Revenue Content

Thursday, October 9, 2014

Bloomberg: Three Ways to Get a Steady Paycheck Long After You've Retired

From Bloomberg, Oct 7, 2014, 2:09:24 PM
Photographer: Jill Battaglia/Getty Images

Guaranteed income for life. That was the plan -- now the fantasy -- during the golden age of American business, when pension plans were the norm. You did your time as a loyal, hard-working employee, retired at 65 and then monthly checks from your former employer rolled in until you died. A modest livelihood was assured without worrying about depleting your savings.

It sounds so quaint. For most Americans, the responsibility to save and manage retirement money is now all theirs. The good news: There are ways for do-it-yourself investors-turned-retirees to create their own simple pension-like plans at age 65. They involve mixing investments ranging from Treasury Inflation-Protected Securities (TIPS) to annuities to equity funds. None of them can eliminate risk entirely, but they do help minimize the chance that you'll outlive your money. 

Below are three approaches to generating lifetime income for retirees.

Stephen SexauerClimb the TIPS Ladder, Then Annuitize

The lowest-risk way retirees can create lifetime income is to put around 85 percent of their savings in TIPS, says Stephen Sexauer, chief investment officer of U.S. multi-asset management at Allianz Global Investors. TIPS are U.S. government-backed bonds that increase in value as inflation rises. After putting that money into TIPS of different maturities, Sexauer's strategy allocates the remaining 15 percent to a deferred life annuity that kicks in when a retiree is 85.

TIPS help protect money's purchasing power, and there's no credit risk. A TIPS portfolio is actually better than a defined benefit pension plan, Sexauer argues: "The 'golden era' of pension plans wasn't such a golden era -- a lot of companies went out of business and quit writing checks." Also, the payouts weren't adjusted for inflation.

Buying TIPS maturing in different years -- "laddering" -- lets retirees live on the expiring TIPS' liquidated value, as well as the portfolio's overall income. It also helps investors because part of a TIPS' "payout" is its twice-yearly inflation adjustment. Unlike a normal bond, TIPS not only pay income to shareholders but add value to the bond's principal based on changes in the Consumer Price Index. To realize the total return of a TIPS portfolio the bonds must mature or be sold.

You can buy TIPS at TreasuryDirect's web site only in increments of five or 10 years, however. For a fee, a broker can buy you bonds with in-between maturities that are already trading. A recent call to TD Ameritrade found it charging 0.125 percent to 0.25 percent of a TIPS order, depending on the bonds' yields. More yield equals more fee.

Rather than go farther than 20 years out in TIPS, Sexauer recommends a deferred life annuity. These insurance products pay a fixed level of income if you're still alive at a predetermined future date. If you don't live to that date, you get nothing. These don't adjust for inflation. Because about half of all people who reach 65 don't live past 85, insurers are willing to sell such annuities fairly cheaply to retirees. 

Of course, there are wrinkles to this strategy. A big one: With inflation expected to rise, TIPS are expensive, so much so that a 10-year TIPS pays only half a percentage point above the inflation rate. An all-TIPS portfolio for 30 years with no annuity would cost 30 percent to 40 percent more than the TIPS-plus-annuity strategy, according to Laurence Siegel, Sexauer's co-author on an article about do-it-yourself pensions and research director of the CFA Institute, a group of Chartered Financial Analysts.

More on Do-It-Yourself Investing:

William Bernstein: TIPS? Definitely. Deferred Annuities? No.

A TIPS-heavy strategy makes sense to William Bernstein, founder of money manager Efficient Frontier. It's the annuity part of Sexauer's plan that bugs him. Annuities have too much credit risk, he says, because issuers could go bankrupt. There are state insurance guarantee funds meant to help financially troubled insurers. But Bernstein thinks there's too much systemic risk in the financial markets today to rule out a major implosion that would leave annuity holders hanging. 

Instead of an annuity, Bernstein would use a Total Stock Market Index Fund. While not touching it for 20 years might be hard, over the long run stocks are very good inflation hedges. That's because stocks are a claim on real assets, says Bernstein. If you buy $1,000 worth of Proctor & Gamble stock, you're buying a company that has pricing power. If inflation comes along, you'll almost certainly have a positive rate of return as the company adjusts its pricing, he figures. 

