Are Bond Fund Exit Fees In Your Future?

While not getting much mainstream press, the Fed may be thinking about what will occur as interest rates increase and its effect on the value of bond mutual fund prices.  From a Barron’s article, June 21 Up and Down Wall Street:: 

“The Federal Reserve is floating a trial balloon, or at a minimum give bond investors a “heads up”.  It might be well that the Federal Reserve appears to be thinking about the consequences of the end -- and eventual reversal -- of its massive experiment in monetary stimulation. Last week, the Financial Times reported that the central bank is mulling exit fees on bond mutual funds to prevent a potential run when interest rates rise, which, given the ineluctable mathematics of bond investing, means prices fall. Quoting "people familiar with the matter," the FT said that senior-level discussions had taken place, but no formal policy had been developed.
Those senior folks apparently did not include Fed Chair Janet Yellen. Asked about it at her news conference on Wednesday, she professed to be unaware of any discussion of bond-fund exit fees, adding that it was her understanding that the matter "is under the purview" of the Securities and Exchange Commission.
That nondenial denial leaves open the possibility that some entity in the U.S. financial regulatory apparatus is indeed mulling bond-fund exit fees. The Financial Stability Oversight Council established by the Dodd-Frank legislation oversees so-called systemically important financial institutions, or SIFIs, which include nonbank entities. And, indeed, the FSOC has considered designating asset managers as SIFIs, as Barron's has noted previously.”

http://online.barrons.com/news/articles/SB50001424053111903927604579628353649352222

Remember that in the jaws of the last financial crisis, a run on money market accounts during the fall of 2008 caused the Feds to alter money market fund status by temporarily guaranteeing them, equaling the protection of FDIC-insured bank savings accounts.  This temporary guarantee expired in Sept 2009. 

An exit fee for bond fund sales might be an attempt to stem potential fund outflows as rates increase.  While most commentators do not believe this will actually happen, it is important for investors to take notice of the Fed’s worry.   

Most of us have some bond funds and it essential for investors to understand the “interest rate risk” and its potential impact on that specific fund.  While seemingly a complex calculation, it is actually quite easy.  Most of the complicated math has been done for you and is reflected in two important bond fund fundamentals.   These are “Average Maturity” and “Average Duration”.

The important takeaway is the topic of interest rate hikes is starting to gain traction, even within the inner circle of the Fed.  How are you preparing for the next move up in the interest rate cycle and how will it affect your finances?

First published June issue of  My Investment Navigator newsletter

Goldman Sachs Moves Up The Date For the Demise Of The Bond Market - The Modified Taylor Rule and Eurodollar Futures Agree

From a Marketwatch news article published July 6, 2014:

LONDON (MarketWatch) -- Goldman Sachs now believes the first hike in the U.S. federal funds rate will come in the third quarter of 2015, rather than in the first quarter of 2016. The changed forecast comes in response to "the cumulative changes in the job market, inflation, and financial conditions over the past few months," chief economist at Goldman Sachs, Jan Hatzius, said in the note from Sunday. The revised forecast is close to current market expectations, but Hatzius said the change is important because it is the first time since the crisis that Goldman Sachs has moved forward its rate-hike expectations. "We view this as an illustration of the substantial progress that the U.S. economy has made in overcoming the fallout from the housing and credit bubble," he said. Goldman Sachs now expects the funds rate to rise gradually back to 4% by 2018.”

http://www.marketwatch.com/story/goldman-sachs-brings-forward-forecast-for-first-us-rate-hike-2014-07-07?siteid=yhoof2

Seeking Alpha’s reading of the Eurodollar futures seems to agree with the Goldman Sachs’ belief and offered the following news headlines on July 7, 2014:

“Checking Eurodollar futures for expectations of tighter monetary policy, they've backed off a bit from rate hikes as well, the June 2016 contract ahead by four basis points, but still pricing in a Fed Funds rate about 130 basis points higher in two years then it is now.”

http://seekingalpha.com/news/1833425-treasury-yields-reverse-post-employment-report-surge

The current yield curve for US treasury notes/bonds is below.  Based on the curve, the 10-yr is yielding 2.65%, 20-year is yielding 3.21%, and the 30-year is yielding 3.47%

Yield Curve July 5, 2014, www.treasury.gov

Yield Curve July 5, 2014, www.treasury.gov

If 10-yr rates are expected to increase to 4.0% and based on the same yield curve slope, one should expect yields to increase to 4.56% on 20-yr and 4.82% on 30-yr, for a net increase of 1.35% across the board.  

Below is a graph of historic 2-yr and 10-yr rates going back to 2004.  As shown, before the 2008 financial debacle, both 2-yr and 10-yr rates were in the 4.0% range, and it was not until the easy money of the past few years that rates dramatically declined.

http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-Yield-Data-Visualization.aspx

In addition, the Modified Taylor Rule adds another layer of agreement with rates climbing dramatically after 2015, as shown below.  The chart outlines how the Modified Taylor Rule has mirrored the Fed Funds rate from 1985 to the current crisis’ beginning in 2008. 

Modified Taylor Rule and Fed Funds Rate.  www.brookings.edu

Modified Taylor Rule and Fed Funds Rate.  www.brookings.edu

“A simple, but highly effective way of transforming output gap estimates into monetary policy comes from the Taylor Rule, which is based on John Taylor’s 1993 paper Discretion Versus Policy Rules in Practice. It calculates a recommended federal funds rate based on only three variables: the amount of slack in the economy; the deviation of inflation from its target; and the neutral interest rate described above. While there is much disagreement about the exact definition of these variables and the appropriate weights on them, the modified Taylor Rule depicted in Figure 3 seems to do a very good job at modeling Fed behavior.

The modified Taylor Rule suggests that the fed funds rate should’ve been cut well below zero during 2008 and should remain negative today. Since it is very difficult to charge negative interest rates, the Fed came up with alternate policies, such as expansion of its balance sheet to initially ease up frozen credit markets in 2008-09, then to lower longer-term interest rates as well as encourage credit creation and risk taking today. Though the latest jobs report of weak payrolls but a lower unemployment rate present a confusing picture of the economy, the modified Taylor Rule currently recommends that since the economy is recovering and starting to eat into the spare capacity - as evident by the declining unemployment rate - interest rates should not be as negative as before.

