Adding Color to the Medium Duration Income Portfolio

Expanding on our earlier announcement on the new Medium Duration Income Portfolio.

We know from history and logic that bonds and term preferred stocks are more stable in price as there is a ‘date certain’ for redemption or maturity–the longer the date in the future the  redemption/maturity date is the more volatile the share price will be as interest rates move.  This means that even if interest rates rise the share price reaction will be just a tiny fraction of the movement in a similar coupon issue of a perpetual preferred which has no state maturity and may well be outstanding for decades and decades.  If the price is way above $25 or way below $25 as the redemption/maturity date approaches the share price will move closer and closer to $25.

In the past we have composed portfolios of the above types of securities and they have performed very well.  They have paid a reasonably good income stream while maintaining relatively level share prices–this helps us sleep very well at night.  We currently maintain 2 portfolios similar to these on the website.  The longest running portfolio we have constructed in this manner can be found here and has returned about 6.5% annually.

Now it should be obvious that the investor will not ‘get rich’ owning a similar portfolio and that is not the point of the portfolio.  The point is a reasonable return with low volatility which allows a retired person to sleep well at night.

A key to the portfolio is that the general economy remain fairly strong–not in recession.  The issues in the model are NOT investment grade and thus you have to watch the issuer of these securities to make sure financials are NOT going ‘south’ on a sustained basis.  A weak quarter or two is generally not a large concern, but a steady 6 quarter slide would be a cause for concern.

A few words on the starting issues.

Gladstone Capital–a BDC (business development company) has generally performed well.  Being a BDC which is also a closed end fund they are required to have asset coverage of 200% or more which adds a level of safety.

Eagle Point Credit–a specialty finance company which owns a portfolio of CLO’s (collateralized loan obligations) which has performed very well in recent quarters.  While we are not fans of CLO’s and similar instruments ECC is a closed end fund and subject to the 200% asset coverage requirements.

RiverNorth Marketplace–is a non traded mutual fund which owns a portfolio of loans secured from peer-to-peer lending sites.  We are not huge fans of peer to peer lending as the credit risk seems to be higher from our personal experience.  Given the short maturity of the term preferreds we believe shares will perform just fine in spite of what we believe will be marginal performance of their loan portfolio.

To expand further on peer-to-peer sites (ie Prosper).  Originally borrowers would ‘apply’ for loans and ‘lenders’ (you and I) would bid on the loans.  Initially the credit quality was highly suspect  and we didn’t believe the sites were doing a very good screening job on the ‘borrowers’.  After poor performance the sites tightened credit screening and loan performance improved.  Then a few years ago ‘bulk buyers’ of loans came into the market place which changed how these sites operate.  Instead of bidding for loans the bulk buyers are allowed to short circuit the bidding process and instantly do the loan. This means (in our opinion) that the bulk buyers are allowed to buy the best loans–by best we mean the highest credit quality with extremely solid credit histories.  We have not checked RiverNorth portfolio in extreme detail, but we are guessing the quality of loans is better than what we have personally experienced.

Personally we had invested thousands of dollars into loans when Prosper initially launched the site.  Because of issues with their credit screening we experienced losses of 8% for the first couple of years.  After improvement our returns went higher and now are at 4.86% annually since inception.  This was more a trial of the site than a search for yield and we have now been reducing our holdings (as the loans mature we have withdrawn) and are down to around $500 now.

Arbor Realty Trust–a commercial mortgage REIT with good financial performance in the last couple of years.

Sotherly Hotels–a small lodging REIT that has had decent FFO (funds from operations) recently

We think investors in these term preferreds and baby bonds need to at a minimum pay attention to the quarterly earnings reports to ensure resources are adequate to fund dividends and interest payments–BUT if the economy softens subtantially investors have to use more intuitive feelings to determine whether to buy or sell these securities.



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