Income investing can be a full-time job in-an-of-itself. Incomes assets include fixed- and variable-income securities. Once the investable sectors and sub-sectors are understood, we’ll review some popular ETFs and CEFs to express the investment themes.

Study Objectives

Define income sectors
Review popular ETFs and CEFs
Explore portfolio construction with income assets

Income Sectors

Incomes assets include fixed- and variable-income securities. Rather than organizing the income asset section by fixed- vs. variable-income securities, however, the author has chosen to highlight the primary investable assets in which we are interested for this diversified portfolio: Bonds, REITs, and Closed-End Funds.

Bonds

Bonds are a type of fixed-income security. A fixed-income security is a debt instrument which provides a return to the debt purchaser in the form of fixed, periodic payments and is issued by a government, corporation or other entity to finance and expand their operations. The issuer of the debt promises to repay the principal investment at a set date in the future.

Bonds are broadly grouped into two categories based on the issuing authority: government or corporate:

Government Bonds

Treasuries (U.S. Government)
Emerging Market Debt
Municipal Bonds
Agency Bonds

Corporate Bonds

Investment Grade Bonds
High-Yield Bonds
Convertible Bonds
Preferred Stocks

REITs

REITs, or Real Estate Investment Trusts, are companies that own and operate income-producing real estate assets. Essentially a real estate fund with special tax considerations, the REIT business entity allows the average investor an opportunity to take part in large-scale real estate operations, diversify one’s portfolio, produce a stable income stream, and seek investment total-return.

In 2016, REITs were reclassified and added for the first time to the S&P 500 Index. To qualify as a real estate investment trust, companies must meet certain guidelines set by Congress, including:

Be considered a corporation under the IRS revenue code
Be managed by a board of directors
Be held by at least 100 shareholders, with no fewer than five holding 50% of shares
Invest at least 75% of assets in real estate, cash or U.S. Treasuries
Derive at least 75% of income from real estate
Have 95% of income be passive, which is income that doesn’t require direct action from the corporation, such as rental payments
Pay out at least 90% of its taxable income to shareholders through dividends

There is an overwhelming amount of information about REITs online, with many articles promotional and focused on a single opportunity. Meanwhile, there are three major groupings of real estate income investments, including equity REITs, mortgage REITs, and real estate management and development companies.

Equity REITs

Equity REITs are companies that aggregate real estate holdings into a single portfolio for ease of investment and also physically own and operate the properties in their portfolio. They are responsible for acquiring, managing, building, renovating, selling, and marketing the assets.

Equity REITs span a variety of sectors:

Diversified REITs
Industrial REITs
Hotel & Resort REITs
Office REITs
Health Care REITs
Retail REITs
Residential REITs
Self-storage REITs
Data Center REITs
Infrastructure REITs
Specialized REITs

Mortgage REITs

Mortgage REITs provide real estate financing via mortgage loans and mortgage-backed securities, generating their revenues from interest earned on lending activities. Specializing in lending rather than operations, mortgage REITs do not own any physical properties.

Mortgage REITs are considered amongst the riskiest of REIT investments, so will play little, if any, role in our diversified portfolio.

Not only are mortgage REITs extremely susceptible to interest rate fluctuations, but mortgage REIT management teams often seek to mitigate risks associated with their short-term borrowings through any numbers of financial contracts, including but not limited to interest rate swaps, swaptions, interest rate collars, caps, floors, adjusting average asset maturities, and asset trading to take advantage of interest rate opportunities.

Types of mortgage REITs include:

Agency mREITs (AMREITs)
Non-Agency mREITs
Commercial mREITs

Real Estate Management & Development Companies

The real estate management and development sub-sector can offer investors direct exposure to real estate developers, but does not provide the same diversification benefits as many opportunities found in the equity REIT sector. Real estate management companies attract investors seeking high dividend payouts, and the sub-sector is further segmented by analysts into three additional categories.

These three sub-sectors are:

Real Estate Operating
Real Estate Development
Real Estate Services

Thoughts on Non-Traded REITs

Because they do not trade on a stock exchange, non-traded REITs involve special risks. These risks include lack of liquidity, lack of transparency, obfuscated yields, and conflicts of interest. Because of these risks, non-traded REITs are not appropriate for our diversified portfolio.

Closed-End Funds

A closed-end fund (CEF), also known as a “closed-end investment” or “closed-end mutual fund”, is organized as a publicly traded investment company. Like a mutual fund, a closed-end fund is a pooled investment with a designated portfolio manager. A closed-end fund raises a fixed amount of capital through an initial public offering (IPO) and is structured, listed and then traded on a stock exchange.

Typically, closed-end funds specialize in a market sector and/or advanced financial instruments such as derivatives. One example would be a CEF focused on tech stocks and using calls/puts for additional income.