Using the latest FOMC Economic Projections (Table 1) in combination with the CBO’s estimate of potential, we can attempt to forecast monetary policy going forward (see the right hand side of Figure 3). The modified Taylor Rule forecasts that the Fed will start raising interest rates at the end of 2014, and the funds rate should be above 3% by the end of 2016.”

More information on the Modified Taylor Rule can be found here:

http://www.brookings.edu/blogs/up-front/posts/2014/02/07-strong-correlation-cbo-projections-fed-actions-coheng

http://en.wikipedia.org/wiki/Taylor_rule

http://web.stanford.edu/~johntayl/Papers/Discretion.PDF

A inescapable fact is that bond prices in the secondary market react inversely to interest rate movements.  As interest rates go up, bond prices go down; as rates go down, bond prices go up.   So what does this mean for bond investors?  In a short sentence – it means a massacre of long bond prices is in the offing.  IF  the yield curve does not steepen and IF  long rates are held to only a 1.35% increase, the following ETF/bond funds will decline by the following percentages: 

ZROZ PIMCO 25 Year+ Zero Coupon Treasury Bond will decline by 37.15%

EDV Vanguard Extended Duration Treasury Bonds will decline by 33.75%

TLT iShares 20 Year+ Treasury Bond will decline by 22.1%

TLH iShares 10-20 Year Treasury Bond will decline by 13.1%

IEF iShares 7-10 Year Treasury Bond will decline by 10.2%

Below is a Morningstar graph of the cumulative inflows and redemptions of bond vs. stock funds for the 5-years from 2008 to 2013.  As shown, the inflow for bond funds is about five times the outflow of stock funds. 

Bond Fund Inflow vs Equity Fund Outflows 2008 to 2013 www.morningstar.com

Bond Fund Inflow vs Equity Fund Outflows 2008 to 2013 www.morningstar.com

What to do?

The first step is to determine your personal interest rate risk by fund or ETF.  Morningstar.com on its quote offers the average duration, or the ratio of rate sensitivity, for almost all bond funds and ETFs.  To calculate a specific bond fund’s interest rate exposure, multiply the anticipated rate movement by the duration.  For example, ZROZ has duration of 27.5 and the example above is a 1.35% rise in rates.  Multiply 27.5 x 1.35 = 33.75, or a decline of 33.75%.

While floating rate ETFs and funds have no duration as they reflect the current rate environment, duration of 4.0 or less would be considered low. The easiest means of lowering duration would be to shorten maturity exposure.  

Bond investors are facing a difficult choice – reduce short-term income by moving out of higher yielding, longer term and higher duration investments.  Which is better for you 1) reduce your income over the next few years or 2) experience a considerable loss of principal?  It is like the deciding the better of two evils.

What is under that FIG leaf? Distributions and more distributions

Fortress Investment Group (FIG) is a controversial hedge fund manager that either analysts love or they hate.  A share price at $7.50 and a dividend yield of 4.5% would seem to reward shareholders with a longer-term horizon.  However, FIG is not without issues.

A good two sentence overview from their press release:

Fortress Investment Group LLC is a leading, highly diversified global investment firm with approximately $62.5 billion in assets under management as of March 31, 2014. Founded in 1998, Fortress manages assets on behalf of over 1,500 institutional clients and private investors worldwide across a range of private equity, credit, liquid hedge funds and traditional asset management strategies.

Like many of its peers in the alternative investment field, Fortress Investment Group is structured as a LLC, much like a MLP, where unit holders receive a K-1 tax form. 

FIG generates revenue based on fees charged for their investment services.  As shown below, the bulk of AUM, along with revenue growth is in its fixed income programs. Going forward, this segment should continue to be the driver for growth in AUM to over $115 billion by 2017. 

The following chart taken from its 1st qtr. 2014 press release outlines the major business sectors by Assets Under Management (AUM). 

 

Chart-AboutFortress_Overview_OurBusinesses.gif

The latest investor presentation dated 2013 can be found in the link below:

http://shareholders.fortress.com/Cache/1001183295.PDF?Y=&O=PDF&D=&fid=1001183295&T=&iid=4147324

Earnings per share are expected to increase from $0.80 per unit in 2013 to between $0.94 and $1.28 by 2017.  Distributions are expected to grow from $0.30 per unit, for a 37% payout ratio, to a minimum of $0.55, for a 58% payout ratio, in that timeframe as well.  Consensus price targets range from $10.50 to $11.50, but FIG has a high beta at 2.5, so investors could expect a volatile ride up.

While these estimates vary widely, it is important for investors to understand the structure and use of units as a management compensation vehicle.  FIG has two classes of units, Class A and Class B.  Class A is publically traded while Class B, also known as Operating Group Units, is not. Class B units are owned by management and are a used as an important compensation tool.  Not only do they receive equal distributions, but B units are sometimes bought back by the firm, or are swapped, directly or indirectly, for publically traded A units.   For example, in March 2014, FIG announced that it will sell 23.2 million newly issued Class A units in a secondary offering, with proceeds used to buy Fortress Operating Group Units from management. At $7.50 a share, the value of the purchase of Class B units would be around $175 million.  As of the end of the 1st qtr, there were 229 million Class A and 226 million Class B shares outstanding.  As shown, management owns a substantial percentage of total units outstanding  and this ownership provides them with a valuation of $1.7 billion of units and an annual income flow of $67 million.

Management is definitely on the same page as us lowly Class A unit holders.

Credit Suisse offers an interesting thesis:

Our Outperform Thesis: We remain Outperform on the FIG stock given that (1) FIG has almost $3 per share in net cash/investments. We think FIG will look to return capital to shareholders as their illiquid PE and credit fund investments on B/S return capital to LPs (which includes FIG). This will be source 1 of dividends going forward. (2) We estimate FIG will earn between $0.50 and $1.40 per share over the next five years and will target a dividend payout of earnings (source 2) around 50-80% (with a larger dividend payout occurring in 4Q – starting in 4Q14). So after adding dividend source 1 and 2 – we think FIG may be returning a very large amount of cash to shareholders over the next five years ($2.50 to $4.00 range or ~45% of current share price). (3) We think the core FIG business (x-the large excess capital balance) is worth about ~$11-12 - supported by $8-9 in value from mgmt. fee-based revenues (~$0.40 in normal year x 20x multiple – these fees are growing quickly and generally have very high persistency) and $3 in value for performance-fee-based EPS (~$0.50 in norm year x 6 multiple).

