3 Years in 3 months Rule in a "Hypothetical" Bear Bond Market

[unaided]

Wanted to build off some concepts brought up in UNSCRIPTED ....

-"F*ck you" pot: cash you sit on so you can act on opportunities
-"Paycheck" pot: non-speculative cash earning you income at 5%
-Rent rule: demand rent on your capital, otherwise, don't speculate
-SNAP rule: be able to get your cash back with a snap of your finger.
-3 Years In 3 months Rule: If expected yield is 3%, and the stock price goes up 3x that rate (9%) in 3 months or less. Sell the stock and take your gains that would have otherwise taken 3 years to achieve.

ex./ stock A yields 3% and went from $100 a share to $109 per share within a 3 month period, you should sell.

Buyback guideline: 66% mean reversion. If the total change in stock price was $9...a 66% reversion to the mean would be $6.00 (66% of $9). You sell Stock A at $109 and sit on the cash. If Stock A then reverts $6.00 to $103, you may then wish to use that as a guideline to buy (rent out your capital) into the stock again.

I wanted to look at how these rules might work in a Bear market where prices are falling.

Interest rates are rising. This means that Bond prices fall in line with the average duration of the bond(s) held.

We've had two recent 0.25% rate increases (.5% total), Bond prices already priced in a full 1% rise (expected .25% in June and again in September), so a 10-year bond would have dropped 10% between September 2016 and March 2017.

It has been suggested that interest rates may climb an additional 2% (3% total) by the end of 2019. This means that while things are likely going to be stable through 2017, the same 10-year fund may see a principle drop of an additional 20% in the subsequent next 2 years (which is not yet priced in the market). If a yield on a 10-year bond is just at 3%, that's a lot of years to make if you already felt the 10% drop in principle and an additional 20% speculative drop that may be on the 2-3 year horizon.

Questions:

1.) All losses are unrealized until you actually sell, you can still receive the dividend you intended, and the price can still recover if interest rates swung back down....would an income investor just sit on those unrealized losses and take the "rental income" without worrying about taking some losses here and there? Or does the violate the SNAP rule since your principle would only be available to you at a loss?

Or would part of being the income investor say, well if I truly believe the culture has changed and higher interest rates are on the horizon....that I'll just sit on cash and wait until 2018-2019 to get back in?

Or do you sit on the loss...and just let the "F*ck you pot" fund any deals that may come up in 2018-2019.

2.) Can you reverse the "3 years in 3 months" rule (and 66% reversion to the mean guideline) to apply to minimizing losses?

For instance in the 3% yield example:

You buy stock A for $100 at expected yield of 3%, it drops 9% to $91. Would you then sell all shares to minimize further losses, and buy again if it dropped another $6 bucks to $85? (or raised another $6 to $97?)

Since income-investing is a newer concept to me. I just want to make sure I'm framing these decisions in the right way when it comes to an income-producing "paycheck pot" mentality.

1.) do you have a system to protect against losses (specifically rising interest rates and bonds)?
2.) do you just say "tough luck" and sit on the unrealized losses and take the income either way knowing that you can't pull that principle without realizing the loss? Re-invest with money from elsewhere ("F*ck you" pot/future invested dividends etc)
3.) Do you trust your research and sit on cash in these instances even though that decision is based on speculation and less on income?

 

Dislike ads? Remove them and support the forum: Subscribe to Fastlane Insiders.

[Leoto]

1.) do you have a system to protect against losses (specifically rising interest rates and bonds)?

Depending on circumstances, there are times when I buy protective put options on my income-generating positions. I especially like employing this strategy when my underlying position gains significantly.

