The High Income Factor

Income Strategies to
Triple Your Return
by Tom Hutchinson
A Special Report
2 Special Report
he world is changing fast.
For example, take the way I communicate. Just
a few years ago, I would talk on the phone, send
faxes, and write letters. Now I e-mail, text, and
use Skype for phone calls. I can’t remember the
last time I used my fax machine or even mailed
a check to pay my electric bill. (I use all online
banking.). Heck, I don’t even use my home phone.
The benefit to all these changes is that I have
more selection, I save more time, and I can get
everything done at a lower cost. The downside
is that it takes a little bit of time for me to get
equipped to handle all these changes.
My new phone, for example, is extremely
complicated for me. However, my 15-year-old son
was more than happy to show me how to use it.
Once I mastered all its tools, I couldn’t believe
how easy it was to access . . . well, everything.
My phone is a camera, a calendar, an Internet
portal, an alarm clock, a stopwatch, an organizer,
and a calculator. It even tells me the weather.
I play games, check my stocks, listen to music,
text, e-mail, and “instant message,” along with a
gazillion other things.
Investing also goes through changes. The
new strategies and increased selection ofered to
investors today, in general, are a good thing.
However, this market environment with ever-
increasing moving and complex parts requires
more sophisticated investments and strategies to
keep up.
What may appear at the surface to be a
confusing hassle are really opportunities that
modern-day markets ofer income investors
to generate a healthy stream of cash in any
interest rate environment.
There are never-before-seen
opportunities in fixed income because of
the volatile markets, ever-evolving financial
instruments, and the proliferation of
investment opportunities in virtually every
corner of the globe. Like figuring out how to
use my mobile phone, investors who master
these tools have access to a lot of unique
In any other period in history, these
would be tough times for income
investors. Fortunately, there are strategies
and investments that can enable you to get
a solid income in even the most challenging
environment. With all the changes the world goes
through, markets will have periods of extremely
challenging times. The next few years may prove
to be such a time.
Why Today’s Investment Environment Is
an Uphill Batle
Low Interest Rates
Interest rates are near historic lows, thanks
to the zero interest rate policy set by the Federal
Reserve System. These low rates mean that
safe investments, such as money markets, U.S.
Treasurys, and bonds, ofer insultingly low returns.
Here’s a look at the current rates ofered on
several conventional income investments.
• 10-year Treasury — 1.91 percent
• Three-year CD — 1.22 percent
• S&P 500 average dividend yield — 2.1 percent
• Investment-grade corporate bond index yield
— 4.54 percent
• AAA 10-year municipal bond — 3.8 percent
These yields are terrible. Except for corporate
and municipal bonds, these rates don’t even cover
the current rate of inflation. There’s a word for
that: insulting.
A Sideways Market
Pimco’s legendary bond investor Bill Gross,
among others, has forecasted a “new normal” for
the U.S. economy. This “new normal” (code for
lousy) will involve weak economic growth with
Source: DJIA
DJIA 1920-2009

1920 1940 1950 1960 1970 1980 1990 2000 2011
Between 1968 and 1980, the overall stock market stayed fat. Due to infaton,
the market actually hit a cyclical botom before shootng up in the 1980’s
Special Report 3
structural high rates of unemployment for years
to come. This forecast is not new, and it seems to
be coming true.
This scenario portends low interest rates
for the foreseeable future, as indicated by the
Fed’s recent statement to keep interest rates low
through mid-2013. The Fed wouldn’t dare raise
short-term rates with 9 percent unemployment
and an economy always teetering near the brink
of recession.
Meanwhile, the current economic
environment is creating a habitat for a sideways
stock market with upward and downward
pressures. On the upside, corporations are largely
posting healthy profits and the low interest rate
environment presents few alternatives for money
to go.
In short, the market looks like it may face a
prolonged period of “range trading,” akin to the
period between 1968 and 1980 when the stock
market went nowhere.
The Eroding Dollar
The souring fundamentals of the U.S.
economy are destroying the dollar. Debt and
deficits are spiraling out of control. To put things
in perspective, when the Sept. 11 attacks occurred
in 2001, the national debt was roughly $5.8
trillion. That much debt has been ratcheted-up
in just the last four years. Now the total is $14.7
trillion and climbing fast. Something has to be
done. But nothing is being done.
Meanwhile, trillions more dollars have been
pumped into the system in the last several years.
While all these extra dollars have not resulted in
significant inflation yet, the foundation is laid
for inflation to burst on to the scene in the years
ahead once banks start lending money out rather
than hoarding excess cash on their balance sheets.
