3 Little-Known Income Strategies to Triple Your Return

The High Income Factor

3 Little-Known Income Strategies to Triple Your Return

by Tom Hutchinson

A Moneynews.com Special Report

2 TheHighIncomeFactor.com Special Report

The world is changing fast. For example, take the way I communicate. Just

a few years ago, I would talk on the phone, send faxes, and write letters. Now I e-mail, text, and use Skype for phone calls. I can’t remember the last time I used my fax machine or even mailed a check to pay my electric bill. (I use all online banking.). Heck, I don’t even use my home phone.

The benefit to all these changes is that I have more selection, I save more time, and I can get everything done at a lower cost. The downside is that it takes a little bit of time for me to get equipped to handle all these changes.

My new phone, for example, is extremely complicated for me. However, my 15-year-old son was more than happy to show me how to use it. Once I mastered all its tools, I couldn’t believe how easy it was to access . . . well, everything.

My phone is a camera, a calendar, an Internet portal, an alarm clock, a stopwatch, an organizer, and a calculator. It even tells me the weather. I play games, check my stocks, listen to music, text, e-mail, and “instant message,” along with a gazillion other things.

Investing also goes through changes. The new strategies and increased selection offered to investors today, in general, are a good thing.

However, this market environment with ever-increasing moving and complex parts requires more sophisticated investments and strategies to keep up.

What may appear at the surface to be a confusing hassle are really opportunities that modern-day markets offer income investors to generate a healthy stream of cash in any interest rate environment.

There are never-before-seen opportunities in fixed income because of the volatile markets, ever-evolving financial instruments, and the proliferation of investment opportunities in virtually every corner of the globe. Like figuring out how to use my mobile phone, investors who master these tools have access to a lot of unique opportunities.

In any other period in history, these would be tough times for income investors. Fortunately, there are strategies

and investments that can enable you to get a solid income in even the most challenging environment. With all the changes the world goes through, markets will have periods of extremely challenging times. The next few years may prove to be such a time.

Why Today’s Investment Environment Is an Uphill BattleLow Interest Rates

Interest rates are near historic lows, thanks to the zero interest rate policy set by the Federal Reserve System. These low rates mean that safe investments, such as money markets, U.S. Treasurys, and bonds, offer insultingly low returns. Here’s a look at the current rates offered on several conventional income investments.• 10-year Treasury — 1.91 percent• Three-year CD — 1.22 percent• S&P 500 average dividend yield — 2.1 percent• Investment-grade corporate bond index yield

— 4.54 percent• AAA 10-year municipal bond — 3.8 percent

These yields are terrible. Except for corporate and municipal bonds, these rates don’t even cover the current rate of inflation. There’s a word for that: insulting.

A Sideways MarketPimco’s legendary bond investor Bill Gross,

among others, has forecasted a “new normal” for the U.S. economy. This “new normal” (code for lousy) will involve weak economic growth with

Source: DJIA

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Between 1968 and 1980, the overall stock market stayed flat. Due to inflation, the market actually hit a cyclical bottom before shooting up in the 1980’s

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structural high rates of unemployment for years to come. This forecast is not new, and it seems to be coming true.

This scenario portends low interest rates for the foreseeable future, as indicated by the Fed’s recent statement to keep interest rates low through mid-2013. The Fed wouldn’t dare raise short-term rates with 9 percent unemployment and an economy always teetering near the brink of recession.

Meanwhile, the current economic environment is creating a habitat for a sideways stock market with upward and downward pressures. On the upside, corporations are largely posting healthy profits and the low interest rate environment presents few alternatives for money to go.

In short, the market looks like it may face a prolonged period of “range trading,” akin to the period between 1968 and 1980 when the stock market went nowhere.

The Eroding DollarThe souring fundamentals of the U.S.

economy are destroying the dollar. Debt and deficits are spiraling out of control. To put things in perspective, when the Sept. 11 attacks occurred in 2001, the national debt was roughly $5.8 trillion. That much debt has been ratcheted-up in just the last four years. Now the total is $14.7 trillion and climbing fast. Something has to be done. But nothing is being done.

Meanwhile, trillions more dollars have been pumped into the system in the last several years. While all these extra dollars have not resulted in significant inflation yet, the foundation is laid for inflation to burst on to the scene in the years ahead once banks start lending money out rather than hoarding excess cash on their balance sheets.

These factors are causing the dollar to plunge in value relative to other currencies. The U.S. Dollar Index, which measures the dollar versus a basket of major currencies, has lost 38 percent of its value in the last decade and 8 percent just this past year.

