August 18, 2012 Leverage

Risk/Reward Vol. 132

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

"All quiet on the Western Front, nobody saw/A youth asleep in the foreign soil, planted by the war
Feel the pulse of human blood pouring forth/See the stems of Europe bend under force."---lyrics from "All Quiet on the Western Front" sung by Elton John

"My interest level is dropping/My interest level is dropping
I've heard all I want to/I don't want to hear anymore."---lyrics from "No Compassion" by the Talking Heads

"Betty's been down in the iron mine/Bringing home energy
Yeah, I'm goin' steady with Iron Ore Betty/And she's goin' steady with me."---lyrics from "Iron Ore Betty" by John Prine

With all of the Eurozone and most of Wall Street on holiday for the month of August (note how low the volume has been recently), "all is quiet on the Western Front". The Dow Jones Industrial Average stayed within a confined range all week and ended up 68 points. As a holder of high yielding securities, I very much like the tranquility. Indeed, I would have the stock market stay frozen where it is, indefinitely, while I collect my 7+% in dividends and interest. But, no one will be "asleep in the foreign soil" come September. Necessarily, the "stems of Europe will bend under the force" of sovereign debt. How they bend will dictate my future course of action.

Although the downward progression of the yield on 10 year Treasury notes has halted, it still rests at near historic lows---below 2%. The result is that every yield priced off that benchmark, most notably corporate bonds, is likewise at or near historic lows. As of Friday, the average yield on a 10 year, A-rated corporate bond was 2.73%---not nearly enough to support this old boy should he choose to retire. I need 6-7% to support my profligate ways. "I've heard all I want to" about the "interest level dropping". "I don't want to hear anymore". But what can one do?

As I have written previously, one must seek investments that take advantage of low interest rates---those that use leverage.

My favorite leverage plays are closed end funds. As I have explained in earlier editions, closed end funds invest in the securities of other companies much like their better known and better understood cousins mutual funds and exchange traded funds. Like these other two, closed end funds invest in securities in a manner consistent with their published guidelines (e.g. some invest in oil companies, others in preferred stocks, still others in corporate bonds, etc. ). What distinguishes closed end funds is that they do not redeem shares. One's ability to buy into or sell out of a closed end fund is wholly dependent on other shareholders' willingness to buy or sell shares. Thus, a key factor for me in choosing a closed end fund is the volume of trades per day or liquidity. Thankfully, most are sufficiently liquid that I can enter or exit on a heartbeat--just like any other stock. Another very important distinction between closed end funds and their cousins is that closed end funds can incur debt: that is, borrow money to buy stocks. Thus in times of low interest rates (like now), closed end funds can use leverage (here, the difference between the cost of borrowing and the return on the stock purchased) to enhance shareholder returns. I have used them to good advantage in achieving diversity and steady returns in preferred stocks (JPC), senior debt (JFR), real estate (RQI), commodity futures (CFD) and corporate debt (BPP). If you are interested, learn more at www.cefconnect.com .

Another way to achieve a decent return is to buy stocks that are currently out of favor. And nothing is more out of favor than "iron mining". As reported a few weeks ago, I bought Cliffs Natural Resources (CLF) after its disappointing quarterly report. It has rebounded somewhat, but more importantly it is paying me a "goin' steady" 6+% dividend while I wait for "Iron Ore Betty" (read; steel production) to rebound. In the same vein (no pun intended), this week I bought BHP Billiton (BHP), the world's largest iron miner, due to its excellent cash flow and its announced dedication to maintaining (and someday growing) its dividend (currently paying at 3.2%). Also out of favor are commercial mortgages. Commercial mortgages under various names ( cmbs, cre, cdo, etc.) were demonized in the wake of the 2008 real estate downturn when their holders (primarily banks) were required to "mark them to market" (write them down). Billions of dollars of these are coming due this year, and banks are looking to other institutions such as mortgage reits to take them out via refinancing. If properly underwritten, these securities can provide an excellent return. I like the preferred stock of Winthrop Realty Trust (WTR) and NorthStar Realty (NRFpA and NRFpB) in this space.

I close with a bit of trivia. Between 1979 and 1989, Jerry Harrison of the Talking Heads was our neighbor in Shorewood, WI. I only hope that the lyrics from their hit "Once in a Lifetime" do not prove prophetic in regard my current investing gambit.

"Into the blue again, after the money is gone.
Same as it ever was, same as it ever was".