From left, panelists Maury Fertig, Michael Terwilliger, Richard Daskin, Jenny Van Leeuwen Harrington David Yellen for Barron's

It’s time for some cautious optimism. Income investors have had it tough for too long now, settling for 2% yields on high-quality bonds and stocks. As interest rates creep higher, investors can find much higher-income securities, if they’re willing to take a bit more risk and do more homework.
We asked four independent thinkers, all from smaller firms that specialize in producing income for clients, to share some of their best ideas. Their picks include acronym-laced, off-the-beaten-track areas such as business development companies, or BDCs; master limited partnerships, or MLPs; closed-end funds; and mortgage real estate investment trusts, or REITs. Yields of many of the securities they mention are in the lofty 7%-to-11% range.
They also offer ways to minimize risk as they fret over the impact of the Federal Reserve hiking rates and shrinking its balance sheet at the same time that economic growth remains muted. Panelists include Jenny Van Leeuwen Harrington, who runs an equity-income portfolio for her firm, Gilman Hill Asset Management; Richard Daskin, president of RSD Advisors and subadvisor to Cumberland Advisors’ MLP strategy; Maury Fertig, chief investment officer of Relative Value Partners, which emphasizes closed-end funds; and Michael Terwilliger, portfolio manager of Resource Credit Income, an interval fund.

The Case for Owning Dividend Stocks as Rates Rise

Jenny Van Leeuwen Harrington of Gilman Hill Asset Management says dividend stocks do just fine when the Federal Reserve hikes rates, contrary to popular belief. B&G Foods (BGS) is one of her favorites now.

Barron’s: Let’s start with the root of all income investing— your outlook for interest rates and the Federal Reserve.
Maury Fertig: I expect moderately higher rates. Economic growth isn’t going to go to 3%—more like 2%. The Fed wants to push rates up without pushing us into recession. That is going to be a challenge. I expect the 10-year Treasury yield to get into the 3% range in the next 12 months.
What do you see coming next from the Fed?
Michael Terwilliger: The biggest risk right now is the Fed’s plan to shrink its balance sheet by letting its bond holdings run off [mature] at the same time the European Central Bank may start tapering its bond-buying program. That removes two gigantic buyers of bonds from the market. This is an incredibly challenging backdrop for fixed-income investors. A 10-year Treasury yield with a three-handle at the end of this year is a realistic expectation. There is nothing but upside for yield from here.

Jenny Van Leeuwen Harrington, who runs an equity-income portfolio for Gilman Hill Asset Management, says rising interest rates could send more money into the stock market. David Yellen for Barron's

Richard Daskin: The biggest question is whether the Fed will continue to raise rates as its balance sheet runs off. If it does, that would be a headwind for equity markets and long bonds, as well. My worry is that the Fed tightens too much and sends us into a recession.
How worried are you about rising rates during a period of slow economic growth?
Jenny Van Leeuwen Harrington: Logically, as the ECB and Fed wind down their balance sheets, interest rates should go up, but they might not go up that much. Everything the Fed has shown us is that it is going to be super-careful and transparent in its movements.
What are the specific risks of higher rates?
Harrington: As rates go up, people may get shocked when, for the first time in 30 years, they lose money on their bond funds. [Bond prices and yields move in the opposite direction.] That could actually cause investors to pull money out of bond funds and move into equities. That could put a floor under stock prices.
Terwilliger: Investors are still not as cognizant about interest-rate risk as they should be. If you’re an individual investor, you can get absolutely crushed in a rising-rate environment. We’re trying to manage that risk within our fund. That’s why we’re very much overweight floating-rate BDCs, loans, and shorter-duration corporate bonds.
Let’s get into some of those ideas, starting with business development companies.
Terwilliger: We like BDCs. They are direct lenders to small and medium-size businesses; the interest income they earn is paid out as dividends to investors. Most of these loans have floating rates, so if rates move up, you get the benefit of incremental interest income. Also, you are getting significant yields relative to what you get in more-liquid markets. BDCs generally negotiate the loan directly with the borrower, so investors still get covenants [contracts as to what the borrower can and can’t do during the life of the bond] to protect them.

