Strategy Meeting Key Points Column (Originally Published on June 21, 2012)

Please note current holdings and new positions to the Yield Portfolio are published to the weekly Strategy Meeting Key Points column, an exclusive feature of Briefing In Play Plus.

In my time as an active market participant the past fifteen years, I have developed two distinct styles: one is that of intraday trader; the other is as a yield-focused investor/speculator. The trader role requires constantly being in front of the market, applying fundamental and technical analysts and keeping on top of a variety of industry groups. The yield side of things mostly requires that I read prospectuses, understand the structure of each security and maintain a sense of what constitutes an attractive relative yield on a risk-adjusted basis. It certainly requires a certain aptitude, but relative to the wear and tear of trading, it is a cakewalk.

I consider trading “working hard” and yield investing “working smart.” Knowledge of the yield space also provides me periodic opportunity to catch a fat pitch, such as the Preferred Stock I bought earlier this year for about a 50% one-day gain (it actually rose over 100%, but I sold it at a price I considered to be “fair value.”)

In this report I will provide insight into several positions in my Yield Portfolio. The goal is to give you an introduction into “higher yield” investing and an understanding of how I go about building a yield portfolio. I’m not talking the .125% per month in income you might take in from a 10-yr Treasury or the 2-3% per year collected from corporate bonds. Current positions in my Yield portfolio generate a minimum yield of 6.625%, all the way up to 16%.

The 6.625% yielder is my highest-rated, most stable holding. It’s also very attractive because of the unusual feature of paying a monthly dividend. I use this position for “cash management.” It certainly beats the 0.1% my money market account pays.

I am a proponent of using cash management strategies to help diversify trading income streams. This is an environment in which money market yields are sub-0.5% and look to stay there for some time. Paying attention to the capital optimization piece of the portfolio can mean a difference in thousands, if not tens-of-thousands, of relatively passive income that can flow for years to come. I say "relatively passive" because this is not a no-risk proposition. The goal is to find high quality paper that kicks off a strong enough yield that it should continue to remain attractive to investors even in the early stages of rising rates.

Realty Income 6.625% Class F Cumulative Preferred (O/prF 26.60) is a name I added to the Yield Portfolio in February at $25.00 as a “cash management” position. This is a security of Realty Income (O), a commercial retail REIT (O leases property to national retail chains usually under 15-20 year deals) that has paid 504 consecutive monthly dividends throughout its 43 year operating history and that has increased its dividend 66 times since 1994.

One of the big things I pay attention to when looking for conservative yield opportunities is the Earnings to Fixed Cost Coverage, including Preferred payments (this information usually can be found in the offering prospectus). I'm comfortable at 1.5x (these days you'll actually see coverage ratios of less than 1x, which means companies are essentially borrowing or issuing stock to meet interest payments). In the case of the O/prF, the coverage ratio is approx 1.9x. This type of coverage means that the company would have to experience many quarters of adverse operating conditions before it faced any type of difficulty meeting its interest obligations. This would provide plenty of time for anyone even remotely active in the markets to take notice.

Unlike a money market account, there is a chance of loss. During market routs (when investors are blindly selling securities out of fear/panic), you could see a name like this shake out to the $23.50-$24.00 area. While I would expect it to rebound within days to the $25 par area, there are no guarantees. A feature I like about this security is that it pays monthly, which is unusual in the Preferred Stock space, but welcomed by yield investors. The monthly payment should also help limit volatility of the security.

Since purchasing it in February, the security has paid us four monthly dividends and has provided capital appreciation of approximately 6.4%. This is a name I’ll probably hold onto for several years, given that new paper has been coming to market 0.75-1.00 percentage points lower than the 6.625% coupon offered by O/prF (this is the relative value analysis that goes into yield investing).

*The ticker nomenclature of Preferred Securities varies based on the broker/data source you are using. For example, on Yahoo Finance, this security would be listed under O-PF. On Esignal, it is O/PF. Some brokers list it as O/prF. “O” is the base ticker (which is the ticker of the parent company) and “F” is the series.

KKR Financial Holdings LLC 8.375% Senior Notes (KFH 27.03). This is a name I purchased in January at $25.20, which represented an 8.3% yield based on the $2.09 annual payout. This was a $225 mln offering done back in November when markets were just coming off a period of heightened volatility. KKR Financial is an affiliate of private equity firm KKR & Co (KKR). The company focuses on investing in bank loans and high yield securities, mezzanine, special situations, natural resources, commercial real estate and private equity.