On the other side of the fence, Morningstar offers a down-in-the-mouth assessment of FIG in their most recent review.

The aftermath of the 2008-09 financial crises has changed Fortress Investment Group permanently, and we don't think for the better. We believe Fortress' reputation was severely damaged as the firm used side pockets to prevent redemptions on its most illiquid investments and suspended redemptions at its major Drawbridge Global fund at the height of the crisis. These actions as well as poor returns angered investors, who pulled out billions in capital over the next few years.

Fortress' struggles mean that its outlook is very different from many of its peers. The company raised only about $9 billion in new capital for its alternative funds over 2011-13. This level of fundraising is far lower than peers that raised several times more in new capital and consequently have stronger growth prospects. Believing that the firm will continue to face challenges with client inflows, we anticipate that Fortress will struggle to raise enough capital to offset our forecast level of redemptions and realizations as its funds age. As a result, we expect alternative assets to reach just $43 billion in 2017 from $40 billion in 2014, leaving the majority of Fortress' most valuable assets under management and earnings power to be largely stagnant in the near future.

Instead, we think the bulk of Fortress' growth over the next few years will come from its traditional fixed-income business, Logan Circle, which was acquired in 2009. We expect AUM for the segment to reach about $36 billion in 2014 and $70 billion in 2017, which will be roughly 60% of Fortress' total AUM and far greater than 2009's $11.5 billion. Inflows will be driven by fund performance, which is in the industry's top quartile, but Fortress earns only about 14 basis points (versus 150-200 basis points plus performance fees at its alternative funds) on the capital. Separately, the company recently hired a group of managers who have experience managing $20 billion of equities, believing it can charge investors 60 basis points to participate in the new strategy. However, given the significant difference in fees, we still expect the contributions of this segment to be around 10% of distributable earnings in 2017.

I fall on the side of Credit Suisse and think the current price offers adequate future total returns. With a payout ratio in the 50% range and high-end earnings estimate of $1.28, the distribution could grow to $0.64 a unit.  With a payout ratio of 80% and low-end earnings estimate of $0.95, the distribution could be $0.76 a unit.  Either way, the yield on cost could explode from a current 4.5% to between 7.5% and 10.0%.  

Oh, by the way, the firm has $2.2 billion in cash and investments and $1.2 billion in liabilities.  This equates to net cash and investment assets of $2.83 per unit, or about 37% of the current share price. Looking for a future high-yielder with additional capital gains potential?  FIG may fit the bill.

Disclosure: I am long FIG and the company is followed by MyInvestmentNavigator.com monthly newsletter.  FIG currently carries a rating of Full Speed Ahead.

 

Man-o-Man, Based on these guys, I would never take my advice

There are a growing number of websites that offer to rate specific analyst's and blogger's stock picks. One such site is tipranks.com.  A detailed description of their service is available on their website.  So, I did what any self-respecting financial writer would do – I looked up my performance on TipRanks.com

I have the unique situation of writing for Seeking Alpha from Feb 2010 to Feb 2012 using my given name.  Due to compliance issues, during the later days of being a RIA from Sept 2012 to March 2014, I wrote using the pen name Jon Parepoynt.  Therefore, I looked up both authors.

The various options for searching performance is “stock ratings automatically closed at “1 qtr., 1-yr., or 2-yr.”  Comparisons are available using “S&P 500, Sector, or None” . 

When selecting “2-yr timeframe” and “None”, George Fisher generated a 16.3% average return per recommendation with a 31 out of 44-success ratio, or 70%.  However, when compared to the S&P 500, the results plummeted to -4.1% average return above the S&P and a 20 out of 44-success ratio or 45%.

When selecting “2-yr timeframe” and “None”, Jon Parepoynt generated a 12.2% average return per recommendation with a 40 out of 48-success ratio, or 83%.  However, when compared to the S&P 500, the results plummeted to -2.3% average return above the S&P and a 28 out of 48-success ratio or 58%.

I reviewed my own rating and found it obviously quite disappointing.  As author George Fisher, I was rated #2019 and as author Jon Parepoynt I was rated #2469 out of 3233 bloggers tracked compared to the S&P.    Man-o-man, I would never take my own advice.

TipRanks.com website has been discussed on the contributor forums of Seeking Alpha.  One contributor contacted TipRanks.com to clarify their measuring methodology and below is the reply, as posted on the forum:

I understand there is a thread on SeekingAlpha regarding TipRanks and I would like to explain a bit how experts performance are measured. I would appreciate it if you could publish this on the thread so all the dear contributors will get answers to their questions.

Before I dive deep into the calculations, I would like to point out that TipRanks is here to let laymen investors know who they can trust there are 3100 sell side analysts 3200 bloggers (out of which 800 are from SA) and it is amazing to see that average bloggers performs so much better than an average sell side from Goldman Sachs.  And our users love the fact that they can easily find rock stars from blogs and see what they have to say as experts.

Our measurement system was developed by a leading professor of Finance from Cornell University called Roni Michaeli who is an industry leader in performance research and published hundreds of academic articles in the field of analyst performance.

When our machine detects a recommendation to Buy a stock, we "virtually" buy it, but we also buy relevant benchmarks, the SPY and an ETF of the sector of the stock recommended….When a blogger recommends a stock we will close his position either after the time defined or if he writes another article about the stock (if it is a buy and then a buy we will close first position and open a new one, and the performance of both "buy" calls will be added to his portfolio).

We also measure success rate which is the number of stocks who had positive return in case of no benchmark or outperformed the benchmark if a benchmark is chosen.

We then run a Z test on the success rate meaning that the more the data is significant the more weight the expert is getting (e.g. if someone has 10 out of 10, he is not as good as someone who has 75 out of a 100 even though the first one has 100% success rate and the second has only 75%)

These 2 factors are combined into a single ranking which is displayed by the amount of stars.  Our platform was awarded twice as the best of show on Finovate for its power and innovation and there are many thousands of happy users using it on a daily basis.  It is a powerful tool to research stock and filter out underperforming analysts when using analyst consensuses, which institutional investors use as a benchmark. bWe were also offered many times to close the platform for individuals and provide it only to professional money managers and refused to do so, arguing that our vision is to empower the main street.