There is one kind of deferred annuity Bernstein likes, and it's even inflation-adjusted: Waiting to take social security. You get a 30 percent bump in income if you wait from age 62 to 66, and another 30 percent if you wait from 66 to 70, he says.

While Bernstein thinks an all TIPS portfolio would be ideal, few people could afford it. Typically, a traditional pension would replace about 70 percent of your working income, and with today's skimpy yields, you'd have to invest a lot up front to reach retirement income goals.

To show how much money you'd need to invest in order to get the income you want from TIPS, Sexauer and Siegel created a website, It provides a table of current payouts for $100,000 invested in the 85 percent TIPS/15 percent deferred annuity strategy. This September, a 65-year-old putting $100,000 in the strategy would get just $4,486 in the first year of retirement. If inflation stays at 2.1 percent, that payout would rise to $6,728 when year 20 ends and the annuity begins. (The website projects inflation out 20 years based on long-term averages.) So to have a payout of about $45,000 this year you'd need to invest $1 million. Sexauer says it's not as bleak as it sounds because Social Security would augment the income from TIPS.

Phil Blancato: Forget TIPS. Take some credit risk. 

A better strategy than buying overpriced TIPS is to create buckets of income-producing assets during retirement, says Phil Blancato, chief executive officer of Ladenburg Thalmann Asset Management.. He suggests a laddered portfolio with high-quality corporate bonds for one bucket, a junk bond mutual fund for another and perhaps income-producing equities or preferred stock for the third. "We're in the lowest default cycle in probably 50 years," he says, so investors should take some credit risk. For someone with a 20-year horizon, Blancato thinks the risk of default is worth taking as opposed to the other risk -- not having enough income to live on.

Blancato uses an example of a 65-year-old retiree who wants her 500,000 portfolio to generate about 5 percent in average annual income. To get that, he'd take $300,000 and buy individual corporate bonds, and maybe some Treasuries and municipal bonds. The other $200,000 would go into a widely diversified portfolio that might include a high-yield bond fund, some master-limited partnerships and alternative income-producing products, maybe even preferred stock. Just know, he says, that these are your speculative investments and you'll need to weather some periods of temporary loss. 

That won't have the same certainty as a pension, he says. But over time, he thinks it will provide a retiree the income they need. It's undoubtedly a much more expensive strategy that that of Bernstein or Sexauer, and not exactly a do-it-yourself solution, though.

A cheaper way to take some risk in the bond portion of a do-it-yourself pension: Build a portfolio of exchange-traded funds that hold corporate or high-yield bonds of varying maturities. Guggenheim Investments offers a slew of "BulletShares" ETFs that each invest in corporate bonds maturing in a specific year. Just remember that it's the guaranteed part of an income-for-life strategy you give up when you take on credit risk.

To read the entire article with comments, go to

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Monday, October 6, 2014

BDC Boot Camp: An Introduction To The 9.7% Yield Animals, Debt-Based Business Development Companies

BDC Boot Camp: An Introduction To The 9.7% Yield Animals, Debt-Based Business Development Companies

Thu, Oct 2 | by John Cole Scott


  • The similarities between traditional CEFs and BDCs are what initially drew us to the structure. However, it is important to understand both the similarities and differences for both funds.
  • Forty-two of the fifty-one publicly listed BDCs are debt-based, or have 66.6%+ debt investments according to our definition, and have an average yield of 9.7% as of September 19, 2014.
  • The average BDC has $696M in market cap and trades on average $6.4M a day. When compared to traditional taxable CEFs, the debt-based BDCs are generally 5X more liquid.
  • BDCs handled rising rates well in the past. There was a 4%+ yield increase, for 30-day Libor from March 2004 to September 2007.
  • There was a 4.8% BDC yield increase, on average, for the 5 Debt-based BDCs that existed. The average market price TR was +32%, while The S&P 500 was up 42%.

Our firm has been zeroing in on BDCs for most of 2014; adding them to our CEF Universe data and news/SEC filing coverage, our Monthly Best Ideas List, launching a managed BDC account in September or partnering with a UIT provider for a BDC UIT for November. The similarities between traditional CEFs and BDCs are what initially drew us to the structure. However, it is important to understand both the similarities and differences in order to decide how and/or when to invest in a BDC. We hope this article will help prepare you to be able to do this. We will begin by discussing the origin of BDCs. This is the companion video to one we released yesterday.