These factors are causing the dollar to plunge
in value relative to other currencies. The U.S.
Dollar Index, which measures the dollar versus a
basket of major currencies, has lost 38 percent of
its value in the last decade and 8 percent just this
past year.
Between low interest rates, low growth rates,
and the willful destruction of the dollar, it’s clear
that investors today need a stable, secure way to
lock in high-yielding investments to win in this
challenging environment.
That’s why I’m sharing with you three key
strategies to maximize the value of your high-
income investments.
Three Strategies for High Income
Boost Your Returns With Leveraging Tools
The lever is one of six simple machines
designed to either exert a large force over a small
distance or a great force over a small distance.
Basically, a lever allows objects to be moved with
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Source: Yahoo Finance

$14.0 T —
$13.0 T —
$12.0 T —
$11.0 T —
$10.0 T —
$9.0 T —
$8.0 T —
$7.0 T —
$6.0 T —
$5.0 T —
$4.0 T —
$3.0T —
$2.0 T —
$1.0 T —
$0.0 T —


Natonal Debt from 1940 to Present
In the past 6 years alone, nearly
$6 trillion in new debt has been
Source: U.S. Natonal Debt Clock htp://
Total Government Debt Outstanding
US Dollar Index: Investors Have Lost Substantal
Purchasing Power in the Past Decade
4 Special Report
greater ease.
It’s not that diferent in finance. Leverage
is a term that’s used to describe any technique
that multiplies gains (and losses). For most
investments, leverage is borrowing money at low
short-term interest rates and using that money to
invest in higher-return investments, thus earning
additional money on “the spread.”
This process increases risk by amplifying
potential losses and also increases potential return
by amplifying potential gains. The primary risk to
using this type of leverage is rising interest rates
or, more specifically, rising short-term interest
However, the current environment is highly
Normally, interest
rates are very tricky
to predict beyond the
immediate or foreseeable
future — but these aren’t
normal times. Clarity
exists in the interest
rate environment that I
have never seem in my
The Fed has
announced that it will
keep short-term rates at
current levels until at
least mid-2013 — about
two years from now. Investors who know how to
use this unusual situation to their advantage have
a great opportunity to earn a high income and
maintain or even grow principle.
Here are a few ways to take advantage:
Closed-End Funds
Closed-end funds ofer some huge advantages
to income investors. First, you own a share of a
huge portfolio of securities, providing a level of
safety through diversification that you can’t easily
get yourself.
Second, funds have the resources and expertise
to scour the markets on a continuous basis for
the best opportunities. And finally, they have the
beautiful feature of ofen paying monthly, rather
than quarterly, dividends.
They also do something else — use leverage.
These funds ofen borrow money against their
assets (usually up to 35 or 40 percent) at low,
short-term interest rates and reinvest the money
in their higher-yielding securities, juicing the
distributions with extra income. The additional
spread earned enables investors to enjoy a higher
income than the regular portfolio generates.
Right now, there are 59 leveraged closed-end
funds paying distribution rates of 8 percent or
higher and 32 paying at least 9 percent. These
funds come in all diferent sectors including high
yield (junk bonds), preferred stock, international,
and tax free.
Even a relatively conservative closed-end fund
such as the Western Asset Premier Bond Fund
(NYSE: WEA) currently yields 8.45 percent from
a portfolio of primarily investment-grade rated
bonds. The fund has had an average annual return
of more than 11 percent per year for the last five
years. That’s a solid track record any conservative
investor can bank on.
And, as you can see on the one-year chart for
WEA, the share price trades within a relatively
narrow range (barring credit concerns over the
summer thanks to the debt-ceiling debacle).
Mortgage REITS
As the name implies, mortgage real estate
investment trusts invest in loans secured by pools
of mortgages rather than pure land. Now, many
people hear the word “mortgage” and run the
other way. Afer all, mortgages are what caused the
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Source: Yahoo! Inc.
Western Asset Premier Bond Fund (WEA): Narrow Price Range, 8.45% Yield
Special Report 5
financial crisis.
Of course, those were subprime mortgages.
Many mortgage REITs invest only in mortgages
guaranteed by U.S. government agencies (Fannie
Mae, Freddie Mac, Ginnie Mae). Since the
government has taken over the organizations, they
are essentially obligations of the U.S. government
with essentially zero credit risk.
Real estate investment trusts enjoy a huge tax
advantage that enables them to pay much higher
dividends than regular companies. They pay zero
income tax at the corporate level provided that 90
percent of net income is paid out in dividends. So
money normally lost to taxes is available to pay
higher dividends.