I would be happy if you could publish this on the thread to clarify the questions some contributors might have.  Sincerely,  Uri.

So, I dug a little deeper and decided to upload my own portfolio based on the specific advice as offered by tipsrating.com.  The site does allow for review of each data point they analyze with the date and share price.  I use the premium service at Morningstar.com to track my personal portfolio and to evaluate portfolio construction.   

 I uploaded into the M* portfolio tracker the same buys as listed on TipRanks.com, using a cumulative $2,000 per recommendation.  If there were three recommendations offered, the portfolio would be credited with three $2,000 purchases on the day each recommendation was made. The difference between TipRanks and M* was most interesting.  Needless to say, there is some stark and distinctive variances.

Using the M* portfolio analysis tools, each position as described by TipRanks was added.  There were two companies that were bought out: Thomas and Betts was bought by ABB for a substantial gain of 200% and CHG was purchased by Fortis at a 30% profit.  Both of these were stock mergers and the site had difficulty correctly accounting for the shares.    Three positions were closed.  There were some discrepancies in prices quoted in the linked article and on the site, such as DMLP was quoted as $15.16 when the actual market price for the day was $20.50. 

First off, according to M*, the performance of the 44 Jon Parepoynt selections were “1-yr” 16.6% total returns, and a “Since Purchased Annualized” total return of 17.1%.  M* also offers a “Personal Total Return” calculation that incorporates the timing within the month of deposits/buys into the portfolio, and is a bit higher at 18.4% and 21.6% respectively.  According to M*and using the M* US Market Index as a benchmark, the index returned 16.2% and 18.9% respectively. Below is their return performance graph.

Jon Parepoynt Performance Sept 2012 to May 2014

Jon Parepoynt Performance Sept 2012 to May 2014

Combining the 44 recommendations of Jon Parepoynt and the 48 recommendations of George Fisher brought the number to 92 specific recommendations in 59 different companies.  Adding these specific recommendations together would produce the following M* performance chart:

Combined George Fisher and Jon Parepoynt Performance Feb 2010 to May 2014

Combined George Fisher and Jon Parepoynt Performance Feb 2010 to May 2014

There are two very important differences with these comparisons. The first is the concept of price-returns as offered by TipRanks.com and the total returns offered by M*.  The second is the asset allocation.  M* offers their calculation combining both capital gains and income while tipranks.com offers price-based capital gains only.  The portfolio income is $6,600 annually, for a current yield 2.8%.

The second major difference is asset allocation.  The 59 companies with 92 transactions nowhere near duplicated the sector represented in the index.  Below is a sector breakdown of the final portfolio as offered by M*. 

Sector Allocation of the 56 companies in the Combined portfolio

Sector Allocation of the 56 companies in the Combined portfolio

As shown, there are large gaps of underweighted sectors and substantial overweighting of others.  Specific stock recommendations are not necessarily made to conform to asset allocation parameters and focusing on certain sectors, such as utilities, will skew both investor expectations and performance. 

Probably the most interesting aspect with tracking of my recommendations is the omission of about 2/3 of the articles published on Seeking Alpha.  I have a combined total of almost 300 articles published since 2010 and TipRanks.com offers a link to 92 articles While not all 300 are specific stock recommendations, there are more offerings than listed on TipRanks.com

On second thought, I guess I would take my own advice – and do.  However, I will not publish a continuum of all 300+ articles, as these 92 should suffice.

Below are the positions in the combined portfolio, from M*:

Performance by position and purchase date for Combined portfolio

Performance by position and purchase date for Combined portfolio

Disclosure: I am long CBI, NFG, ITC, RICK, DMLP, RYN, UTX, BGCP, SO, ETP, SE.  All long positions are followed by MyInvestmentNavigator.com monthly newsletter.

Update June 1:  I received the following email from TipRanks:

Hi George,

My name is Gilad Gat and I’m the CTO of TipRanks.  I read with great interest your  article on MyInvestmentNavigor.com.  I wanted to make a few clarifications as to our performance measurements.

My goal is to clarify and to get your perspective so we can fine-tune and perfect our methodology.

·        To measure stock ratings we use the EOD price on the day of the recommendation. We have started an internal committee on this and are considering using the opening price of the day following the recommendation. Would be interested to get your thoughts on this.

·        For S&P-500 we use SPDR S&P 500 (ticker SPY) which also incorporates the dividends of the S&P-500 companies.

·        Stock prices used by our engine are taken from Xignite, a leading financial provider recommended by Nasdaq.

·        For sector benchmarking we use the sectors from Yahoo! Finance, we will likely switch to sectors definitions by Xignite during the month of June.

·        Performance is measured on a per-rating basis, not as a portfolio (i.e., no rebalancing and re-investment of dividends).

·        My team will evaluate the two companies that have been bought-out to verify we deal with such cases correctly.

Please feel free to contact me directly with any question, comment or concern.

3 Income Ideas from Mario Gabelli

Mario Gabelli manages several different investment platforms with a few focused on being income investments.  Over time, the main attraction of these is a steady cash flow into your account.  For some, the steady flow takes precedents over variations of market value of the underlying security.  Income funds may be suitable, for instance, to a retired individual who is looking to improve their income.

Gabelli Utility Fund (GABUX) is an income fund focused on utility stocks. The strategy is to specialize in stocks with the potential of being purchased by larger utilities as the multi-decade sector consolidation marshes along. However, these stocks must also pass Gabelli’s value criteria and should be worthy of ownership on its own merits. From their 2013 Annual Report:

“For several decades, utility companies have acquired other utilities and utility assets for the sake of gaining economies of scale and efficiency. The same forces that resulted in more than one hundred utility takeover announcements over the past two decades remain in place, and new forces have come into play that continue to drive this long term trend. Climate change and environmental policy have pressured marginal players. The pickup in merger activity reinforces the long-term bias of utilities to increase scale or gain a strategic benefit. Small companies are selling out at premium prices as the cost of staying in the game rises.

The historically lengthy merger review and approval process appears to have eased, as policy makers come to understand the new economic dynamics. Despite over ninety completed utility mergers/acquisitions since 1993, the electric and gas utility sector remains fragmented, with over sixty electric utilities and thirty gas utilities. This is fifty more than we need, from the standpoint of economic efficiency.