A closed-end fund differs from traditional, or open-end, mutual funds in several important ways. Not only are CEFs closed to new capital once they begin operations, but CEF shares trade on stock exchanges and can be traded at any time during open market hours. In this way, CEFs are closer to ETFs. Unlike either mutual funds or ETFs, though, closed-end funds often trade at a premium or even discount to net-asset-value (NAV). Finally, U.S. based CEFs can own unlisted securities, which are generally considered “risky” assets.

The three primary risks associated with CEF investing include alternative portfolio holdings, use of leverage, and questionable distributions.

Risks, uncertainties, potential tax consequences, and high fees detract from the attractiveness of closed-end funds. At the same time, leverage can increase price volatility and the potential for loss of investment capital.

Popular ETFs and CEFs

As we look at income specific investments, note that the author has excluded some sectors previously discussed as inappropriate for our diversified portfolio. For example, the author has eliminated from the conversation: emerging market debt, convertible bonds, preferred stocks, some equity REITS (diversified REITs, self-storage REITs, data center REITs, infrastructure REITs, hotel & resort REITs, specialized REITs), mortgage REITs, real estate management & development, and non-traded REITs. We are left to review ETFs and CEFs for the sector and sub-sectors below:

Government Bonds – $EGF

Treasuries – $TLT
Municipal Bonds – $TFI, $MYD
Agency Bonds – $VMBS

Corporate Bonds – $BTZ

Investment Grade Bonds – $VCLT
High-Yield Bonds – $HYG, $JNK, $AWF

REITs – $VNQ, $REZ

Industrial REITs
Office REITs
Health Care REITs
Retail REITs
Residential REITs

Get the book What is Investment Diversification? for more detail on the Government Bond, Corporate Bond, and REIT portfolio selections and reasoning.

Portfolio Construction

Three primary income sectors were chosen to represent the income asset class: government bonds, corporate bonds, and REITs, with closed-end funds available as an investment in any of those three income sectors. One CEF and one ETF were discussed in each bond sector, with several CEFs chosen for the author’s watch list rather than immediate investment. One CEF and three stocks were chosen to represent the REIT sector.

Get the book What is Investment Diversification? to learn which investments were selected and why.

So, What’s the Point?

The lesson learned was that it is more important to diversify across assets classes than in an asset class, when the goal is risk management, minimized drawdown, capital preservation, and stable returns.

Next…

Now, let’s take a look at commodities in the next study guide.

Terminology

Agency Bond
A special category of government bond, with the issuer often representing a hybrid of government and private industry. Some issuers of agency bonds include the Government National Mortgage Association (Ginnie Mae) and Government-Sponsored Enterprises (GSEs) such as the Federal National Mortgage Association (Fannie Mae).

Bonds
A type of fixed-income security. A fixed-income security is a debt instrument which provides a return to the debt purchaser in the form of fixed, periodic payments and is issued by a government, corporation or other entity to finance and expand their operations.

Closed-End Fund (CEF)
Also known as a “closed-end investment” or “closed-end mutual fund”, is organized as a publicly traded investment company. Like a mutual fund, a closed-end fund is a pooled investment with a designated portfolio manager. A closed-end fund raises a fixed amount of capital through an initial public offering (IPO) and is structured, listed and then traded on a stock exchange.

Corporate Bond
Issued by either public or private corporations, are used to raise funds for a variety of reasons including but not limited to: building facilities, purchasing equipment, expanding operations, and M&A. Typically, a corporate bond is rated by Standard & Poor’s, Moody’s, and/or Fitch.

Emerging Market Debt
Bonds issued by foreign governments of regions classified as emerging market.

Equity REITs
Companies that aggregate real estate holdings into a single portfolio for ease of investment and also physically own and operate the properties in their portfolio. They are responsible for acquiring, managing, building, renovating, selling, and marketing the assets.

Government Bond
A relatively liquid debt security whose risk is tied directly to the credit worthiness of the issuing country or government.

Mortgage REITs
Company that provides real estate financing via mortgage loans and mortgage-backed securities, generating revenues from interest earned on lending activities. Specializing in lending rather than operations, mortgage REITs do not own any physical properties.

Municipal Bond
Issued by governments other than the U.S. federal government, such as U.S. states and local governments, also called municipalities, to fund projects such as schools, hospitals, roads, and bridges. The interest earned from these bonds is tax exempt at the federal level, and, in the case where an investor resides in the state where the bond is issued, the interest earned is tax exempt at the state and local level, as well.

Real Estate Investment Trust (REIT)
Company that owns and operates income-producing real estate assets. Essentially a real estate fund with special tax considerations, the REIT business entity allows the average investor an opportunity to take part in large-scale real estate operations, diversify one’s portfolio, produce a stable income stream, and seek investment total-return.

