Retirement: The Power Of Compounding

Co-authored with “Hidden Opportunities.”

Everything around us is increasingly getting automated. It all started in the 16th Century when all labor was manual. William Lee proposed mechanizing as a part of stocking production, making it quicker and cheaper than the traditional method. Automation penetrated automobile manufacturing in the 20th Century with Fiat showcasing the Strada – hand built by robots, and the rest is history. Today, we self-checkout at the grocery store, place orders at McDonald’s Corporation (MCD), and get someone to drive us around by tapping our fingers on screens. As artificial intelligence, or AI, becomes more advanced, our imaginations today probably only cover 1/10th of the potential automation of the future.

Automation is efficient, easy, and powerful and can be employed on your investments too. Dividend reinvestment is a powerful tool that you can use when you don’t need the income. Use your dividends to buy more shares, which in turn will provide you additional income! The power of compounding can grow your income at an amazing rate. A portfolio yielding an average of 8%, reinvesting the dividends at an average of an 8% yield, will double its income production every 10 years. That is before accounting for any new money added.

Generating a reliable and livable income stream in retirement isn’t challenging; the earlier you begin, the easier it gets. That is the power of compounding. Let’s discuss two +7% yields to put this into action.

Pick #1: UTF – Yield 8.8%

Infrastructure assets form the backbone of modern society. This sector provides a wide range of services from energy distribution, managing waste, and enabling mobility through roads and airports, offering the essentials for everyday life.

Infrastructure companies maintain their profitability through thick and thin and share these profits with shareholders. We like the dividend stewardship from the sector and protect ourselves from the geographic and regulatory risks of individual companies through diversification.

Cohen & Steers Infrastructure Fund (UTF) is a closed-end fund, or CEF, diversified across 250 holdings. The fund’s top holdings are highly stable businesses with tremendous competitive advantages in their respective domains. Source.

UTF pays monthly distributions of $0.155/share. This calculates to a solid 8.8% yield. The fund trades at a bargain ~6% discount to NAV, making it an excellent opportunity to add during this market uncertainty.

As of December 2022, UTF operated with a 29% leverage, with 85% of its borrowings carrying a fixed 1.9% interest rate and a 3.5-year average term. The fund’s variable rate debt has a 5.2% weighted average rate. Realistically, it would be impossible for individual investors to leverage their portfolios at such low rates. Despite the unreliability of their words and actions, the Fed is close to the end of its hawkish pursuit. Leveraged funds composed of mission-critical assets like UTF are well-positioned to benefit from the Fed pause/pivot.

$10,000 invested in UTF at its inception would have produced over $16,000 in distributions to date, and investors will continue to sit on an equity position valued at ~12,000.

The Biden Administration has funded 32,000 projects totaling $220 billion in planned spending towards repairs of roadways and bridges, airport upgrades, railroad expansion, and broadband enhancements. There are billions allocated to increased resilience of the electric grid. UTF’s portfolio companies will receive substantial government dollars to expand and modernize their asset base, further enhancing their monetization potential.

UTF is a fund built with assets that provide essential services. The demand for this sector will largely remain unaffected by economic downturns and recession pressures. We will sit back and watch the rebuilding of the American infrastructure while collecting 8.8% yields.

Pick #2: DFP – Yield 7.6%

A balanced diet is necessary because it supplies the essential nutrients to the human body to stay healthy and function effectively. Such a balanced diet will usually include vitamins, minerals, carbohydrates, proteins, and fats. While these nutrients each provide unique benefits for your health and well-being, they must be consumed in a balanced proportion based on age, physical activity level, and other considerations. A 100% protein diet is as dangerous as having one composed of only fats.

Similarly, in our pursuit to be prepared for any economic event, we are maintaining a rate-agnostic portfolio with a healthy balance of securities that can produce sustainable distributions during high and low-interest environments.

In this rising rate, some securities are bound to struggle to maintain their distributions. Flaherty & Crumrine Dynamic Preferred and Income Fund (DFP) is one such black sheep in the HDO portfolio. But such securities are essential to maintain portfolio balance due to the need to be prepared for a changing interest rate cycle. Getting rid of securities like DFP is as good as eliminating fats altogether from your diet – it creates an imbalance, and you will be poorly prepared for a shift in the rate cycle.

DFP is a CEF with a heavy emphasis on current income from preferred securities of banking and insurance companies. These industries represent almost ~80% of the fund’s holdings.

This rising rate cycle has caused 2022 to be the worst year for fixed-income securities. Not only has the ~40% leveraged fund been affected by rising rates, but the banking sector took a massive hit in March following the collapse of three banks.

DFP has faced multiple headwinds, forcing the fund to reduce its distributions to maintain overall health. Notably, DFP has 201 holdings, making it highly diversified in this currently troubled sector. Regional bank stocks are floundering amid widespread fear about the banking sector’s stability. However, most will survive, and a diversified fund allows a risk-adjusted exposure to benefit from the sector recovery.

Long-term investors can earn high income with moderate interest rate risk and good credit quality by investing in preferred and contingent capital securities today as they wait for better days ahead. – Flaherty & Crumrine Economic Update, February 2023.

DFP has cut its distribution six times since 2021, which isn’t a confidence builder for investors. However, the fund continued to pay special distributions through realized capital gains. We believe the fund has better days ahead as we are almost at the end of the rate increases. DFP is well-positioned to participate in recovery and carries the potential for distribution raises in the new cycle.

The CEF trades at a 9% discount to NAV and represents an attractive valuation to lock in an income-oriented and beaten-up sector. Almost 30% of the fund is composed of large banks, which are likely to emerge as big winners after scooping up the failed institutions at pennies on the dollar. Source.

Flaherty & Crumrine is one of the oldest and most experienced firms that specialize in the management of preferred securities. Despite varying distributions, a $10,000 investment in DFP during its 2013 IPO would have produced $917 in average annual income. We expect the fund manager to pursue an active strategy to pick winning securities and help protect our income when yields are scarce.

Your diet can’t be only custard; it must have some broccoli too. It may be distasteful for some, but it adds much value to your well-being over the long term. Similarly, DFP may be painful to buy and hold now. Still, the fund is well-positioned to reward shareholders over the long term because rates and economic parameters are not as predictable as the pundits claim.

Conclusion

A dividend strategy is built on the principles of the power of compounding to define and enhance your portfolio. It is a timeless technique that works in bull and bear markets and is suitable for investors of all ages. Most importantly, it is effective automation you should utilize to build your income. The sooner you begin, the faster you can create a living income stream.

“Life is like a snowball, all you need is wet snow and a really long hill” – Warren Buffett.

At High Dividend Opportunities, we recommend reinvesting at least 25% of your dividend income to compound your returns over time and maintain your standard of living against rising prices. Our model portfolio emphasizes diversification across industry sectors and security classes and has 45+ securities. We hold BDCs, REITs, CEFs, ETFs, MLPs, C-Corps, royalty interests, and preferred securities, and our portfolio carries a +9% overall yield.

This fearful market provides the best opportunity to start rolling snowballs and see the power of compounding in action. We discussed two +7% yields to get your income flowing – what are you waiting for?