Our investments in regulated companies have primarily, though not exclusively, focused on fundamentally sound, reasonably priced, mid-cap and small-cap utilities that are likely acquisition targets for large utilities seeking increased bulk. We prefer utilities that operate in more constructive regulatory environments, possess lower carbon footprints, and/or have access to strategic geographies. We favor utilities with pending transmission line developments, and we focus on natural gas pipelines and storage operators as a way to take advantage of the growing demand for natural gas in the U.S.”

Annual Report: http://www.gabelli.com/Gab_pdf/annual/470.pdf

GABUX distributes $0.07 a month, or $0.84 annually on a share price of $5.60, for a distribution yield of 15%.  However, the majority of the distribution is termed Return of Capital.  As such, the ROC is deducted from share cost basis, reducing overall accounting cost of the position.  Taxes are due when the position is sold rather than upon receipt of distribution.  As the cost of shares continually declines until the cost is recorded as $0.00, any distributions after the cost is zero will be taxed as income. 

 

Gabelli Global Gold and Natural Resources Income Fund (GGN) is a closed-end fund with monthly distributions of $0.09 a share and yielding about 10.2% based on a price of $10.59.  The strategy is to buy mining and energy stocks and  to increase income from writing covered calls on these positions.  While this strategy will generate about a 10% income stream from the option contract proceeds, it also limited potential upside if the underlying stocks are called away during a market sector rally. From the 2013 fund annual report : 

“GAMCO Global Gold Natural Resources & Income Trust is a non-diversified, closed-end management investment company. The Fund's primary investment objective is to provide a level of current income. The Fund invests primarily in equity securities of gold and natural resources companies and focuses to earn income primarily through a strategy of writing (selling) primarily covered call options on equity securities in its portfolio. Because of its primary strategy, the Fund forgoes the opportunity to participate fully in the appreciation of the underlying equity security above the exercise price of the option.

 

At the end of the fourth quarter of 2013, implied volatility levels contracted to 46% for gold equities, 32% for mining companies, and 30% for energy companies. The volatility in the gold mining sector continues at an above average level due to continued uncertainty about the pace of the economic recovery and inflation expectations. The energy sector continued to perform well, especially at the exploration, production, and U.S. refiner’s levels. The metal mining sector extended its recovery at the same pace. The overall maturity of the option portfolio was approximately 2, 2, and 1.8 months for gold, mining, and energy holdings, respectively. The participation of the Fund to the upside was close to 88% for gold, 60% for mining, and 56% for energy.”

Annual Report: http://www.gabelli.com/Gab_pdf/annual/-116.pdf

Of the $1.44 distributed in 2013, 4% was from investment income, 52% from short- and long-term gains, and 44% from return of capital.  Corresponding distributions for 2012 were 2%, 84% and 15% respectively. In Jan 2014, the monthly distribution was reduced to $1.09 a yea r($0.09 a month), from $1.44 ($0.12 a month) in 2013 and $1.66 ($0.138 a month) prior. The reason for the decline is an overall deterioration in gold and silver mining stocks, and these comprise about 40% of fund assets.  However, the fund has done better than the Philadelphia Gold and Silver Index of mining stocks.   Comparing GGN to Morningstar Natural Resources Index, total return on a 1-yr basis for GGN is 11.7% vs. 5.4% for the index; -4.9% vs. -3.8% on a 3-yr basis; and 5.7% vs. 8.6% on a 5-yr basis.   The fund has about 40% in gold and silver mining stocks, 44% in oil and gas companies, and 16% in US Treasury Notes.       The current price is a 3.6% premium to the NAV of $10.22.

Investors looking for increased allocation exposure to gold and energy, along with desiring monthly income should review GGN.

An alternative to these two funds is the Preferred Stock Series B for GGN, ticker GGN.PB or GGN.PrB.  Trading at $21.75 and paying a quarterly dividend totally $1.25 a year, GGN.PrB offers a 5.7% yield and 15% discount to the par value of $25.

All three of these should be well suited for most investors seeking steady income over capital appreciation, and are very worthwhile for further due diligence.

Disclosure: I am long GABUX, GGN.  GABUX is followed by MyInvestmentNavigator.com and is currently rated Power Up

POPE's Loss is Rayonier's Gain

Pope Resources’ (POPE) loss is Rayonier’s (RYN) gain.  David Nunes is moving from the Washington-based POPE timber REIT to the Jacksonville-based RYN REIT.  RYN has announced it will split its timber assets from the performance fiber business in an attempt to unlock the valuations of its timber holdings. 

From the press release: “David Nunes brings three decades of timber and real estate industry leadership to his new role, including more than 15 years as a senior executive. He joins Rayonier Inc. from Pope Resources where he has served as president and CEO since 2002. Appointed president and CEO in 2002, Nunes launched the company’s private equity timber fund business, which now manages timberlands in three funds. Pope Resources also manages development acreage in the Seattle metropolitan area. In his tenure as CEO, Nunes has consistently delivered value to Popes unit holders.

Rayonier is a leading international forest products company with three core businesses: Forest Resources, Real Estate and Performance Fibers. The company owns, leases or manages 2.6 million acres of timber and land in the United States and New Zealand. The company's holdings include approximately 200,000 acres with residential and commercial development potential along the Interstate 95 corridor between Savannah, Ga., and Daytona Beach, Fla. Its Performance Fibers business is one of the world's leading producers of high-value specialty cellulose fibers, which are used in products such as filters, pharmaceuticals and LCD screens. Approximately 50 percent of the company's sales are outside the U.S. to customers in approximately 20 countries. Rayonier is structured as a real estate investment trust.”

Nunes has been a driving force in expanding POPE’s timber assets through the development of private equity funds.  POPE invests alongside outside investors, providing a cost effective platform for expanding its Northwest asset base.  Over the past few years, POPE has been trading timberland closer to Seattle/Tacoma for assets in Southern Washington/Northern Oregon. 

While POPE is fully valued at its current price, the breakup of RYN may provide some interesting gains.  The combination of the performance fibers with the timber business gave shareholders two distinct exposures – specialty fibers and commodity timber.  RYN has substantial land holdings along the I-95 corridor in the Southeast that has the potential of offering a steady stream of higher and better use sales revenues.   