Maury Fertig of Relative Value Partners is avoiding high-yield bonds, but recommends some diversified closed-end bond funds that have proved adept at managing risk. David Yellen for Barron's
Daskin: The problem with BDCs is that their corporate governance is all over the map, and the dispersion of returns among different companies in that space is huge.
Terwilliger: Tremendous.
Daskin: So individual investors should be very careful or maybe hire Mike or someone else to do the due diligence. There is a huge variability in how BDCs are run.
Harrington: It’s also almost impossible for an individual to assess the underlying loans.
Fertig: Another risk—well, there are many risks, but one very clear risk is the name concentration in some of these BDCs. They can have 7%, 8%, 10% of the portfolio in a single company. That’s a big risk; a problem with a single asset could wipe out a meaningful chunk of your investment. There are many BDCs that have a lot of concentrated risk that I would never touch.
Terwilliger: Some of them are real Dumpster fires; you really have to go case by case. One that I like right now is WhiteHorse Finance [ticker: WHF]. It has only a $270 million market value, so it may not be for everyone. White Horse only does direct origination; they go to each individual business and underwrite it under their terms, which often means getting good covenantsin place. It is unbelievable the competitive advantage you can get from good covenants. WhiteHorse has a dividend yield of 10.8%—you’d buy that all day long. OFS Capital [OFS] is similar; they don’t do syndicated deals; they don’t do sponsored deals. It is all direct origination of mostly smaller companies, which gives them higher yields and better covenant terms.
Daskin: Another perk of BDCs is that as part of their loan underwriting, they often get equity kickers, which can make up for a BDC’s mistakes or losses. Hercules Capital [HTGC] owned Facebook [FB] warrants and made a killing from them. That could offset a lot of default risk or even a default.

Richard Daskin, of RSD Advisors, is watching the yield curve for signs the Fed may be hiking rates too fast. For income with less credit risk, he likes high-yield and taxable munis. David Yellen for Barron's
Harrington: We only own one, and it is Hercules. We like that, for a BDC, it is relatively transparent; it makes loans to tech and biotech companies. It yields 9.3%.
As rates rise, it makes sense to look at products that have payouts tied to rates. Where are the opportunities in floating-rate investments?
Fertig: Preferred securities often have floating-rate features, although they are a little expensive right now.
But I have one niche idea—a preferred issued by a mortgage REIT, Chimera Investment [CIM]. It is callable and has an option to turn into a floating-rate preferred in 2024. So either the company redeems it at par at $25, or it turns it into a floater. That gives it a much lower effective duration of five years, compared with what may be 11 years on a normal perpetual preferred. Chimera’s stock trades near book value, so the market thinks well of the company.
Why is the preferred better than the stock?
Fertig: The stock has a different risk profile. I do, however, like another mortgage REIT, Ares Commercial Real Estate [ACRE]. It has an 8.4% yield and trades at 90% of book value, and about 90% of its assets are floating rate.
Terwilliger: I don’t love mortgage REITs as a business model. They buy pools of agency mortgages and lever them up. You are making a bet on the shape of the yield curve [if it steepens, investors benefit]. But there is one that we do like a lot: Great Ajax [AJX]. It buys pools of distressed mortgages directly from banks at absolute fire-sale prices. The dividend yield is 8.6%; it trades at 90 cents on the dollar of book value. That’s a compelling yield, and you’re buying it a discount. Plus, Ajax has a joint venture with Jeffrey Gundlach of DoubleLine Capital. DoubleLine gets a management fee, but more than anything, it’s a seal of approval from Gundlach.
You’ve offered a few interesting, if complex, investment ideas. Let’s consider some more mainstream fixed-income options. Rick, what are you doing with munis?

