Breaking Down our Favorite Model Portfolio

By Tim McPartland

Since we began writing on our original “Yield Hunter” website in 2006, we have searched for the Holy Grail for conservative income investors.

The Holy Grail to us was the portfolio that we did not feel we had to watch over constantly, that we did not have to trade, that maintained a fairly low volatility and yet provided a high return compared to treasury notes and bonds. Of course, finding the perfect portfolio is like searching for a needle in a haystack.

As we search for the perfect portfolio, we are mindful that each and every investor has different needs. All investors have different tolerances for risk and, of course, the resources available to individual investors differ quite dramatically

Because of this, the choices we made as we have built our models over the years reflect our own risk tolerances, as well as our own goals for annual returns. These models are not meant to be for all investors, but instead we always hope that readers will review our information and find bits of information or ideas which are helpful to their particular situation.

It has been a long time since we have taken a real close look at our Medium Duration Income Portfolio with Zip (terrible name, we know). The model initially was put together on August 13, 2015. The parameters that we set for the portfolio were as follows.

• A starting balance of $80,000
• Composed of only baby bonds and term preferred stocks
• Maturity dates of 10 years or less
• Include up to two real estate investment trusts (REITs) or master limited partnerships (MLPs) in the portfolio to provide for potential capital gains (the potential zip)
• Minimizing of unnecessary trading

With the above in mind, the number of income securities available to be held in this portfolio is small. You can check here for the 11 term preferreds and around 54 baby bonds that fit these parameters. With just 65 securities meeting our parameters, it is kind of tough to stay invested with issues to achieve our goal for this model of an 8% annual return.

Now, we are just about three weeks away from the second anniversary of the construction of this model. While we could have done a bit better, we feel we have achieved our goal of a low-volatility portfolio. It took a little babysitting to provide returns that have been clearly superior to treasury notes and bonds and low return income investments like certificates of deposit (CDs). As of the close of the market on Monday, July 24, the model has a gain of 16.78%, or 8.39% annually, for its nearly-two-year existence.

Let’s take a closer look at the composition of the model at the current time.

The model now has three “term preferreds,” which are preferred stocks that have mandatory redemption dates. They all happen to be issues from two different Gladstone companies.

One is a REIT, while the other is a business development company (BDC). The various Gladstone companies have chosen to issue term preferreds to finance much of their business, so there generally are issues available for purchase.

Do we like Gladstone Investment (NASDAQ: GAIN) and Gladstone Land (NASDAQ: LAND)? No, we would not be a buyer of the common shares, but it is a mistake to decide not to buy preferreds of companies that are not the strongest of the strong. Investors too often determine that if they wouldn’t buy the common shares, they also would not buy the senior securities either. Most of the time, this is a mistake and investors should review company financials to ensure their preferred dividend is safe and that the general business climate is favorable. The coupons on the three issues we own are 6.25%, 6.375% and 6.75%, which obviously are well below our 8% model goal. However, it is what currently is available and why this model has room for a couple REITs or MLPs, which are needed to help us attain our goal.

In addition to the term preferred issues, we hold nine baby bond issues. Of these, four issues are from business development companies, one from a REIT, three from financial firms and one from a travel center owner. The coupons range from a low of 6.375% up to 8%. These are not investment-grade companies, but we don’t need to hold investment-grade companies to have a relatively safe model.

We seldom hold investment-grade securities because we simply can’t attain a rate of return that is acceptable. We generally feel plenty safe with junk-rated issues (or unrated ones), as long as the general economic picture is trending or strengthening. But I would be a bit fussier on issues held if the United States fell to negative gross domestic product (GDP) growth.

To date, these issues have performed almost exactly as expected with the exception of the TravelCenter notes, which have traded lower because of weak financial reports thus far this year. We don’t feel that these notes are at risk, but we may pay a bit of a price for holding the issue if they don’t improve their quarterly numbers soon.

Lastly, this model holds two REITs at this time. Independence Realty Trust (NYSE: IRT) is an apartment REIT that has traded in a nice $6.50 to $10.50 range in the last two years to let us buy the issue twice at periods of low prices, while selling it once for a very nice capital gain. This is the zip we need to get a return above 8%, while at the same time holding what we believe is a fairly low-risk issue.

Additionally, since IRT pays a nice dividend of 7.07%, we receive a safe income stream even if the shares trend or fall a bit. We also hold New Residential Investment Corp. (NYSE: NRZ), a mortgage REIT, with a current yield of 12.03%. While we generally don’t care for mortgage REITs (mREITs), since they sometimes are complicated companies, most now are paying outsized dividends and we need the boost to our income stream to make our 8% target. Plus, we believe that NRZ is somewhat undervalued and provides a great opportunity to secure capital gains. Previously, the model held shares of industrial REIT STAG Industrial (NYSE: STAG), which was sold for a large gain (the added zip for the portfolio).

On the bottom of the portfolio page, we list the sales and purchases made in the model. It should be noted that with the exception of the sales made of “zip” securities, all sales were forced by the redemption or maturity of each of the issues. Like all portfolios holding baby bonds and preferred stocks, we have had to battle to stay fully invested and we have learned over time that holding too much cash for too long will mean that reasonable goals can’t be reached.

We should note that Independence Realty Trust has a fairly large capital gain at this time and may be sold in the next few days. Our purchase price was $8.64 a share and shares are currently trading at $10.21, so it may be time to capture the “zip” in this issue.

We will be continuing on our quest to perfect our portfolios, although the performance thus far has been as good as we had hoped and improving with the parameters set forth for this model will be difficult.

Disclosure: I have one personal portfolio constructed in a manner similar to, but not exactly the same as, this model portfolio.