As timber is a very cyclical commodity, buying into these timber REITs needs to be timed very carefully.  There are a few strong outside forces that will benefit the long-term pricing model of NW timber, such as the mountain pine beetle and growing exports to China.  However, housing has the biggest impact on the long-term pricing of timber.  With housing on the rebound, timber REITs are no longer the bargains they were a few years ago and investors should tread lightly.   The exception could be RYN, especially with the appointment of David Nunes.

Disclosure: I am long POPE, RYN.  POPE and RYN are followed by MyInvestmentNavigator.com monthly newsletter and is currently rated as Neutral

Economist Gary Becker - RIP


The following is a repost of an article offered by First Trust Advisors FTA on the passing of Mr. Gary Becker.  I have been a reader of FTA's articles and market commentary as they have been very straightforward, insightful, and informative.  I fully agree with the statement in the last paragraph:  "The world would be a better place if lawmakers of both political parties were more familiar with his work."  Enjoy.

"The economic world lost a leading thinker this weekend with the passing away of Gary Becker, who, since the death of Milton Friedman in 2006, was the most influential, and important, living economist.

Becker, who won the Nobel Prize in 1992, led an invasion of classical economic thought into previously sloppy and hidebound areas of study such as sociology, demography, and crime. He studied human capital. Think of it this way: Without Becker, bestselling books like Freakonomics wouldn’t even be possible.

Prior to Becker, the academic study of these topics was dominated by social determinists in general and Marxists in particular. So, for example, conventional wisdom held that people commit crime because of discrimination, overly strict fathers, capitalist oppression, or the exploitation of the working class.

Becker shoved all these simplistic (and unscientific) answers aside, applying the free-market principle that people have an incentive to pursue their self-interest not only as producers and earners but also outside the workplace.

To Becker, people commit crimes more often when they perceive that the benefits outweigh the costs. So, better policing to apprehend criminals and harsher sentences would result in less crime because they raise the potential costs of crime. To Becker, becoming a predator was a choice, like becoming an engineer, or a bus driver, or a politician (known as predators in some circles).

Becker was instrumental in developing the economic analysis of the family, fertility and marriage. He also focused on drug addiction and education. Decades ago, he analyzed education as an investment choice, with time as a key cost of investment. Becker is largely responsible for this now being the mainstream view.

One of his early path-breaking findings was that employment discrimination can hurt not only workers who are discriminated against but also the firms that discriminate, particularly in more competitive business sectors. And so, firms in competitive sectors have an incentive to hire the best workers regardless of race, ethnicity, religion, or sex.

It’s also fair to say that he didn’t think highly of the direction of economic policy in the US over the last several years. Becker noticed that the largeness of some corporations could undermine effective decision-making, but thought the problem much worse with the federal government because it was involved in so many endeavors and faced no competition at all.

Becker opposed further increases in the minimum wage, opposed Dodd-Frank, supported lower taxes on Corporate America, and argued that a larger more-intrusive government cuts economic growth.

In recent years some economists have argued that we are in an era of “secular stagnation,” where we simply have to accept slow economic growth. Becker said the theory was just another version of a similar theory that had popped up in the past, and would likely be proven untrue with time. Innovations in energy and health care could push the economy back toward a faster growth path and government policy should focus more on economic growth and less on redistribution.

The world would be a better place if lawmakers of both political parties were more familiar with his work. We’re not holding our breath waiting for that to happen. But long term shifts in public thinking sometimes start in the academic world, which Gary Becker changed for the better by challenging and enlightening, making many see the world with clearer vision than they had before".

What to do With Foreign Dividends?

Besides fixed income, one asset allocation that is often overlooked is foreign dividend paying stocks.  While some may think there is not much difference between foreign dividend payers and their US counterparts, the reality is there are several important aspects to consider.

The first is the impact of foreign exchange fluctuations between the payer’s currency and the US dollar.  Even with ADRs, (American Deposit Receipts) that trade on US exchanges, dividends are paid in the currency of the country the company is domiciled in.  For example, HSBC Holdings (HSBC), the parent company of giant international HSBC Bank and formerly known as Hong Kong Shanghai Bank is headquartered in London after moving from Hong Kong in 1999.  While the stock has dual listings on both the Hong Kong and London exchanges, the company reports its results and pays its dividends in Great Britain Pounds (GBP). 

One HSBC ADR traded on the NYSE represent five London traded shares and ADR investors in America acquire five times the dividend per London shares because of this ratio.  Therefore, if the London shares announced a USD $0.10 per share dividend, ADR investors would receive $0.50 per ADR.  However, dividends are declared and paid in GBP, not USD.   For example, over the past nine years, the list below are the annual dividend paid by HSBC.

Year;  Pound dividend declared;  USD : Pound exchange rate;  USD dividend paid per London Share;  Total dividend paid per ADR

2013 - 0.3016 - 1 : 1.62 - $0.49 x 5 = $2.45

2012 - 0.2816 - 1 : 1.74 - $0.49 x 5 = $2.45

2011 - 0.2597 - 1 : 1.57 - $0.41 x 5 = $2.05

2010 - 0.2273 - 1 : 1.58 - $0.36 x 5 = $1.80

2009 - 0.2179 - 1 : 1.59 - $0.34 x 5 = $1.70

2008 - 0.3826 - 1 : 1.67 - $0.64 x 5 = $3.20

2007 - 0.4593 - 1 : 1.99 - $0.90 x 5 = $4.50

2006 - 0.4193 - 1 : 1.93 - $0.81 x 5 = $4.05

2005 - 0.4033 - 1 : 1.81 - $0.73 x 5 = $3.65

The impact of the exchange rate fluctuations becomes quite clear using the above long-term table.  As the USD strengthens and the GBP declines, the USD dividend paid goes down, and the opposite is true.  For example, the highest exchange rate is in 2007 at 1:1.99 and the lowest is in 2011 at 1:1.57.  This represents a 21% differential.  All else being equal, the same declared dividend by HSBC in GBP could fluctuate by as much as 21% for US investors, based on exchange rates.

American investors buying foreign stocks will receive a higher relative USD dividend when the USD is weaker than when it is stronger – regardless of the amount declared and paid in the foreign currency.  If you believe the USD is in a cyclical or structural decline versus other currencies, then investing in foreign dividend paying stocks could provide a improved return than dividend growth alone.