 Michael Terwilliger, manager of the Resource Credit Income fund, expects rates to rise further and thus recommends floating-rate BDCs and short-term corporate bonds. David Yellen for Barron's
Daskin: Municipal bonds are still important sources of income. There are two exchange-traded funds I’m using for clients seeking yield. One is VanEck Vectors High-Yield Municipal Index [HYD]. Even though it has high yield in its name, it is very different from a junk-bond fund. The historical default rates for munis are much lower than for corporates. Plus, munis tend to be underrated from a credit point of view. An A-rated general-obligation bond has about the same default rate as a triple-A corporate.
HYD holds high-yield munis, but the average rating is probably about double-B [an upper tier of junk bond], and about 40% of its holdings are investment grade. The yield is almost 4%; that is the equivalent of a 6% yield for someone in a high tax bracket. It is especially attractive when you compare it with a 5% yield for high-yield corporates.
What about Puerto Rico?
Daskin: HYD has less than 1% of its assets in Puerto Rico. But investing in insured paper of Puerto Rico is one of my best ideas for yield now. I’m very satisfied with the credit quality of the insurers, and you still get high-yield muni returns of 3.5% to 4.5%, depending on maturity.
What is the other muni fund you like?
Daskin: The PowerShares Taxable Municipal Bond Portfolio [BAB]. The income is subject to tax, so it’s best held in a tax-deferred account. The average credit rating in that fund is A to double-A, which I consider equivalent to a triple-A corporate. The yield is 4%, and if you graph it versus the 10-year Treasury, it mimics it almost exactly. But the 10-year yields 2.27%, and BAB after expenses yields about 3.5%, so you get a nice pickup in yield. The downside is that the space is a bit illiquid.
What about muni closed-end funds? They have been popular since they offer even higher tax-free yields.
Fertig: I would be very careful with parts of the closed-end market, particularly muni funds. The overwhelming majority of these funds are levered, so they are very sensitive to higher short-term rates, which increases their borrowing costs. Another 25-basis-point move higher in the fed-funds rate, and many funds will have to reduce their dividend.

