Today income investors are battling a low interest rate environment, which is being reinforced by the Fed’s $85 Billion a month treasury bond purchasing spree.1 The time is near for the Fed to consider easing its monetary policy, and that could have a dramatic negative impact on current bond valuations. With interest rates at all-time lows, current bond holders could lose money until their bonds mature. This is because as interest rates rise, existing bond values may go down as new bond issues tout better rates. If current bond holders do not sell, they could wind up losing a considerable amount of their portfolio to bond declines and inflation. They will receive ‘Par’ at maturity, of course, but what $1,000 will be worth in the future is impossible to tell.
It may be a very hard pill for bond buyers to swallow, but the 30 year bond bull market appears to be over and it may be time for investors to find new ways to produce income. One option is liquidating bond portfolios while values are up and attempting to boost income by utilizing BDC’s, REIT’s, Royalties, Direct Energy Investments and Annuities.
Business Development Companies (BDCs)
One category of investment alternatives to consider is Business Development Companies (BDCs). In a nut shell, BDCs loan money to small and midsize businesses at high interest rates (9%-12%) and secure the loan with hard collateral assets. Investors can buy into a BDC loan portfolio and participate by receiving monthly income loan repayments. With distributions of about 8% annualized to investors2, BDCs are currently receiving considerable investment inflows. Many BDC loans are "senior secured" debt, meaning that in the event of bankruptcy, they must be paid before junk bonds. Also, many BDC loans carry floating interest rates that help to mitigate the risk of price declines if rates broadly rise. In addition, BDCs typically have relatively little competition as their customers are generally too small to tap the bond market, and commercial banks are finding such lending less attractive in the wake of new capital requirements.
Real Estate Investment Trusts (REIT’s)
REIT’s invest in different types of real estate such as hospitals, commercial and residential property, computer data centers, and storage facilities to name a few. REIT’s receive income from rent payments. from which the profits are distributed to shareholders. The problem with some REIT’s in the past has been their exit strategy, so it is important to learn how to liquidate the investment.
Another way to invest in income producing assets is through the purchase of royalty licenses. This is one asset that sees little market liquidity as owners typically hold on to them long-term, but we were able to find one way to participate in the space. In the oil and gas energy arena, investors can purchase mineral land royalty rights of currently producing energy fields. Royalty owners receive a gross 20% licensing fee for any oil produced on their land and have none of the risk associated with the costs of drilling (note that the investment itself does still present risk of loss of some or all of the principal invested).
Institutional investors like Harvard, Yale, and Stanford have been participating in this market for decades. One of the largest royalty acquirers in the U.S. has an audited track record of 8.7% annual IRR to their investors over the last ten years and holds $1.3B in mineral rights.3 Investors can purchase a small percentage of over 1,000 wells in the hopes of receiving royalty payments. The royalties will fluctuate with the current price of energy, but can last several 35 years or longer.
Direct Energy Investments
The demand for oil has continued to increase. In fact, the world currently consumes about 85m barrels of oil per day4, which means that drilling is happening almost everywhere on a massive scale. Oil is used in many household products such as tires, computers, paint, and about one million other products, even the environmentally conscious Toyota Prius owner cannot escape the fact that the car itself is made of 27 barrels of oil. One way to play this investment in your own back yard is by looking at the Bakken Shale oil region of North Dakota which is now home to the 2nd largest oil supply in all of North America.5 New technology that allows for sideways drilling has created a huge burst of drilling in the region with some investors receiving 10% -40% income annually6. Another great perk is that investors participating as a general partner can also write down their income taxes by the amount invested (AMT may apply).7
Annuities have always been a staple for the income investor but have recently undergone some transformations. Annuity investments produce guaranteed income for life8 which is quite helpful for those who plan on living into their 80’s and 90’s. Newer Equity Indexed Annuities (EIA’s) allow investors to participate in some of the stock market upsides while offering downside protection. The real strength of the asset is with the living benefit rider that guarantees9 a larger income check each year one delays income, much like social security. Some newer EIA’s also provide a long-term care benefit feature and a death benefit feature. Variable annuities offer income and death benefit guarantees10 and have more room for upside growth, but have higher fees to consider. Fixed rate annuities are currently outperforming CD rates at around 3.5% for a five year annuity.11 With several income alternatives in place, bondholders and income seekers should consider the new paradigm of retirement income planning.