Below is one of several online currency exchange rate graphing sites.  This one is easy to use and allows for 5-year graphs.  It is important for investors to appreciate the impact of currency exchange fluctuations on the income received.

http://www.oanda.com/currency/historical-rates/

Another aspect is the taxation of foreign dividends and the impact on total stock returns. The discussion below should not be construed as tax advice and a qualified tax advisor should answer all questions.   In the US, most dividends are separated into “qualified” and “non-qualified”, with different income taxes for each category.  Unless specified, for US residents, the IRS does not withhold taxes from each dividend payment and all taxes are due annually.   However, this is not the case with foreign governments.

Each country either has or has not a tax treaty with the US. Usually, if the country has a tax treaty with the US, the issue of withholding taxes is addressed and amounts of withholding are set via the treaty.   Some countries exempt all dividends from withholdings while others limit the exemption to IRA-type account only.  Others have no exemption regardless of where the investment is held. 

For most investors with less than $300 deducted in tax withholding from dividends from investments held in non-tax advantaged accounts, it is pretty simple to reclaim this withholding.  There is a line on your personal Form 1040 for foreign dividend taxes paid, and it is a credit again total tax due.   

However, the amount withheld may not be a one-for-one offset.  From the IRS Publication 514: “The amount of foreign tax that qualifies as a credit is not necessarily the amount of tax withheld by the foreign country. If you are entitled to a reduced rate of foreign tax based on an income tax treaty between the U.S. and a foreign country, only that reduced tax qualifies for the credit.”

 For example, Switzerland has a 35% withholding rate, even though the US Tax Treaty stipulates a 15% tax due. Since the Swiss government does not which country the investor is located, they withhold the same 35% for every investor.  In this case, taxpayers can deduct only 20% of the 35% withheld by the Swiss government.  

Investors should not shy away from investing in foreign dividend paying stock just because of these tax issues.  The final impact should be figured into the anticipated return to determine the desirability of the specific investment.

For instance, Pargesa (PGRAF) is a Swiss-based investment holding company that owns 50% of Groupe Bruxelles Lambert (GBLBF).  GBLBF is headquartered in Brussels.  PGRAF is subject to 35% Swiss withholding while GBLBF is subject to 25% Belgium withholding – even though the dividend is originally paid by GBLBF.  The investment thesis for holding the higher-taxed PGRAF is the possibility that the Frere Family may purchase all shares sometime in the future, which could be at a premium to the added taxes paid over time.

Canadian companies usually do not withhold tax for investments held in IRA-type accounts, but will for accounts with no tax advantages.

It is important for investors to determine their exposure to foreign withholding dividend tax, and the ability to recoup the tax, prior to investing in the shares. 

More information can be found at the IRS website here:

http://www.irs.gov/pub/irs-pdf/p514.pdf

http://www.irs.gov/Individuals/International-Taxpayers/Foreign-Tax-Credit-Compliance-Tips

Below is a list of tax withholdings by country:

No withholding tax will be credited from the following countries:

Cuba, Iran, Libya, North Korea, Sudan, Syria

 

The table below lists the countries that have no withholding taxes on dividends paid to U.S. residents:

http://www.djindexes.com/mdsidx/downloads/withholding_tax.pdf

Countries with No Tax Withholding Rate for Dividends:

Argentina 0.00%, Bahrain 0.00%, China - Red Chips 0.00%, Colombia 0.00%, Croatia 0.00%, Cyprus 0.00%, Egypt 0.00%, Estonia 0.00%, Hong Kong - Local Shares  0.00%, India 0.00%, Jordan 0.00%, Mauritius 0.00%, Oman 0.00%, Qatar 0.00%, Singapore 0.00%, Slovakia 0.00%, South Africa 0.00%, Tunisia 0.00%, United Kingdom 0.00%, UAE 0.00%, Vietnam 0.00%

The following table below shows the withholding tax rates by country on dividends paid to U.S. residents:

Country Withholding Tax Rate for Dividends

Australia 30.0%, Austria 25.0%, Bangladesh 15.0%, Belgium 25.0%, Bosnia 5.0%, Brazil 15.0%, Bulgaria 15.0%, Canada 15.0%, Chile 35.0%, China - A Shares* 10.0%, China - B Shares**, 10.0%, China - C Shares*** 10.0%, Czech Republic 15.0%, Denmark 28.0%, Finland 28.0%, France 25.0%, Germany 26.4%, Greece 10.0%, Hungary 10.0%, Iceland 15.0%, Indonesia 20.0%, Ireland 20.0%, Israel 20.0%, Italy 27.0%, Japan 10.0%, Kazakhstan 15.0%, Kenya 10.0%, Kuwait 15.0%, Latvia 10.0%, Lebanon 10.0%, Lithuania 15.0%, Luxembourg 15.0%, Macedonia 10.0%, Malaysia 25.0%, Malta 35.0%, Mexico 10.0%, Morocco 10.0%, The Netherlands 15.0%, New Zealand 30.0%, Nigeria 10.0%, Norway 25.0%, Pakistan 10.0%, Peru 4.1%, Philippines 30.0%, Poland 19.0%, Portugal 20.0%, Romania 16.0%, Russia 15.0%, Saudi Arabia 5.0%, Serbia 20.0%, Slovenia 20.0%, South Korea 27.5%, Spain 19.0%, Sri Lanka 10.0%, Sweden 30.0%, Switzerland 35.0%, Taiwan 20.0%, Thailand 10.0%, Turkey 15.0%, UK - REITS only 20.0%, Ukraine 15.0%

Disclosure:  I am long HSBC, PRGAF, GBLBF.  HSBC is followed by MyInvestmentNavigator.com monthly newsletter and is currently rated Full Speed Ahead

Are Non-Traded REITs Right for You?

 

What are “Non-Traded REITS”?  These are real estate investment trusts very similar to their publicly traded counterparts.  Non-traded REITs are not available to all investors and are usually sold by financial advisors and broker-dealers. Non-traded REITs have some basic differences from listed REITs in their commissions and sales fees ranging from about 7% to 15% and in their average yield of 6.7% vs a listed average of 3.3%. 