The other issue is that there is a great deal of callable bonds in these funds. As those bonds get redeemed, it puts pressure on the earnings yield of the portfolio and could lead to further dividend cuts. Finally, any kind of lowering of income tax rates is not a positive for muni bonds. All of these events may lead to an opportunity down the road to invest in closed-end muni funds. But now isn’t the time.
What about closed-end funds for high-yield bonds?
Fertig: We’ve been avoiding pure high-yield plays because we don’t want to take much credit risk with spreads this tight. The high-yield market has a yield of 5.2% right now, so it is trading only 3.6 percentage points over Treasuries. Credit spreads rose to more than eight percentage points in February last year. There is no question that high yield isn’t nearly as attractive as it has been at many points. You have to be cautious. But we are taking some credit risk when it is embedded within diversified funds.
You mean diversified closed-end bond funds?
Fertig: Yes. Right now the median discount in closed-end bond funds is about 4%. But diversified funds trade at more of a discount because they don’t fit cleanly into a bucket. One we like is Eaton Vance Short Duration Diversified Income [EVG]. It is trading at a 7% discount and has a 1.4-year duration and a 6.4% yield. It invests in three principal areas: mortgage-backed securities, senior floating-rate assets, and foreign-currency short-term debt. Managers have done a nice job generating positive returns in tough times. It has an average credit quality of triple-B, which is a lower tier of investment grade, but it isn’t a junk fund. An individual investor with a reasonable horizon can do OK in EVG for the next couple of years.
And its short duration would be protecting you against higher interest rates?
Fertig: Absolutely. Another closed-end fund that falls into this no-man’s land is Diversified Real Asset Income [DRA]. Its objective is to produce income and capital appreciation from businesses with predictable cash flows. It invests in debt, preferreds, REITs, utilities, and infrastructure, and it has global nondollar assets, as well. It isn’t pure fixed income; the management team can move between asset classes. Currently, it is about 50% equities, 25% preferreds, and 25% debt, both fixed and floating rate. The duration is 3.8 years. It yields 7.2% and is trading at a 9% discount. Later this year, it will merge into Nuveen Real Asset Income & Growth [JRI], which trades at a tighter discount.
Daskin: There are two BlackRock funds I like that go along with what Maury is saying about diversified funds. BlackRock Ltd. Duration Income Trust [BLW] has loans, corporate bonds, and mortgage-backed securities, and yields 6%; BlackRock Income Trust [BKT] is mainly mortgage-backed securities and yields 5%. Both have reasonable fees and trade at discounts of over 6%. BLW is a little bit more of a credit play; BKT has a bit longer duration.
I like to combine these funds with an ETF, iShares Core 1-5 Year USD Bond [ISTB]. It yields only 2%, but it has a 2.8-year duration and extremely low volatility. You put the three together, and you get a 4% yield without too much leverage, low bond volatility, and a pretty high-grade package.
Master limited partnerships had a great run, but suffered when oil prices fell dramatically in 2014. What are your thoughts on MLPs now?
Daskin: I still like MLPs, but I’m wondering where the catalyst for upside will come from. You have to be really patient.
Fertig: A good way to buy into the MLP space is the Alerian ETF [AMLP].
Harrington: I couldn’t possibly disagree with you more. The ETF has to pay tax at the corporate level, so you don’t get the tax benefits of MLPs, and it underperforms its index.
Fertig: I get that, but it has an 7.2% yield and is a very simple way to own MLPs, without dealing with the K-1 tax forms. We put 2% in our balanced portfolio in early 2016, and we’ve done very well with it.
Daskin: If you want a fund, the best way to go is an exchange-traded note like E-TRACS Alerian MLP Infrastructure MLPI]. AMLP has really high fees. To the extent I buy MLPs for clients, I pick individual ones.
Harrington: That’s what we do. Our three main MLPs are Enterprise Products Partners[EPD], Magellan Midstream Partners [MMP], and NuStar Energy [NS]. When clients want to avoid K-1s, we buy proxies like Kinder Morgan [KMI] and Oneok [OKE], which are C corps. That said, I push my clients to own the MLPs whenever possible because of the ability to defer taxes for a very long time.
How do you pick them?
Harrington: I’m trying to create a super-consistent income stream that has resiliency to interest rates, energy prices, and the economy. So I concentrate on the ones that have broad revenue streams. But you have to know that, from time to time, MLPs are going to be painted with the energy brush, even though they are collecting revenue from transporting and storing the energy. Did Magellan deserve to go from $90 down to $55? No way. It has a 5% yield and a vast majority of its revenue is generated by fee-based, low-risk activities. As an MLP investor, you need to stiffen your spine going in.
Where else are you investing?
Harrington: REITs are in many ways similar to MLPs—you need to understand the geographies, the management team, and, most importantly, the specifics of the individual business. It isn’t all commercial real estate. One of the companies we like is Hannon Armstrong Sustainable Infrastructure Capital [HASI]. It finances carbon-reducing emission projects. Most of its clients are government agencies. There is nothing commercial real estate about that. Last year, we bought Ryman Hospitality Properties [RHP]. It owns some of the largest nongaming conference centers in the country. It’s a hotel REIT, but it is totally different because conferences are booked way in advance. It was punished last year because hotel REITs were in a cyclical downturn, so we were able to buy it with a 6% yield.
What about retail REITs?
Harrington: This year, anything that has a hint of the smell of retail is cheap, so we just bought Tanger Factory Outlet Centers [SKT], an outlet mall with a 5.2% yield. It has increased its dividend 24 years in a row and has unbelievable cash-flow resilience. To quote the CEO, in good times, people love a bargain, and in tough times, people need a bargain. We just added another mall REIT, Simon Property Group [SPG], which has a 4.5% yield. As long as I’ve been investing, I don’t think I’ve seen Simon with that high a yield. We also bought Target [TGT], which has a 4.3% dividend yield. Say what you will about Target—it isn’t dying and the cash flows are unbelievable. It should have about $6 a share of cash flow, which more than covers the $2.48 dividend.
Terwilliger: It does seem that retail is the new energy. One of our larger positions right now is loans backed by BJ’s Wholesale Club, which is like a smaller, private Costco or Sam’s Club. These loans traded off to around 95 cents on the dollar, and I would argue the market is simply wrong on this one.
Every year, 60% of its earnings before interest, taxes, depreciation, and amortization comes from memberships, which gives incredible visibility into its earnings. Even if you have try to compete on price, it is already 20% below traditional grocery. It is highly levered, so I get a 9.2% yield. I would own that all day long.
Are there bonds you like?
Terwilliger: The bond market is very challenging right now, but there are still opportunities even if you think rates are going higher. We own Jo-Ann Stores, which sells fabrics and arts and crafts. It’s a labor-intensive business that is largely e-commerce proof, and it doesn’t work in the big-box format.
You can buy bonds with a 9.75% coupon for about 99 cents on the dollar for a 10.4% yield. So there are opportunities within bonds and loans. Yes, spreads are tight, and this is a challenging market, but there are places you can find yield.
Aren’t these opportunities risky?
Terwilliger: They can be illiquid. That’s one of the things people need to understand.
Fertig: That’s one reason we are being very selective. If and when this higher-interest-rate environment comes, our investments will hold up. And if it doesn’t come, they’ll do even better.
Thanks, everyone.