Between low interest rates, low growth rates, and the willful destruction of the dollar, it’s clear that investors today need a stable, secure way to

lock in high-yielding investments to win in this challenging environment.

That’s why I’m sharing with you three key strategies to maximize the value of your high-income investments.

Three Strategies for High IncomeBoost Your Returns With Leveraging Tools

The lever is one of six simple machines designed to either exert a large force over a small distance or a great force over a small distance. Basically, a lever allows objects to be moved with

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In the past 6 years alone, nearly $6 trillion in new debt has been created!

Source: U.S. National Debt Clock http://www.brillig.com/debt_clock/

Total Government Debt Outstanding

US Dollar Index: Investors Have Lost Substantial Purchasing Power in the Past Decade


greater ease.It’s not that different in finance. Leverage

is a term that’s used to describe any technique that multiplies gains (and losses). For most investments, leverage is borrowing money at low short-term interest rates and using that money to invest in higher-return investments, thus earning additional money on “the spread.”

This process increases risk by amplifying potential losses and also increases potential return by amplifying potential gains. The primary risk to using this type of leverage is rising interest rates or, more specifically, rising short-term interest rates.

However, the current environment is highly unusual.

Normally, interest rates are very tricky to predict beyond the immediate or foreseeable future — but these aren’t normal times. Clarity exists in the interest rate environment that I have never seem in my lifetime.

The Fed has announced that it will keep short-term rates at current levels until at least mid-2013 — about two years from now. Investors who know how to use this unusual situation to their advantage have a great opportunity to earn a high income and maintain or even grow principle.

Here are a few ways to take advantage:

Closed-End FundsClosed-end funds offer some huge advantages

to income investors. First, you own a share of a huge portfolio of securities, providing a level of safety through diversification that you can’t easily get yourself.

Second, funds have the resources and expertise to scour the markets on a continuous basis for the best opportunities. And finally, they have the beautiful feature of often paying monthly, rather than quarterly, dividends.

They also do something else — use leverage. These funds often borrow money against their assets (usually up to 35 or 40 percent) at low, short-term interest rates and reinvest the money in their higher-yielding securities, juicing the distributions with extra income. The additional spread earned enables investors to enjoy a higher income than the regular portfolio generates.

Right now, there are 59 leveraged closed-end funds paying distribution rates of 8 percent or higher and 32 paying at least 9 percent. These funds come in all different sectors including high yield (junk bonds), preferred stock, international, and tax free.

Even a relatively conservative closed-end fund such as the Western Asset Premier Bond Fund

(NYSE: WEA) currently yields 8.45 percent from a portfolio of primarily investment-grade rated bonds. The fund has had an average annual return of more than 11 percent per year for the last five years. That’s a solid track record any conservative investor can bank on.

And, as you can see on the one-year chart for WEA, the share price trades within a relatively narrow range (barring credit concerns over the summer thanks to the debt-ceiling debacle).

Mortgage REITSAs the name implies, mortgage real estate

investment trusts invest in loans secured by pools of mortgages rather than pure land. Now, many people hear the word “mortgage” and run the other way. After all, mortgages are what caused the

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Western Asset Premier Bond Fund (WEA): Narrow Price Range, 8.45% Yield


financial crisis. Of course, those were subprime mortgages.

Many mortgage REITs invest only in mortgages guaranteed by U.S. government agencies (Fannie Mae, Freddie Mac, Ginnie Mae). Since the government has taken over the organizations, they are essentially obligations of the U.S. government with essentially zero credit risk.

Real estate investment trusts enjoy a huge tax advantage that enables them to pay much higher dividends than regular companies. They pay zero income tax at the corporate level provided that 90 percent of net income is paid out in dividends. So money normally lost to taxes is available to pay higher dividends.

But mortgage REITs pay huge dividends even for REITs. That’s because in addition to the tax advantage, mortgage REITs use leverage more than any other securities on the market. The business plan is simply to borrow money at low short-term rates and reinvest that money in longer-term higher-paying mortgages, earning profits from the “spread.”

(These REITs also raise money issuing new shares of stock.)

In this space, American Capital Agency Corp. (NASDAQ: AGNC) is a mortgage REIT established in 2008 that invests exclusively in mortgage securities guaranteed by U.S. government agencies (Fannie Mae, Freddie Mac, Ginnie Mae). The REIT is managed by an affiliate of global asset manager and private equity firm American Capital Ltd. (NASDAQ: ACAS).

The business plan is pretty simple. As I’ve outlined above, the company borrows money at low short-term rates and invests the money in higher-paying long-term mortgage securities. Low short-term rates are the engine that drives profits.