From a 2012 Forbes article, “Non-Listed REITS continue to be an excellent source of hard-asset investing for suitable investors,” says Investment Program Association (IPA) CEO and President Kevin Hogan. “Meant to be held for the long term, these products provide significant benefits, including true portfolio diversification, to the retail investor who typically would not have access to such options.” Hogan adds, “the structure and lifecycle of these products allow you and I the unique opportunity to invest in office buildings, medical facilities or retail malls, managed by world class real estate firms. This design is a significant value proposition of these products. There is no better time for investors to consider adding these products to their portfolios than now.”

Collectively, non-traded REITs represent about $100 billion in investor assets vs. its traded brethren with about $500 billion in investor assets. 

There are 63 non-traded and private REITs listed on NARIET website as Association members (with links to each home page) and the list is found here:  http://www.reit.com/investing/investing-tools/reit-directory/public-non-listed-private-real-estate-companies

FINRA offers an article on the pitfalls of non-traded REITS and it can be found here: http://www.finra.org/investors/protectyourself/investoralerts/reits/p124232

Below is a list of the difference between non-traded REITs (NTR) and exchange traded REITs (ETR) from this article:

Listing Status

NTR - Shares do not list on a national securities exchange.

ETR - Shares trade on a national securities exchange.

Secondary Market

NTR - Very limited. While a portion of total shares outstanding may be redeemable each year, subject to limitations, redemption offers may be priced below the purchase price or current price.

ETR - Exchange traded. Generally easy for investors to buy and sell.

Front-End Fees

NTR - Front-end fees that can be as much as 15% of the per share price. Those fees include selling compensation and expenses, which cannot exceed 10%, and additional offering and organizational costs.

ETR - Front-end underwriting fees in the form of a discount may be 7% or more of the offering proceeds. Investors who buy shares in the open market pay a brokerage commission.

Anticipated Source of Return

NTR - Investors typically seek income from distributions over a period of years. Upon liquidation, return of capital may be more or less than the original investment depending on the value of assets.

ETR - Investors typically seek capital appreciation based on prices at which REITs’ shares trade on an exchange. REITs also may pay distributions to shareholders.

Also from the FINRA article, “Private REITs - There is another type of REIT—a private REIT, or private-placement REIT—that also does not trade on an exchange. Private REITS carry significant risk to investors. Not only are they unlisted, making them hard to value and trade, but they also generally are exempt from Securities Act registration. As such, private REITs are not subject to the same disclosure requirements as public non-traded REITs. The lack of disclosure documents makes it extremely difficult for investors to make an informed decision about the investment. Private REITS generally can be sold only to accredited investors, for instance those with a net worth in excess of $1 million. As with any private investment, it is a good idea to have the investment reviewed by an investment professional who understands the product and can offer impartial advice.”

For most investors, sticking with the diversity of publically traded REITs would be recommended.  Non-traded and private REITs are fraught with investment pitfalls that can be avoided by utilizing their more transparent brethren.

Disclosure: No positions

Canadian Power Companies Will Add Power to Your Financial Portfolio

Power Financial (PWF.TO) and Power Corporation (POW.TO) are powerhouse Canadian financial companies connected at the hip.  Founded by the Demarais family, these two companies are usually overlooked by US investors.  However, they offer stable exposure to Canadian financial consumers and to European equity markets.  Investors seeking greater exposure to Canadian financial markets should review both companies.

Power companies reach 12 million Canadians and serve about 1 in every 3 Canadian citizens.   The Power companies  proved their investment value during the financial crisis of 2007 to 2009 by actually earning their dividends.  However, like much of the rest of the financial sector, Power company stocks slid by about 50% before rebounding in 2010.

Power Corp is a holding company whose largest investment is a 68% ownership of Power Financial.  As the organizational chart describes, POW also owns a communications and media firm along with various investments.   The investments include private equity positions in companies in Europe, the US, China and the Pacific Rim. 

Power Financial Corp is a financial services company involved in insurance, money wealth management, and European equity investments.  PWF offers some well-known financial services brands, such as Canada Life, Great-West Life and Putnam Investments.   ICM Financial offers wealth management services along with commercial employee benefit packages.  PWF, through its interest in Pargessa (PRGAF), owns about 13.9% of Groupe Bruxelles Lambert (GBLBF), itself a holding company with concentrated equity investments in major European companies.    For example, GBL owns a 3.6% interest in the French oil-giant Total (TOT) and represents about 20% of GBL’s book value. 

I strongly suggest reviewing the Organizational Chart on their website here:  https://www.powercorporation.com/en/about/organization-chart/

Both pay a dividend which was pretty stable during the recent financial crisis.  However, both POW and PWF have not raised their dividend since 2009.  POW pays a dividend of CAD$1.16 while PWF pays CAD$1.40 per share.  At a current price of $31 for POW and $35 for PWF, the current yield would be 3.8% and 4.0%, respectively. 

Comparing the value fundamentals, both POW and PWF are about equal with PE’s of 14.7 and 13.5, and both carry the same consensus buy recommendations at a lukewarm 2.4.

The biggest fundamental difference is price to book value valuation where POW is trading at 1.2x book value while PWF is trading at a premium of 1.8x book value.   One reason for this discrepancy is the better 10-yr average return on invested capital ROIC of PWF at 8.7% vs a 10-yr average ROIC for POW at 5.9%.

If consensus price targets of $35 for POW and $39 for PWF are reached over the next two years, POW would generate a 13.2% total annual return while PWF would generate a 9.7% total annual return. 

Power Corp has a higher Navigator Rating by virtue of its lower current valuation and is in a buy range while Power Financial is a neutral Rating, mainly due to its premium to book value.

POW’s other assets above its ownership of PWF provide some interesting diversification.  However, the bulk of POW’s  cash earnings, and hence dividends, comes from PWF.  For the year 2013, total-operating earnings for POW was $1.035 billion, with PWF accounting for $1.124 billion and the balance generating a loss of $89 million.   

Power Corp owns the controlling interest in PWF.  In addition, POW’s exposure to the other assets offering a potential turnaround makes POW the preference between the two.   With the dividend payout ratio fluctuating between 52% and 64%, earnings growth from here should create the opportunity for increasing the dividend to match earnings growth.    

We are adding Power Corp POW.TO to our list of followed companies. 

More information on POW can be found on its website: https://www.powercorporation.com/en/

We have no positions in POW.TO.  It is followed by MyInvestmentNavigator.com monthly newsletter and is currently rated as Power Up