Real Estate Operating Companies (REOCs)
Companies engaged in the operation of real estate properties for the purpose of leasing and management. A real estate operating company is similar to a REIT, except that a REOC can reinvest its earnings back into the business rather than being required to distribute earnings to shareholders (remember that REITs payout 90% of earnings to shareholders).

Treasuries
Issued by the federal government to finance its budget deficits. Not only are Treasuries considered credit-risk free as they are backed by the full faith-and-credit of the U.S. government, they are also extremely liquid. There are additional tax benefits for U.S. residents, as well.

Zero Coupon Bonds
Issued at a discount to face value and do not make interest payments during the life of the bond (no coupons). Instead, interest is accumulated over years until the full face value of the bond is reached at maturity. At that point, the investor receives all interest income earned in one lump sum, although it should be noted that accrued interest income from zero coupon bonds is taxed annually as ordinary income.

Sources

SEC requirements for Real Estate Investment Trusts (REITs) https://www.sec.gov/fast-answers/answersreitshtm.html
Nareit REIT data https://www.reit.com/data-research
Closed-end fund characteristics https://www.aaii.com/journal/article/closed-end-bond-funds-versus-individual-bonds-a-case-study
U.S. yield curve inversion https://twitter.com/HayekAndKeynes/status/1108457115641958403
Health care REITs for 2019 https://seekingalpha.com/article/4230931-healthcare-reits-hope-2019
REITs by sector https://www.fool.com/investing/2018/08/15/your-complete-guide-to-reit-investing-for-beginner.aspx
A comparison of $VNQ and $RNP https://seekingalpha.com/article/3340305-choosing-the-best-reit-cef
$RNP holdings (dtd q3, 2018) https://seekingalpha.com/article/4205013-best-high-yield-reit-cef-growth-income-7_6-percent-yield
Commodities
Definition of an agricultural commodity, via Cornell Law School https://www.law.cornell.edu/cfr/text/17/1.3
Alternative Investments – CAIA Level 1, Wiley, 2012, by Donald Chambers, et all
Physical-gold ETFs https://seekingalpha.com/article/3825846-long-wrong-physically-backed-gold-etf
Cost of contango https://seekingalpha.com/article/4008985-cost-contango-daily-roll
Contango and backwardation http://tradinggods.net/what-is-vix/contango-and-backwardation/
History of gold https://briandcolwell.com/2019/02/a-brief-history-of-gold/.html
Gold facts https://briandcolwell.com/2019/02/interesting-facts-about-gold/.html
Gold royalties https://briandcolwell.com/2019/02/what-are-gold-royalties-streaming-companies/.html
Advantages of gold royalties and streaming https://briandcolwell.com/2019/03/advantages-of-gold-royalties-streaming/.html
Sandstorm Gold https://briandcolwell.com/2019/03/sandstorm-gold-mining-focused-vc/.html
Franco-Nevada https://briandcolwell.com/2019/03/franco-nevada-more-than-gold/.html
Complete history of oil https://briandcolwell.com/2019/02/a-complete-history-of-oil/.html
An article on coal carbon capture and sequestration (CCS) https://briandcolwell.com/2016/08/coal-part-5-carbon-capture-and-sequestration-ccs/.html
History of corn https://briandcolwell.com/2017/04/a-giant-sized-history-of-corn/.html
History of wheat https://briandcolwell.com/2017/04/a-giant-sized-history-of-wheat/.html
History of soybeans https://briandcolwell.com/2017/04/a-giant-sized-history-of-soybeans/.html
History of cannabis https://briandcolwell.com/2019/03/a-complete-history-of-cannabis/.html
Landrace cannabis strains https://briandcolwell.com/2019/03/all-about-landrace-cannabis-strains/.html
Copper facts https://briandcolwell.com/2017/02/the-big-list-of-things-you-might-not-know-about-copper/.html
Steel facts https://briandcolwell.com/2017/02/65-things-you-might-not-know-about-steel/.html
Iron ore facts https://briandcolwell.com/2017/02/21-things-you-might-not-know-about-iron/.html
Lithium facts https://briandcolwell.com/2017/02/21-things-you-might-not-know-about-iron/.html
Silver facts https://briandcolwell.com/2017/02/58-things-you-might-not-know-about-silver/.html
Platinum facts https://briandcolwell.com/2017/02/56-things-you-might-not-know-about-platinum/.html
Cobalt royalties and streaming https://briandcolwell.com/2017/07/cobalt-27-capital-corp-owning-the-future-of-energy/.html
Uranium facts https://briandcolwell.com/2017/02/41-things-you-might-not-know-about-uranium-nuclear-energy/.html