What Your Mother Never Told You About Income Investing: Twenty Questions (7 thru 15)

7. So, you are saying that the brokerage firms make more money by selling short term individual securities and new issues than they do by encouraging investment in long term vehicles like managed Closed End Funds.

Yes that's exactly correct, they even compensate their employees in a manner that encourages such dysfunctional investing. They are not required to show their markups on bonds, nor are they required to disclose their syndication income on new issues. Their take is much higher than it would be if they sold a closed end income fund.

8. What would it be then?

Simply the commission for buying shares of the Closed End Fund. Closed End Funds are managed investment programs where investors buy equity-like shares of the investment company that manages each particular fund. By having a diversified portfolio of CEFs, a person can generate significant income with less risk than owning individual bonds, parcels of land, oil wells, etc.

9. --- so, many different types of income CEFs are available?

Excellent question, and the answer may make some of your listeners angry that their advisors have not told them about this investment medium. Every type is available: alone or combined with others, various durations, quality levels, etc. Most pay regular monthly income, taxable and tax exempt, and they trade like common stocks on the New York Stock Exchange.

10. How much about the "innards" of income investing does the average investor need to know?

Investors should certainly know the basics about what they are doing. Corporations raise capital for their operations by issuing common stock, or shares of ownership in the company. They also raise money by borrowing from banks, insurance companies, and the public through the use of debt instruments called bonds, debentures, notes, and others.

Equity investing involves ownership of a corporation. If the company prospers (i.e., is profitable) the value of the business "grows" and the market value of the securities owned within your IRA, 401(k), and investment portfolios in general will react favorably.

 If the corporation is less profitable because of regulation, higher benefit costs, economic conditions, etc, those portfolio values are likely to suffer. When companies are killed by acts of politicians, the people who suffer most are the equity investors, not the corporate CEOs that are being targeted.

Income investing involves the ownership of debt instruments and more complicated securities that combine some of the characteristics of equities with the debt by including terms of "convertibility" into common stock. These are the types of income securities that are generally referred to as "fixed income investments".  

11. Don't all income investments produce a "fixed" level of income?

 No, not at all. Commercial real estate payments will depend on rents received, mortgage backed securities pay out both principal and interest, and the content of the investment vehicle changes periodically. Oils & Gas Trusts and partnership payments will depend on demand, market prices, etc.

 Generally speaking, pure debt instruments like bonds, notes, and most preferred stocks pay the same amount two or four times per year. Debt that includes principal repayment pays increasing levels of principal over the life of the debt. Finally, income securities that depend on market forces other than interest rates may pay variable rates of return.

12. How complicated are bonds, preferred stocks, and other income investments.

Well, let's put it this way. I've been an income investor for forty-five years, and I don't pretend to know all there is to know about income securities. My efforts to apply the "KISS Principle" to bonds, preferred stocks, etc. were not nearly as successful as they were with stocks.

13. Because?

Because, as interest rates fall, the best yielding securities are called away, or partially redeemed. Also, small portfolios cannot afford the risk associated with normal "round lot" portions, say $50,000 for corporate bonds. It was nearly impossible to obtain all the information about a security quickly enough; and it was tough to properly diversify a portfolio.

Fortunately, over the years, Wall Street recognized the demand for a more manageable way for smaller investors to diversify into bonds, mortgages, and the like. Unit Trusts became the security of choice to safely and conservatively put together a well diversified income portfolio.

14. Tell us more about Unit Trusts.

In a Unit Trust, a Trustee creates and supervises portfolio of bonds, mortgages, preferred stocks etc. The trustee makes all the decisions, acts as the custodian for the securities, and pays out the monthly income plus returns of capital to the investors. A fixed number of units are sold, and new units cannot be created.

Investors just need to be careful not to reinvest the returned principal. These vehicles worked really well for a long period of time before the development of income Closed End Funds. The only drawback was their illiquidity. That problem was totally eliminated with the CEFs. 

15. What about regular (open ended) Income Mutual Funds, why don't they work?

Pretty much for the same reason that open end equity Mutual Funds can't work very well --- particularly in the short run. In both instances, bad news, a bad economic report, the political environment here and abroad, can disrupt the management of the portfolio as individual unit owners either panic or create speculative bubbles.

Investment decisions are taken out of the hands of the manager and given over to the mob --- in 1987, for example, or during the recent financial crisis, open-end fund managers were forced to sell to meet customer orders to cash out their positions. Consequently, managers are structurally unable to take advantage of the bargains being created by the downturn. They also can't say "no" to prices that they know are too high.

So, when the going gets tough, the manager gets fired as the mob panics and, most often, takes losses out of fear and desperation. Interestingly, these facts lay bare the fallacy of Modern Portfolio Theory and its attraction to passive investing techniques. These managers can't "beat the market" because their decision-making is influenced by the fund shareholders. True managers beat the market pretty regularly.