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Maximum Income for Retirees:
 Year End Summary

By Jim Pearce on January 19, 2018

The inflationary forces described on the first two pages of this issue had a negative impact on the type of high-income securities held in our Maximum Income for Retirees portfolio during the second half of 2017.

These securities borrow money to buy income producing assets, from which distributions are paid to their shareholders. As the cost of borrowing goes up, the net income available to pay out as dividends to shareholders is reduced.

For that reason, last quarter the 15 individual securities in the portfolio declined in value by an average of 2.5%, compared to a 6.2% gain in the SPDR S&P 500 ETF (NYSE: SPY).

However, that performance was better than the 4.8% decline posted by the three broadly diversified exchange-traded funds (ETFs) in the portfolio, proving the value of individual security selection.

Also, the 8.8% average yield of our individual holdings was higher than the 7.4% average yield of our ETFs, and more than four times greater than the 1.9% on the SPY.

The results for the year as a whole were about the same. The SPY gained nearly 20% during 2017, while our group of stocks lost 4.2%.

In large part that was attributable to major declines in our sleeve of master limited partnerships (MLPs), all of which are in the energy sector.

The biggest loser was Genesis Energy (NYSE: GEL), down 38% for the year. However, it has not cut its dividend and is now yielding close to 13%.

Also losing ground in 2017 was Energy Transfer Partners (NYSE: ETP), which dropped by more than 25% as its parent company went through a series of restructuring events that created confusion over how much income would flow through its subsidiary. However, both GEL and ETP rebounded strongly at the start of this year, suggesting the worst is behind them.

In fact, I wouldn’t be surprised to see our group of MLPs reverse course and post a stellar 2018. Oil prices are on the rise, the global economy is strengthening, and energy consumption is accelerating. That bodes well for the pipelines, storage tanks and transportation vehicles owned by our group of “midstream” MLPs that facilitate energy production and consumption.

Our group of business development companies (BDCs) should also fare well in 2018, thanks in part to the recently enacted corporate tax cut. That will not directly help the companies they lend to, since most of them are marginally profitable.

But it should stimulate increased merger and acquisition (M&A) activity as larger companies put their tax savings to work by acquiring smaller businesses. Most BDCs include an “equity kicker” as part of their loan agreements, which would pay off handsomely when one of their portfolio companies is acquired.

As a group, our BDCs eked out a 0.7% gain for all of 2017, while paying an average yield of 9.1%. However, they declined 1.8% during the fourth quarter as investors poured money into the stocks most likely to immediately benefit from a tax cut. Our star performer in this group for the year was Stellus Capital Management (NYSE: SCM), increasing in value by 9% while paying a 10.4% dividend yield.

The best returns for 2017 came from our group of real estate investment trusts (REITs), which grew by an average of 3.1% for the year while paying a 7.7% dividend yield. Our best performer for the year was AG Mortgage Investment Trust (NYSE: MITT), gaining 11.1% while paying out an even 10% dividend yield. Coming in at a close second was Digital Realty Trust (NYSE: DLR), increasing in value by 15.9% with a 3.3% dividend yield.

A quick comment regarding Government Properties Income Trust (NYSE: GOV). Although it is currently trading below our support level, in this case I feel comfortable continuing to hold it since the reason for its recent decline should benefit it in the long run.

Last summer, GOV acquired First Potomac Realty at a cost of $1.4 billion. The cost of servicing the debt used to finance that transaction will most likely prevent GOV from raising its dividend in 2018, but after that the net impact on cash flow should be positive.

Tax Bill Benefits MLPs

As noted above, I feel our sleeve of MLPs is undervalued, in part due to misplaced fears over the recent tax reform bill. Since MLPs pay no corporate income tax, the relative advantage of that feature is lessened by a lower tax rate for companies that do pay income tax.

However, that is only the case if some of those tax savings are paid out to shareholders as dividends. If not, the relative income advantage of MLPs remains unchanged.

I’m sure some companies will increase their dividend payments as a result of the tax cut, but I doubt that will make a difference to income investors. Even if the SPY increased its dividend payout by a whopping 25% because of the tax cut (extremely unlikely, in my opinion), that would only raise its yield to 2.4% compared to 9.5% for our group of MLPs.

Lost in the shuffle is the fact that the estate tax ceiling was doubled to $10 million from 2018 through 2025. That may turn out to be beneficial to MLPs, since many investors elect to hold them for life and then pass them on to their heirs at a stepped up cost basis upon death to avoid capital gain taxes.

For wealthy investors looking for a way to transfer wealth more tax-efficiently to their heirs, being able to put more of their money into MLPs may be one of the better ways to accomplish that objective.

Finally, the tax bill reduced the deduction for dividend income that a corporation receives from other taxable entities to 50% from 70% (and to 65% from 80% if the corporation owns at least 20% of that entity).

However, since MLPs are not taxable entities this provision should not result in corporations dumping shares of MLPs that they own. The same holds true for BDCs and REITs, which are also non-taxable provided they distribute most of their net income to shareholders as dividends.

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