The REIT also raises money by issuing new shares in the capital markets and investing that money, with essentially zero cost, in the mortgage portfolio.

AGNC has been successful at earning enough with the newly raised money to maintain the existing dividend for its newly created shares.

Currently, AGNC’s portfolio consists of 88 percent fixed-rate mortgages (49 percent 15-year, 4 percent 20-year, 34 percent 30-year) and 12

percent adjustable-rate mortgages. In the most recent quarter, the REIT reported

a cost of funds of 0.89 percent and a portfolio yield of 3.35 percent, for a spread of 2.46 percent, down slightly from last quarter but up significantly from the year-ago quarter.

This REIT pays an absolutely amazing dividend that seems too good to be true. Because of the tax benefit, REITS generally pay a much higher dividend than regular stocks. But AGNC’s dividend is stratospheric. AGNC has paid a quarterly dividend of $1.40 since late 2009. That translates to $5.60 per share, a staggering 20 percent yield at today’s price ($5.60/$27.80).

Now comes the million-dollar question: Is the dividend safe?

Since AGNC invests only in securities that are guaranteed by the U.S. government, the main risk is with interest rates. The business model works as long as short rates are lower than long rates, the bigger the difference the higher the profit. Today’s short rates enable AGNC to borrow money for virtually nothing (0.89 percent average costs) and enjoy the bounty of the spread.

Obviously, rising short-term rates would narrow the spread, reduce profits, and sink the dividend and stock price. However, since the Fed has announced that short-term rates will remain at or near historic lows until at least mid-2013, AGNC’s main risk has been all but eliminated in the near term.

The other risk is something called prepayment risk. Borrowers prepay mortgages when mortgage rates fall so they can enjoy lower payments for the remainder of the mortgage. However, for a holder of mortgages (like AGNC), a prepaid mortgage must be reinvested at lower rates, thus reducing the spread and profits.

This prepayment risk appears to be mitigating, as well. Mortgage rates are near record lows, with little room to fall. At this point, mortgage rates have a better chance of rising than falling in the months and years ahead.

As well, AGNC has changed the portfolio over the past year toward lower-paying mortgages that have favorable prepayment attributes and less prepayment risk.

In fact, AGNC reported falling prepayment


rates in the last quarterly earnings report. The second quarter constant prepayment rate, which reflects the percentage of the portfolio likely to be prepaid over the course of a year, fell to 9 percent from 13 percent in the first quarter and 20 percent in the year-ago quarter. It’s still falling, too, as July’s annualized prepayment rate was reported at 8 percent.

AGNC, as well as other mortgage REITs, will get clobbered in a rising rate environment. However, given the unusual degree of certainty on the interest rate front that currently exists, the company should remain profitable and the dividend should remain safe for the next few years. As with other high-income investments, AGNC has traded in a narrow range. It’s a stock to own for its massive yield, not capital appreciation.

AGNC is a great way to pick up yield and income in a low-rate environment with the more speculative portion of an income portfolio. It’s an easy way to employ leverage and take advantage of the Fed’s zero interest rate policy.

Covered-Call WritingCovered-call writing is a simple strategy that

can boost income. Why? Because it’s another form of leverage to magnify gains and losses. Here’s a brief rundown:

A call is an option to buy a stock at a certain price at a certain date in the future. It is generally a bet that the price of the stock will go up.

Buying a call is highly speculative because there is a good chance the stock will not rise to meet the price and the option will expire worthless. When that happens, you lose 100 percent of your investment.

However, selling (or “writing”) a call when you own the underlying stock, aka covered-call writing, is a very conservative options strategy. Here’s how it works:

Let’s say you own 1000 shares of a $30 stock. You write (sell) 10 calls (each call represents 100

shares) at a strike price of $34 expiring three months from now for $3 each or $3,000.

The stock price must rise above $34 for the option to be in-the-money, otherwise it expires worthless. Whatever happens, you keep the $3 premium. One of three things will happen:• The stock trades flat (below $34) — In this

case, as the writer of the option, the options will expire worthless and you will simply keep the $3,000 premium, supplementing your income.

• The stock price falls — The options expire worthless and you keep the premium. Although the price is down, you outperform the stock by the amount of the premium collected.

• The stock rises above $34 — The option is exercised, capping your upside in the stock at $34, plus the $3 option premium.Covered-call writing works best with a stock

that you would be happy to continue owning over the longer term. However, in the short term, you believe the stock will trade flat to down. You can generate income from the stock with the options premium. If the stock does rise above the strike price, you lose the stock.