But mortgage REITs pay huge dividends even
for REITs. That’s because in addition to the tax
advantage, mortgage REITs use leverage more than
any other securities on the market. The business
plan is simply to borrow money at low short-
term rates and reinvest that money in longer-term
higher-paying mortgages, earning profits from the
(These REITs also raise money issuing new
shares of stock.)
In this space, American Capital Agency
Corp. (NASDAQ: AGNC) is a mortgage REIT
established in 2008 that invests exclusively
in mortgage securities guaranteed by U.S.
government agencies (Fannie Mae, Freddie Mac,
Ginnie Mae). The REIT is managed by an afliate
of global asset manager and private equity firm
American Capital Ltd. (NASDAQ: ACAS).
The business plan is pretty simple. As I’ve
outlined above, the company borrows money at
low short-term rates and invests the money in
higher-paying long-term mortgage securities. Low
short-term rates are the engine that drives profits.
The REIT also raises money by issuing new
shares in the capital markets and investing that
money, with essentially zero cost, in the mortgage
AGNC has been successful at earning enough
with the newly raised money to maintain the
existing dividend for its newly created shares.
Currently, AGNC’s portfolio consists of 88
percent fixed-rate mortgages (49 percent 15-year,
4 percent 20-year, 34 percent 30-year) and 12
percent adjustable-rate mortgages.
In the most recent quarter, the REIT reported
a cost of funds of 0.89 percent and a portfolio
yield of 3.35 percent, for a spread of 2.46
percent, down slightly from last quarter but up
significantly from the year-ago quarter.
This REIT pays an absolutely amazing
dividend that seems too good to be true. Because
of the tax benefit, REITS generally pay a much
higher dividend than regular stocks. But AGNC’s
dividend is stratospheric. AGNC has paid a
quarterly dividend of $1.40 since late 2009. That
translates to $5.60 per share, a staggering 20
percent yield at today’s price ($5.60/$27.80).
Now comes the million-dollar question: Is the
dividend safe?
Since AGNC invests only in securities that are
guaranteed by the U.S. government, the main risk
is with interest rates. The business model works as
long as short rates are lower than long rates, the
bigger the diference the higher the profit. Today’s
short rates enable AGNC to borrow money for
virtually nothing (0.89 percent average costs) and
enjoy the bounty of the spread.
Obviously, rising short-term rates would
narrow the spread, reduce profits, and sink the
dividend and stock price. However, since the Fed
has announced that short-term rates will remain
at or near historic lows until at least mid-2013,
AGNC’s main risk has been all but eliminated in
the near term.
The other risk is something called prepayment
risk. Borrowers prepay mortgages when mortgage
rates fall so they can enjoy lower payments for the
remainder of the mortgage. However, for a holder
of mortgages (like AGNC), a prepaid mortgage
must be reinvested at lower rates, thus reducing
the spread and profits.
This prepayment risk appears to be mitigating,
as well. Mortgage rates are near record lows, with
little room to fall. At this point, mortgage rates
have a better chance of rising than falling in the
months and years ahead.
As well, AGNC has changed the portfolio over
the past year toward lower-paying mortgages that
have favorable prepayment attributes and less
prepayment risk.
In fact, AGNC reported falling prepayment
6 Special Report
rates in the last quarterly
earnings report. The
second quarter constant
prepayment rate, which
reflects the percentage
of the portfolio likely
to be prepaid over the
course of a year, fell to 9
percent from 13 percent
in the first quarter and 20
percent in the year-ago
quarter. It’s still falling,
too, as July’s annualized prepayment rate was
reported at 8 percent.
AGNC, as well as other mortgage REITs,
will get clobbered in a rising rate environment.
However, given the unusual degree of certainty
on the interest rate front that currently exists,
the company should remain profitable and the
dividend should remain safe for the next few
years. As with other high-income investments,
AGNC has traded in a narrow range. It’s a stock to
own for its massive yield, not capital appreciation.
AGNC is a great way to pick up yield and
income in a low-rate environment with the more
speculative portion of an income portfolio. It’s an
easy way to employ leverage and take advantage of
the Fed’s zero interest rate policy.
Covered-Call Writing
Covered-call writing is a simple strategy that
can boost income. Why? Because it’s another form
of leverage to magnify gains and losses. Here’s a
brief rundown:
A call is an option to buy a stock at a certain
price at a certain date in the future. It is generally
a bet that the price of the stock will go up.
