Preferred Stock and Baby Bond Portfolio Investing Lessons
By: Tim McPartland,
Using Rules and Lessons for Investing in preferred stocks and baby bonds
A couple of months ago, we wrote about the model portfolios that we maintain, primarily as learning tools for ourselves and others. We have found that even though we have been investing almost exclusively in preferred stocks and baby bonds for 13 years now, there are always “lessons” to be learned.
I have written about these portfolios in the past, but I want to explain the “rules” on these portfolios. Since we like to minimize interest rate risk, the holdings mostly have shorter-dated maturities.
We also do not trade issues just to try to capture a dividend or to purchase a slightly superior issue. By and large, we hope for somewhat minimal portfolio maintenance. These portfolios were started 4-5 years ago, so our intent is to show gains over longer periods of time. Our goal is always 7% annually, but we are satisfied with a bit less.
Using Rules and Lessons for Investing in our First Portfolio
One of the portfolios we maintain is the 2014-2019 Short/Medium Duration Income Portfolio, which has been our star performer model portfolio. The portfolio shows a gain of 33.31% to date over the course of slightly more than 4½ years. With a modest goal of 7% returns annually, the portfolio is right on target. In fact, the portfolio has just 11 issues with a value of $113,314. None of the holdings have a maturity date later than 2027.
The intent of this portfolio is that we do not “trade” the holdings. Our strategy is pretty much “Buy and Hold.” Given the strength of the fixed income markets, we have seen share price appreciation in some holdings that we would normally sell to capture the gains. Unfortunately, there are few replacement securities available for purchase that provide the coupon and relative safety we desire.
This portfolio is now carrying a cash balance of about 16%, which we are comfortable with at this time. However, to maximize portfolio gains, the cash balance should be invested, and we may add an issue to at least use a portion of this cash. As we look at the individual issues in the model, note that seven of 11 holdings are securities issued by Business Development Companies (BDCs). The BDCs typically lend to lower-quality companies that banks won’t or can’t finance.
Those kinds of less creditworthy borrowers carry quite a bit of risk if we move into a softening economy. While we have not reached the point of a dramatic softening in the economy, it is reasonable to assume that this portfolio would not perform well if we move into a recession in the future. It would be likely that business development companies would incur substantial losses in a recession and that holding their senior securities would become hazardous to one’s wealth.
Using Rules and Lessons for Investing in our Second Portfolio
The second portfolio we maintain is the 2015-2019 Medium Duration Income with Zip Portfolio. The difference between this and the first model is simply that this one uses modest investments in real estate investment trusts (REITs) to try to “goose” the returns.
This has worked well. We have one REIT issue in the portfolio right now that we will be selling as it has over a 20% capital gain.
Unfortunately, this portfolio has taught us a lesson on diversification. While we know that one should be well diversified, this portfolio and the first one are too concentrated. Poorly performing issues can severely impact the results. Because of concentration, this portfolio has seen diminished returns.
The portfolio has garnered returns of 25.63% in just under four years. While this is not in and of itself a poor return, it is a far cry from where the portfolio would be if not for some poor investment choices. The portfolio held the Atlas Financial 6.625% baby bonds (NASDAQ:AFHBL), which we sold for $15.80, incurring a substantial loss on 400 shares of the bonds. Additionally, the portfolio currently holds the Medley LLC 6.875% baby bonds (NASDAQ:MDLX), which have performed poorly and will be sold.
Our portfolios have provided a couple of “lessons” recently. First, even on a modestly sized portfolio, there must be diversification — holding only 10-12 issues in a $100,000 portfolio is asking for trouble if one or two issues perform poorly.
Second, diversification means not just by total issues held, but also by industry. Both model portfolios above are highly concentrated in business development company issues. While we have been fortunate thus far in holding this industry concentration, we need to move to correct that situation for the future.
In summary, we will be working to correct diversification issues over the course of the next month with the aim of strengthening portfolio performance in the future.