For example, suppose I bought 100 shares of a particular stock at $100 per share and the stock pays $1.25 per share per quarter (5% annual yield). That's a $10,000 investment generating $500 per year. Now let's say the stock price increases to $110 per share. In that situation, I might take $1,000 off the table (by selling 9 shares), and use some of those proceeds to buy a protective put. If a put option with strike price of $100 and 1 year until expiration is selling for $4, then $400 of out of the $1,000 that I took off the table will go towards the purchase of the option and the remaining $600 would be a "bonus payout" for me. My annual income will decrease from $500 to $455 (since I now own 91 shares instead of 100), but I'm fine with that because of my $600 instant "bonus," which is more than a year's worth of dividend income, and the fact that I've eliminated all my downside risk for the upcoming year. Also, the stock price increase may have been a precursor to a dividend increase, in which case my annual income might actually not even go down, in spite of the fact that I own less shares.

That's just one example. Risk management is all about creativity

2.) do you just say "tough luck" and sit on the unrealized losses and take the income either way knowing that you can't pull that principle without realizing the loss? Re-invest with money from elsewhere ("F*ck you" pot/future invested dividends etc)

An unusual decline in an income-generating stock is often a sign that the market is questioning the sustainability of the income (the dividend may be too high relative to the company's free cash flow). Often what follows is a dividend cut, or worst case, an indefinite dividend suspension. I've been victim to this too many times. I try to monitor dividend-related ratios for all my positions every now and then, but a disorderly decline in the stock price is a red flag that gets me to review the company's financials immediately and more closely, and I will SNAP sell if something doesn't smell right.

3.) Do you trust your research and sit on cash in these instances even though that decision is based on speculation and less on income?

Sorry, I don't understand this question. :-/

 

[unaided]

Depending on circumstances, there are times when I buy protective put options on my income-generating positions. I especially like employing this strategy when my underlying position gains significantly.

For example, suppose I bought 100 shares of a particular stock at $100 per share and the stock pays $1.25 per share per quarter (5% annual yield). That's a $10,000 investment generating $500 per year. Now let's say the stock price increases to $110 per share. In that situation, I might take $1,000 off the table (by selling 9 shares), and use some of those proceeds to buy a protective put. If a put option with strike price of $100 and 1 year until expiration is selling for $4, then $400 of out of the $1,000 that I took off the table will go towards the purchase of the option and the remaining $600 would be a "bonus payout" for me. My annual income will decrease from $500 to $455 (since I now own 91 shares instead of 100), but I'm fine with that because of my $600 instant "bonus," which is more than a year's worth of dividend income, and the fact that I've eliminated all my downside risk for the upcoming year. Also, the stock price increase may have been a precursor to a dividend increase, in which case my annual income might actually not even go down, in spite of the fact that I own less shares.

That's just one example. Risk management is all about creativity



An unusual decline in an income-generating stock is often a sign that the market is questioning the sustainability of the income (the dividend may be too high relative to the company's free cash flow). Often what follows is a dividend cut, or worst case, an indefinite dividend suspension. I've been victim to this too many times. I try to monitor dividend-related ratios for all my positions every now and then, but a disorderly decline in the stock price is a red flag that gets me to review the company's financials immediately and more closely, and I will SNAP sell if something doesn't smell right.



Sorry, I don't understand this question. :-/

Thanks for the detailed reply -really helped to clear up what is meant by using options for insurance.

Now if the stock price goes down and the dividends seem to be going with....there are points where you want to stop the bleeding or speculate that the declines aren't over. What kind of triggers would have you clearing your positions?

So does this mean that you always have a put option on your high income positions? What triggers you to start/stop buying insurance so to speak?

I am still transitioning to an income mindset over a growth mindset.

I see dividends as easy to manipulate and hide rocky conditions for the company. I figure payout ratio gets equal footing for this reason.

I guess...by the time I notice it? Wouldnt bigger badder dividend investors have noticed it before me and sold?

Thinking out loud...looking at trading volume would give you an idea of how well you could get out at a reasonable price.

My fear is you have these 3 to 5% dividends on stocks that could drop 20% of principle on an interest rate change etc.....you need a lot of years to make up that principle loss.

What am I missing?

Sent from my SM-G930V using Tapatalk

 

[Leoto]

Thanks for the detailed reply -really helped to clear up what is meant by using options for insurance.