A Business Development Company is a closed-end fund that is publicly listed, with exposure to private equity investments. BDCs were created by Congress in 1980 as an amendment to the 40 Act and are required to own 70%+ of US small to midsized businesses; they can make both debt and equity investments in private or thinly traded companies as long as they are under $250M market capitalization for the 70% exposure.

Like CEFs, BDCs, as regulated investment companies, receive tax beneficial treatment, as defined by the Investment Company Act, as long as they pass on 90%+ of their income to shareholders. They are regulated by the SEC and file 10-Qs, 10-Ks and 8-Ks. BDCs also must have a majority of independent directors, offer to provide managerial assistance to their portfolio companies, place securities at a custodian and provide and maintain a Fidelity Bond to protect the company from larceny and embezzlement. They must maintain a code of ethics and a comprehensive compliance program, and are prohibited from most affiliated transactions. Historically on average about 10% of filers get reviewed by the SEC each year. For BDCs, some years it is none and some years it has been half the funds in existence. We hear the SEC will be increasing audits as more investors use BDCs for their portfolios. In addition, BDCs are similar to venture capital or private equity as they provide a vehicle for investors to invest in small or private companies without having to be accredited investors.

This introduction to the history of why the BDC sector was created demonstrates how retail investors were the intended benefactors. However, it is also important to know what characteristics are common among well-performing funds to be able to choose the one(s) that are right for your portfolio. With a rising rate environment around the corner, it is better to begin your education on this sector sooner rather than later.

Forty-two of the fifty-one publicly listed BDCs are debt-based, or have 66.6%+ debt investments according to our definition, and have an average yield of 9.7% as of September 19, 2014. That is why it is important for investors to know what is normal for debt-based BDCs. The average fund is showing 91% dividend coverage from Net Investment Income and 90% debt assets in their portfolio. The average fund has $696M in market capitalization and trades on average $6.4M a day. When compared to traditional taxable CEFs, the debt-based BDCs are generally more liquid; 44% of traditional taxable funds trade under $1M per day, with an average of $1.3M per day in liquidity versus only 25% of debt-based BDCs trade under $1M per day. Discounts are currently at an average of par. Premiums are normal for Debt BDCs; current +0% levels vs. a one-year average of +4.5% and a three-year average of +2.3% demonstrates this claim. 90% of the 9.7% avg. yield of debt-based BDCs is short-term gains, and therefore they should not be considered tax-sensitive vehicles.

BDCs handled rising rates well in the past, and we anticipate that they will also do so the next time around. There was a 4.5% yield increase, on average, for the 5 Debt-based BDCs that existed from March 2004 to September 2007 when 30-Day Libor went up over 4%. The average market price TR was about 32% vs. the S&P 500, which was up 42% over the same time period. For some of these funds, like for other dividend-focused investments, when rates rise investors often pull back and prices can initially decline. Plus, many BDCs have Libor floors that are currently beneficial, but will cause a short-term lag to performance on their portfolios when rates rise. However, many of the BDCs we like have a significant amount of their leverage that is fixed (normal is about half) and assets that are variable or floating. Therefore, for most funds, after the first 1% move in Libor, the trends should generally be favorable.

Manager due-diligence and portfolio analysis is important in selecting a BDC because NAV is only updated quarterly. For example, this quarter there was about a 5-week period from the end of July through the first week of September when NAV/Earnings were updated for BDCs. However, the busiest part of the quarter is the two-week period from the beginning of the second month of a quarter when 80% of BDCs announce their NAV/Earnings. For reference, when looking at the 35 Debt-based BDCs that have been around for over a year, with 4 NAVs posted, the top quartile has an average NAV total return of +16.8% vs. an average of +1.2% for the bottom quartile.

The due-diligence process for a BDC often demands a significant amount of time and money. One of the larger BDCs shared with us that they spend $500K to produce their NAV each quarter and it is a document well over 2000 pages. As the positions held by BDCs are usually non-traded and private in nature, it is hard to have any outside perspective on what it is worth independent of the BDC's evaluation. As a result, it is important to select portfolio managers that have experience in how to properly structure deals, to offset the perceived risk of their Fund.