So you should be willing to sacrifice some capital appreciation potential for extra income in the short term. For tax purposes, this premium is considered a reduction of your cost basis on the shares. So any taxes from covered-call writing will be reflected in capital gains from the sale of a stock rather than the lower tax rate on dividends.

If you’re an investor who doesn’t want to deal with options strategies on your own, you can still use the strategy. An easy way to take advantage of


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American Capital Agency Corp (AGNC): Phenominal 20% Yield!


this technique is with funds and exchange-traded funds that employ covered-call writing. And with these funds can you the strategy on a larger scale than you ever could as an individual investor.

The funds basically seek to generate higher income at the expense of capital appreciation — a great strategy for a sideways market. As an additional bonus, market volatility makes the strategy even better because option premiums increase.

This market has also been quite volatile lately, giving options a better premium for generating income. Here’s one top fund that pays a double-digit dividend yield with a covered-call strategy:

BlackRock Enhanced Capital and Income Fund (NYSE: CII)

This closed-end fund seeks to provide a high level of current income by writing covered calls on 60 to 70 percent of a diversified portfolio of primarily large-capitalization value domestic stocks. CII also has an objective of capital appreciation on its shares.

As of June 30, 2011, top sector holdings included financials (15.7 percent), information technology (13.2 percent), and health care (13.1 percent). The fund held about 48 positions in individual company stocks (as of April 30, 2011), and top holdings included the third largest U.S. telecom provider CenturyLink Inc. (NYSE: CTL), health-care giant Bristol-Myers Squibb (NYSE: BMY), and integrated oil major Chevron Corp. (NYSE: CVX). In fact, more than 90 percent of the holdings were large companies.

The fund employs a managed or level distribution plan by which its strategy to maintain the same distribution for long periods.

CII currently pays $0.36 per share on a quarterly basis, translating to a huge 11.7 percent yield at today’s price. However, the quarterly distribution was cut to $0.36 per share from $0.485, which had been paid since mid-2007.

The fund had maintained its high dividend through the financial crisis and into 2010. However, with the lower level of stock volatility, it was increasingly difficult to maintain the options premiums.

Rather than pay shareholders higher levels of return of capital in the distributions, it cut the payments to a level that should be much more easily sustainable in the current environment. That’s led to a sagging share price, which in turn has ironically helped prop up CII’s yield.

Distribution cuts are never received well in the market, and CII’s price plummeted following the announcement of the cut, from $15.60 per share at the end of May to a low of $10.84 in August

However, I believe the distribution is far more secure going forward and the reduction in price also has increased the yield. The market seems to agree because the price has already moved up 13 percent from its August lows.

CII has had a consistent record of outperforming its covered-call fund peers in three- and five-year periods. It is currently rated

five stars and considered one of the best funds of its type by Morningstar. Also, it has one of the lowest expense ratios (0.90 percent).

Given the timeliness of the strategy, the recent reduction in price, and the more secure level of future distributions; CII is an excellent holding for income-oriented investors.

Dollar DiversificationGiven future prospects and the U.S. dollar’s

long history of decline, it is only prudent to diversify some of your assets and income away from the dollar. There are several ways to do this


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BlackRock Enhanced Capital and Income Fund (CII): A Levered Play on Bonds


and get income. One is by investing in funds or ETFs that buy

debt and equities in foreign countries. Another is to simply purchase U.S. multinational companies that generate a significant amount of revenue in foreign currencies. But perhaps the most direct way is to purchase stock of foreign companies.

There are an ever-increasing number of individual stocks that trade as American depositary receipts on U.S. exchanges that pay dividends in dollars after converting them from the foreign currency. These dividends will rise and fall in dollar terms depending on the dollar’s valuation relative to that currency.

A solid foreign company that pays a strong dividend can provide high regular income and protect your income stream from the falling value of the dollar at the same time. In this space, I’ve found that one of the top titans in this category is down south in Brazil.

CPFL Energia SA (NYSE: CPL): Brazilian Utility Giant

This Brazilian utility giant is one of the largest companies in South America with a 13 percent share of Brazil’s power distribution market. CPFL serves 6.4 million customers concentrated in the affluent southern states of São Paulo and Rio Grande do Sul.

The Brazilian economy is on the fast track. Latin America’s biggest economy (and the fifth largest in the world) is accelerating at the fastest pace of all emerging markets. Unlike most emerging markets, Brazil’s economy is largely driven by domestic consumption fueled by the country’s rising middle class, which now accounts for more than half its 190 million population by some accounts.