Now if the stock price goes down and the dividends seem to be going with....there are points where you want to stop the bleeding or speculate that the declines aren't over. What kind of triggers would have you clearing your positions?

Personally, I'm only interested in owning the creme de la creme. If dividends get cut or even just stagnate for too long, I close the position and roll the proceeds into my other holdings. Even if dividends have not (yet) stagnated or declined, it's not that difficult to foresee sustainability just by taking a quick look at the cash flow statements.

So does this mean that you always have a put option on your high income positions? What triggers you to start/stop buying insurance so to speak?

Macroeconomic analysis plays a big role here. For example, if I think that the overall market is underestimating prospective Fed hawkishness, I might be more inclined to put on protective puts. I know this sounds like an oxymoron, but when I "buy insurance," I'm actually speculating. I'm arrogantly placing a bet that I'm foreseeing the Fed's rate hike plans better than Mr. Market.

My fear is you have these 3 to 5% dividends on stocks that could drop 20% of principle on an interest rate change etc.....you need a lot of years to make up that principle loss.

I look at it a little differently. For example, if I own a rental property and I'm certain that my tenant will not move out and will keep paying me rent that increases each year for the rest of my life (hypothetically, for the sake of illustration), would I really care if the market value of the property dropped by 20% at any given time? I'm not in it for capital appreciation (or even capital preservation for that matter, in this hypothetical example). All I care about is that I get $X dollars every month, and the market value of the underlying instrument is irrelevant.

The caveat, however, is that the 20% drop in the stock value could be a SIGN that the dividends are not sustainable. In which case, I'll do my homework by diving into the financials and, as mentioned earlier, cut my position if the financials no longer pass my sniff test. Of course, it's better to do this more proactively, instead of waiting for a 20% decline

 

Dislike ads? Remove them and support the forum: Subscribe to Fastlane Insiders.

[unaided]

Thanks for the value-adds!

So it does come back to a degree of speculation, but you can do so with tools that don't involve constantly buying in/out en masse. You legitimately want to own your income-producers - not speculate in and out of them.

I've been using some of a "Rule #1" investing principles and playing with a portfolio that seeks to match Ray Dalio/David Swenson allocations as described by Tony Robbins' "Money" - met with 90% Vanguard ETF's.

But these are growth strategies, not income. Robbins basically pushes for buy and hold growth while being super strict on fees, and then quietly recommends annuities for guaranteed income - and then just happens to be partnered up with firms that he's vetted so to speak who will conveniently take care of it for you (annuities are quite profitable for those who run them). Still great advice for slowlaners I would think, but that's not why we're on this forum.

Dalio's "4 seasons" portfolio is actually criticized for not enough exposure to stocks, too much precious metals/commodities/TIPS/Bonds, but to me it sounds like an income strategy with some protections on inflation/growth. Income is always in season .

I'm trying to take that background and switch it to an income-creation standpoint, hence the questions - so again I appreciate your responses!

Now for the me, me, me discussion....(I'll keep it short)

My mortgage is $199K at 4.32% interest (~3.02% "tax adjusted"), it seems with yields the way they are, that I'm better served just paying off the house and building/reinvesting business income over anything else. I can get better, but 3.02% "true" return of paying down mortgage is guaranteed whereas anything else has some aspect of risk to it.

I'm "speculating" an additional 1-2% in interest rates through 2019, and so I want to stay away from 6-15+ year bond funds that might see 6-30% declines in the next 1-2 years while only offering true yields of 2-3%. Even short-term bonds will take a hit...they'll just take "less of a hit".

I "speculate" that bonds are overbought as investors haven't been able to sustain yields elsewhere (lots of stock buybacks at high P/E prices, projected GDP growth is much lower for the next decade, aging demographics who want income/70.5 year old Baby-boomers being forced to pull money from their IRAs).

There's TIPs, Floating rate bonds, emerging market bonds, currency speculation etc, but seems fair to me to just pay off debt, otherwise sit on cash and see what happens in 2018-2019.

A $200K mortgage seems worthy enough of an UNSCRIPTED target.