitably in a downturn, a good starting point in identifying the most likely survivors is to find the shippers with relatively little debt, relatively less exposure to spot rates, and no commitments to purchase new tankers. These are also the tanker companies that will be well positioned when the next expansion cycle begins.
Before investing in these securities, weigh the following:
- Assess your own risk tolerance and how these securities might change the volatility of your portfolio;
- Understand the tax consequences related to each of the discussed securities, particularly as they relate to tax-deferred investment accounts; and
- Make sure that inclusion of these securities, and the associated expected returns, are consistent with your portfolio return objectives especially as they relate to a trade-off between desired capital gains and current income.
Minimize your risk by selecting companies with proven management teams (especially recession proven), modest debt levels relative to cash flow, and histories of increasing distributions for an extended period of time. Also, avoid companies that are required to retire debt unless you are confident that they can refinance in this credit tight environment.
 Some bonds currently trading at discounts offer the potential for capital appreciation.
 REIT.com, REIT Performance, http://www.reit.com/AllAboutREITs/REITInvestmentBenefits/Performance/tabid/142/Default.aspx. (no longer accessible).
 REIT.com, Dividends, http://www.reit.com/AllAboutREITs/REITInvestmentBenefits/Dividends/tabid/143/Default.aspx. (no longer accessible).
 REIT.com, Diversification Benefits of REITs, http://www.reit.com/AllAboutREITs/REITInvestmentBenefits/Diversification/tabid/144/Default.aspx. (no longer accessible).
 DowJonesIndexes.com, Dow Jones Wilshire Real Estate Indexes, http://www.djindexes.com/wilshire/realestate/index.cfm?go=index-data.
 Reuters.com, Canada’s Liberals Get Trust Plan Election-Ready, http://www.reuters.com/article/bondsNews/idUSN0443978220070904.
About the Author(s)
Steven R. Ferraro, CFA, PhD, is an associate professor of finance at Pepperdine's Graziadio School of Business and Management where he teaches corporate finance, valuation and corporate combinations, and investments. His current research interests include corporate restructuring, event-driven investing, and real estate investment trusts. Dr. Ferraro is managing director of the Center for Valuation Studies and principal of Ferraro Capital Management. He holds a PhD from Louisiana State University and is a Chartered Financial Analyst (CFA). He is also a recent recipient of the Howard A. White teaching award.