I passed on this offering when it priced in November 2011. However, the improving Economic data caused me to revisit the Recent Offerings calendar to see if I could find some overlooked opportunities. KFH jumped out at me.

I felt that an improving U.S. economic outlook should be great for their portfolio. But what I really liked was the company's Ratio of Earnings to Fixed Costs. As noted previously, coverage of 1.5x grabs my interest. However, in this case, the coverage was 2.8x, which would mean that this company would have to suffer a dramatic turn of events for them not to have sufficient profits to meet their interest payments. A Fixed Cost Coverage Ratio of almost 3x is almost unheard of for a security sporting such an attractive Relative Yield.

The relative value of this name was further confirmed in March when KKR Financial issued almost identical Senior Notes (KFI) at a 7.5% coupon vs the 8.375% rate they issued Notes in November.

The KFH position was put on in the low-$25s based on the attractive relative yield to the market and strong coverage ratio. My view was that security was mispriced due to timing of the offering (Nov 2011), as markets were still on edge due to sovereign debt woes in Europe. As market conditions improved, KKR Financial was able to issue identical paper at almost a full percentage point lower.

As the table illustrates, even after appreciating 8% from par, KFH still offers a more attractive yield than the security issued a few months later.

Over the past several weeks, I’ve started scaling into SandRidge Permian Trust (PER 18.57) as a dividend relative value trade. What distinguishes PER from other commodities-focused trusts is that it has approximately three-quarters of its overall Oil/Nat Gas production hedged through 2015.

SandRidge Permian Trust is ramping its production profile in a way that should lead to steadily increasing distributions. The target distribution for 2012 is $2.28, equating to a yield of 12.2%. The 2013 target distribution is $2.73 (yield 14.7%); 2014 target distribution is $3.19 (yield 17.1%) and 2015 target distribution is $2.95 (yield 15.8%). After peaking in 2014, the target distribution dips in 2015 and continues to decline in 2016 to $2.59, or a 13.9% yield.

Since its IPO last August at $18.00 a share, PER has been outperforming its target distribution. The strong performance has led RBC Capital Markets to set its distribution estimates well above the base levels the company set when it went public. For 2013, 2014 and 2015, RBC is projecting distributions of $3.34, $3.88 and $3.26. These projections equate to yields of 18.0%, 20.8% and 17.6%.

Specifically, SandRidge Permian Trust (PER) owns perpetual royalty interests in certain of SandRidge Energy's (SD) properties in the Permian Basin in Andrews County, Texas. These royalty interests entitle the Trust to receive, after the deduction of certain costs, (a) 80% of the proceeds attributable to SandRidge's net revenue interest in the sale of production from 509 producing wells and (b) 70% of the proceeds attributable to SandRidge's net revenue interest in the sale of production from 888 development wells to be drilled on drilling locations included within an area of mutual interest consisting of approx 16,800 gross acres (15,900 net acres) held by SandRidge (SD). As of March 31, 2011, the total reserves estimated to be attributable to the Trust were 21.8 mln barrels of oil equivalent.

The reserves consist of 96% liquids (87% oil and 9% natural gas liquids) and 4% natural gas. The Trust is not responsible for any costs related to the drilling of the development wells. Approximately 73% of the Trust's expected production and approx 79% of the expected revenues upon which the target distributions are based from August 1, 2011 through March 31, 2015 are hedged. Expressed in terms of Oil production alone, approx 84% of the estimated oil production from August 1, 2011 through March 31, 2015 is hedged.

As shown in the table below, production is a more important piece of the distribution story than Oil prices, as a result of the hedges that are in place. For example, if Oil prices were to come in at 85% of the hedged price, the distribution would remain at $0.55. However, if production came in at 85% of projected levels, the distribution would fall to $0.47 vs the $0.55 target distribution. So far, production has been coming in above estimates, which is why RBC's estimates are well above PER's base-case distribution outlook.

Drilling risk and commodities price exposure make Royalty Trusts a higher risk proposition than most Preferreds and Senior Notes. However, with potential yields in the mid-teens and reduced commodities price exposure due to the hedges, my expectation is that this will be one of the first names investors come back to in the group as markets settle down. Earlier in the year in the Yield Portfolio, we traded a similar type of name (Rentech Nitrogen Partners, RNF) for a 25% gain over three weeks after buying it at a 13% yield equivalent. The plan was to hold for several months, but my fair value target was hit so it was sold.

Current holdings and new positions to the Yield Portfolio are published on Briefing.com’s Strategy Meeting Key Points page.

--Damon Southward, Chief Market Strategist