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Grab These ‘Pass Through’ Investments

By Jim Pearce on January 20, 2017

While tabulating the performance of our Maximum Income for Retirees portfolio this week, a number jumped out that investors in the portfolio will be extremely happy with, and which may explain how institutional investors are preparing for rising interest rates: 25.9%.

That’s the 2016 return of the portfolio (available to Personal Finance subscribers), and it  soundly trounced the S&P 500’s 9.6% gain. Our portfolio of fifteen “pass through” securities, consists of five each of MLPs (Master Limited Partnerships), REITs (Real Estate Investment Trusts) and BDCs (Business Development Companies). About a third of the Max Income’s gain came from dividends and distributions, while the other two-thirds were due to share price appreciation. (I list some of them at end of the article.)

That these normally mundane “cash cows” suddenly started performing like thoroughbreds suggests something extraordinary is happening. I think this startling change of direction signifies a new dynamic in the fixed income market that could fundamentally alter how these investments perform for years, and perhaps decades, to come.

The triggering event is the reversal of interest rates that began a year ago when the Fed raised the discount rate for the first time since the onset of the Great Recession, and raised again last month. Until then, income investors could rely on the bond market to deliver steady cash flow and capital appreciation as long term interest rates gradually declined.

But now, because of the reversal, the bond bubble that has been building for the past three decades is starting to deflate, pushing bond prices lower. As that gathers momentum, income investors will begin looking elsewhere for cash from investments that are less likely to suffer price declines, and possibly even appreciate. And the one place they won’t be able to find that is the bond market.

I believe some forward-thinking institutional money managers have already figured that out, and have been systematically transferring money out of bonds and into BDCs, MLPs and REITs over the past several months, which would explain their surprising surge in 2016. The bond market is huge, more than twice the size as the stock market, while the pass-through sector is only a small fraction of the stock market. That means a relatively little amount money coming out of bonds can have a huge impact on pass-throughs.

As this trend picks up, demand for a more pass-through securities will increase. For that reason, companies that would have ordinarily issued bonds in the past may instead spin off more assets into pass-through vehicles, which in turn could change the way corporations think about managing their balance sheets.

To us, it means that these types of vehicles will become even better places to invest not just for income—their traditional role—but also for capital appreciation.

A quantum shift like this means a huge opportunity for investors who recognize the trend and invest in it early. A good place to start is our Personal Finance Max Income portfolio.

Here’s a taste of what’s in it:

Our sleeve of BDCs was led by Gladstone Capital Group (GLAD) which appreciated 28.5% in addition to its annual dividend of 8.9% for a total return of 37.4%. One of our REITs did even better; AG Mortgage Investment Trust (MITT) grew 33.3% plus a dividend of 10.9% for a 44.2% net gain. But the biggest winner was one of our MLPs, AmeriGas Partners LP (APU), which increased in value by 39.8% while paying a 7.8% distribution for a total return of 47.6%!




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