Buying a call is highly speculative because
there is a good chance the stock will not rise
to meet the price and the option will expire
worthless. When that happens, you lose 100
percent of your investment.
However, selling (or “writing”) a call when
you own the underlying stock, aka covered-call
writing, is a very conservative options strategy.
Here’s how it works:
Let’s say you own 1000 shares of a $30 stock.
You write (sell) 10 calls (each call represents 100
shares) at a strike price of $34 expiring three
months from now for $3 each or $3,000.
The stock price must rise above $34 for the
option to be in-the-money, otherwise it expires
worthless. Whatever happens, you keep the $3
premium. One of three things will happen:
• The stock trades flat (below $34) — In this
case, as the writer of the option, the options will
expire worthless and you will simply keep the
$3,000 premium, supplementing your income.
• The stock price falls — The options expire
worthless and you keep the premium. Although
the price is down, you outperform the stock by
the amount of the premium collected.
• The stock rises above $34 — The option is
exercised, capping your upside in the stock at
$34, plus the $3 option premium.
Covered-call writing works best with a stock
that you would be happy to continue owning over
the longer term. However, in the short term, you
believe the stock will trade flat to down. You can
generate income from the stock with the options
premium. If the stock does rise above the strike
price, you lose the stock.
So you should be willing to sacrifice some
capital appreciation potential for extra income in
the short term. For tax purposes, this premium
is considered a reduction of your cost basis on
the shares. So any taxes from covered-call writing
will be reflected in capital gains from the sale of a
stock rather than the lower tax rate on dividends.
If you’re an investor who doesn’t want to deal
with options strategies on your own, you can still
use the strategy. An easy way to take advantage of
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Source: Yahoo! Inc.
American Capital Agency Corp (AGNC): Phenominal 20% Yield!
Special Report 7
this technique is with funds and exchange-traded
funds that employ covered-call writing. And with
these funds can you the strategy on a larger scale
than you ever could as an individual investor.
The funds basically seek to generate higher
income at the expense of capital appreciation
— a great strategy for a sideways market. As an
additional bonus, market volatility makes the
strategy even better because option premiums
This market has also been quite volatile lately,
giving options a better premium for generating
income. Here’s one top fund that pays a double-
digit dividend yield with a covered-call strategy:
BlackRock Enhanced Capital and Income
Fund (NYSE: CII)
This closed-end fund seeks to provide a high
level of current income by writing covered calls
on 60 to 70 percent of a diversified portfolio of
primarily large-capitalization value domestic
stocks. CII also has an objective of capital
appreciation on its shares.
As of June 30, 2011,
top sector holdings
included financials (15.7
percent), information
technology (13.2 percent),
and health care (13.1
percent). The fund held
about 48 positions in
individual company stocks
(as of April 30, 2011), and
top holdings included
the third largest U.S.
telecom provider CenturyLink Inc. (NYSE: CTL),
health-care giant Bristol-Myers Squibb (NYSE:
BMY), and integrated oil major Chevron Corp.
(NYSE: CVX). In fact, more than 90 percent of the
holdings were large companies.
The fund employs a managed or level
distribution plan by which its strategy to maintain
the same distribution for long periods.
CII currently pays $0.36 per share on a
quarterly basis, translating to a huge 11.7 percent
yield at today’s price. However, the quarterly
distribution was cut to $0.36 per share from
$0.485, which had been paid since mid-2007.
The fund had maintained its high dividend
through the financial crisis and into 2010.
However, with the lower level of stock volatility, it
was increasingly difcult to maintain the options
Rather than pay shareholders higher levels of
return of capital in the distributions, it cut the
payments to a level that should be much more
easily sustainable in the current environment.
That’s led to a sagging share price, which in turn
has ironically helped prop up CII’s yield.
Distribution cuts are never received well in the
market, and CII’s price plummeted following the
announcement of the cut, from $15.60 per share
at the end of May to a low of $10.84 in August
However, I believe the distribution is far more
secure going forward and the reduction in price
also has increased the yield. The market seems to
agree because the price has already moved up 13
percent from its August lows.
CII has had a consistent record of
outperforming its covered-call fund peers in
three- and five-year periods. It is currently rated
five stars and considered one of the best funds
of its type by Morningstar. Also, it has one of the
lowest expense ratios (0.90 percent).
Given the timeliness of the strategy, the recent
reduction in price, and the more secure level of
future distributions; CII is an excellent holding
for income-oriented investors.