The fact that it has a surplus of energy and agricultural commodities to export to other fast-growing countries helps, too.

Earnings growth for CPFL is tied to increases in the overall energy usage resulting from

a growing national economy, as well as some shrewd acquisitions. Brazil is the fifth largest country in the world by area and population and one of the fastest-growing emerging markets.

CPFL is in an ideal position to benefit from the growth trend because it has a virtual monopoly in some of the most affluent areas in Brazil.

CPFL pays a semiannual dividend in May and October. Dividends over the past year have totaled $1.57 per share. Dividends are tied to earnings growth. The company has a stated policy of paying out at least 50 percent of adjusted net earnings in dividends. Fortunately, dividends have been growing like crazy, from $0.16 per year in 2005 to $1.57 this past year.

There is no withholding tax on dividends. Payments are made in Brazilian reals and converted to U.S. dollars, therefore dividends are strongly tied to the value of the real versus the U.S. dollar. This dividend will increase or decrease in dollar terms depending on this relationship.

While there can always be volatility in the short term, the strong Brazilian economy is likely to increase the value of its currency over time. Take a look at the dollar’s valuation versus the real in the past 10 years:

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U.S. Dollar/Brazilian Real: Long Term Gains for Patient Investors Down South


Don’t let the falling chart fool you. In currency terms, this chart is showing the U.S. dollar declining relative to the Brazilian real. That means American investors will get an extra boost to their income by investing in CPFL because a strengthening real will pay more dollars in dividends, even if the dividend is never increased.

ConclusionTimes change fast, and your investment strategies need to change with

them. There’s more to investing now than a quick trade or a “buy and hold” investment.

There are never-before-seen opportunities in fixed income because of the volatile markets, ever-evolving financial instruments, and the proliferation of investment opportunities in virtually every corner of the globe.

Although the brave new world may be full of new complications, it also empowers investors to generate a strong income under just about any circumstances. And these new ways of generating income couldn’t come at a better time in today’s low-yield environment.

As much at things change, some things stay the same. The need for income is one. And while this brave new world may have more opportunities, politicians and central bankers certainly aren’t making things any easier for investors with record-low interest rates.

With sound leverage, covered-call writing, and currency diversification, however, investors today are well-primed to generate high income through whatever market turmoil may lie ahead.

© 2012 The High Income Factor. All Rights Reserved. The High Income Factor is a monthly publication of Newsmax Media, Inc., and Newsmax.com. It is published for $99 per year and is offered online and in print through Newsmax.com and Moneynews.com.

For rights and permissions, contact the publisher at P.O. Box 20989, West Palm Beach, Florida 33416. To contact The High Income Factor, send e-mail to: [email protected]. Subscription/Customer Service contact (888) 766-7542 or [email protected]. Send e-mail address changes to [email protected].

Chief Executive Officer CHRISTOPHER RUDDY

Financial Publisher AARON DeHOOG

Senior Financial Editor TOM HUTCHINSON

Editor ANDREW PACKER

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DISCLAIMER: The owner, publisher, and editor are not responsible for errors and omissions. This publication is intended solely for information purposes and is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy or sell or trade in any commodities or securities herein named. Information is obtained from sources believed to be reliable, but is in no way guaranteed. No guarantee of any kind is implied or possible where projections of future conditions are attempted. In no event should the content of this market letter be construed as an express or implied promise, guarantee, or implication by or from The High Income Factor, or any of its officers, directors, employees, affiliates, or other agents that you will profit or that losses can or will be limited in any manner whatsoever. Some recommended trades may involve securities held by our officers, affiliates, editors, writers, or employees, and investment decisions may be inconsistent with or even contradictory to the discussion or recommendation in The High Income Factor. Past results are no indication of future performance. All investments are subject to risk, which should be considered before making any investment decisions. Consult your personal investment advisers before making an investment decision. Please view our Terms of Use for full disclosure at www.newsmax.com/terms.html. Copyright © 2012 The High Income Factor.

TheHigh Income Factor

About Tom Hutchinson

I’ve worked in finance my entire career, from the back office of a Wall Street firm to the floor of the New York Mercantile Exchange learning how markets work. Eventually, I became a financial adviser where I met with thousands of investors and managed the portfolio of hundreds over the course of about 15 years.

I left my career as a financial adviser, writing for The Motley Fool as well as Street Authority LLC, researching companies, industries, and markets.

In The High Income Factor, I can bring you the full benefit of my years of investing experience.

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3 Little-Known Income Strategies to Triple Your Return