Some of the risks for BDCs are the same as those that need to be considered before investing in CEFs, and some are unique. Like with traditional CEFs, you are buying exposure to active management, permanent capital and getting daily liquidity. The following figures should give you a basic understanding of a range of data points that can be used to analyze BDCs and what conclusions we take from them.

The average 1-year standard deviation for BDCs is 18, with a range of 11-29. Seven BDCs are under one year old. There has been a 20% increase in debt-based BDCs from a year ago. Over the past 10 years, the average BDC IPO has raised $138M. This is the first year we have seen IPOs over $1B with $3.3B in 6 deals. Over the last 5 years, there has been an average of 4-7 new BDCs, or 1-2 per quarter. The average BDC has added $500M in assets above its IPO (2.5x IPO assets) while paying a high dividend level, generally through the use of secondary offerings to shareholders.

When considering expense ratios, if you use the same formulas for BDCs as are used for Traditional CEFs, total operating cost vs. average net assets, the average cost is 9%, while Traditional Taxable CEFs average 1.7%. But you are getting liquid access to investments typically requiring accreditation and the manager has permanent capital to focus on long-term investment decisions. Year-to-date on average NAVs are up +6.4%, the 1-year figure is up +10% and the 3-year figure is up +30%, but it is important to note that 90%+ of that is yield. In addition, market total returns are up +0.6% YTD, the 1-year figure is up 3% and the 3-year figure is up +46%. This demonstrates that market returns are currently lagging, but NAVs have outperformed over a longer period.

How is leverage different for a BDC vs. a CEF? Leverage figures, for BDCs, average 36%-37% with about 5 funds falling under the 20% leverage level and 21 funds having leverage over 40%, even as high as 50%+ if you include their SBIC facilities. On average, 44% of the leverage used by BDCs is fixed and the rest is variable leverage. About one-quarter of BDCs use only variable leverage and one-quarter use 85%+ fixed leverage and then the rest of BDCs use a healthy mix of both types of leverage. The cost of leverage for traditional taxable CEFs averages 1.8%, whereas, at 3.3%, BDCs average about two times that amount. This is not surprising based on the types of investments they make.

Now is a very exciting time to be interested in this established but underutilized investment structure. We expect to see valuations for debt-BDCs to average 1.1 times book, or an average of a 10% premium to NAV. This level should be common and sustainable for this group of funds overtime. Tax-deferred accounts, including IRAs, are good vehicles to put BDCs in. Investors can get access to unique and exceptional managers, five times the current liquidity of traditional CEFs and potential for yield increases in a rising rate environment.

One of the reasons we are optimistic is that we expect the demographics of BDC investors to shift in the next couple of years. Currently, 21% of the shares of traditional taxable CEFs are held by 13 filers vs. only 9% of BDC shares. However, we do see this gap narrowing in the next 2-3 years; we see a 15%-20% shift in BDC share ownership, taking 13 filers up to the 25%-30% range. As the number of shares of BDC held by 13 filers increases, we expect to see fee costs trend down as these investors will push harder on BDCs than retail investors and financial advisors typically have.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The views and opinions herein are as of the date of publication and are subject to change at any time based upon market movements or other conditions. None of the information contained herein should be construed as an offer to buy or sell securities or as recommendations. Performance results shown should, under no circumstances, be construed as an indication of future performance. Data, while obtained from sources we believe to be reliable, cannot be guaranteed. Data, unless otherwise stated comes from the September 19, 2014 issue of our CEF Universe service.

  • Akaralph
    Oct 2 11:08 AM

    I too am an advocate of BDC's; however, look at their performance over the period Oct 2007 through Mar 2009. 
  • RichAbe
    Oct 3 09:12 AM
    "As the positions held by BDCs are usually non-traded and private in nature, it is hard to have any outside perspective on what it is worth independent of the BDC's evaluation."

    So what you are saying is the NAV is whatever the investment manager says it is. Problem is sometimes they make mistakes and sometimes they cheat. See David Eihorn's excellent book on Allied Capital.  

    There is a reason the SEC is stepping up audits in this sector.

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