Dollar Diversification
Given future prospects and the U.S. dollar’s
long history of decline, it is only prudent to
diversify some of your assets and income away
from the dollar. There are several ways to do this

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Source: Yahoo! Inc.
BlackRock Enhanced Capital and Income Fund (CII): A Levered Play on Bonds
8 Special Report
and get income.
One is by investing in funds or ETFs that buy
debt and equities in foreign countries. Another is
to simply purchase U.S. multinational companies
that generate a significant amount of revenue in
foreign currencies. But perhaps the most direct
way is to purchase stock of foreign companies.
There are an ever-increasing number
of individual stocks that trade as American
depositary receipts on U.S. exchanges that pay
dividends in dollars afer converting them from
the foreign currency. These dividends will rise
and fall in dollar terms depending on the dollar’s
valuation relative to that currency.
A solid foreign company that pays a strong
dividend can provide high regular income and
protect your income stream from the falling value
of the dollar at the same time. In this space, I’ve
found that one of the top titans in this category is
down south in Brazil.
CPFL Energia SA (NYSE: CPL): Brazilian
Utility Giant
This Brazilian utility giant is one of the
largest companies in South America with a 13
percent share of Brazil’s power distribution market.
CPFL serves 6.4 million customers concentrated in
the afuent southern states of São
Paulo and Rio Grande do Sul.
The Brazilian economy is on
the fast track. Latin America’s
biggest economy (and the fifh
largest in the world) is accelerating
at the fastest pace of all emerging
markets. Unlike most emerging
markets, Brazil’s economy is largely
driven by domestic consumption
fueled by the country’s rising
middle class, which now accounts
for more than half its 190 million
population by some accounts.
The fact that it has a surplus
of energy and agricultural
commodities to export to other
fast-growing countries helps, too.
Earnings growth for CPFL
is tied to increases in the overall
energy usage resulting from
a growing national economy, as well as some
shrewd acquisitions. Brazil is the fifh largest
country in the world by area and population and
one of the fastest-growing emerging markets.
CPFL is in an ideal position to benefit
from the growth trend because it has a virtual
monopoly in some of the most afuent areas in
CPFL pays a semiannual dividend in May
and October. Dividends over the past year have
totaled $1.57 per share. Dividends are tied to
earnings growth. The company has a stated policy
of paying out at least 50 percent of adjusted net
earnings in dividends. Fortunately, dividends have
been growing like crazy, from $0.16 per year in
2005 to $1.57 this past year.
There is no withholding tax on dividends.
Payments are made in Brazilian reals and
converted to U.S. dollars, therefore dividends are
strongly tied to the value of the real versus the U.S.
dollar. This dividend will increase or decrease in
dollar terms depending on this relationship.
While there can always be volatility in the
short term, the strong Brazilian economy is likely
to increase the value of its currency over time.
Take a look at the dollar’s valuation versus the real
in the past 10 years:
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
U.S. Dollar/Brazilian Real: Long Term Gains for
Patent Investors Down South
Special Report 9
Don’t let the falling chart fool you. In currency terms, this chart is
showing the U.S. dollar declining relative to the Brazilian real. That means
American investors will get an extra boost to their income by investing in
CPFL because a strengthening real will pay more dollars in dividends, even
if the dividend is never increased.
Times change fast, and your investment strategies need to change with
them. There’s more to investing now than a quick trade or a “buy and hold”
There are never-before-seen opportunities in fixed income because of the
volatile markets, ever-evolving financial instruments, and the proliferation
of investment opportunities in virtually every corner of the globe.
Although the brave new world may be full of new complications, it
also empowers investors to generate a strong income under just about any
circumstances. And these new ways of generating income couldn’t come at
a better time in today’s low-yield environment.
As much at things change, some things stay the same. The need
for income is one. And while this brave new world may have more
opportunities, politicians and central bankers certainly aren’t making things
any easier for investors with record-low interest rates.
With sound leverage, covered-call writing, and currency diversification,
however, investors today are well-primed to generate high income through
whatever market turmoil may lie ahead.
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High Income Factor
About Tom Hutchinson
I’ve worked in fnance my entre career, from the back ofce of
a Wall Street frm to the foor of the New York Mercantle Exchange
learning how markets work. Eventually, I became a fnancial
adviser where I met with thousands of investors and managed the
portolio of hundreds over the course of about 15 years.
I lef my career as a fnancial adviser, writng for The Motley Fool as well as Street
Authority LLC, researching companies, industries, and markets.
In The High Income Factor, I can bring you the full beneft of my years of
investng experience.