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How Income Investors Can Prosper in 2015

2015 will be different from 2014 because of one crucial reason: the recent collapse of oil prices.

Consequently, the returns from once-favored income shelters, particularly energy master limited partnerships (MLPs), are highly uncertain.

In addition, it now seems that Janet Yellen’s merry men at the Fed will pluck up the courage to raise interest rates, which, after being at zero for seven years, ought to cause a few ructions in the market.

As income investors seeking solid dividends and a quiet life, we therefore need to reassess our portfolios for the New Year.

Economically, the track for 2015 is fairly well established.

Oil prices have crashed, and the effects will work their way through the global economy. Prices are unlikely to recover much in 2015, and could decline even further, though probably not for long.

Meanwhile, the Fed will raise interest rates, but probably very slowly, and not until at least April. The U.S. and global economies will continue expanding at a satisfactory rate, at least for the first half of the year. There’s some chance of trouble in the second half.

Oil Prices Have Changed Our Strategy

In the energy sector, MLPs with oil reserves are in trouble. However, this will be disguised initially by the massive hedging programs that most production MLPs undertake, which allow them to report huge profits on their derivatives positions even as prices decline. Linn Energy’s (LINE) best quarter ever, for example, was the last quarter of 2008, when prices fell like a rock.

Thus, in spite of some crazy accounting, the reality is clear: The value of these companies’ reserves has just fallen sharply, and once their derivatives portfolios have run off, their cash flows will crash, as well. Since they have a habit of paying dividends out of cash flow, their dividends will follow suit.

Conversely, refineries will do well in an environment of lower prices (because volumes will increase) and especially well when oil prices are in decline, because margins will also increase. Refinery MLPs such as Northern Tier Energy LP (NTI) should pay out extra-juicy dividends for the fourth quarter, declared in February. NTI currently has a yield of 18.1%, based on the past four dividends, so income seekers invested in this one could enjoy a bountiful early spring.

Elsewhere, commentators are still rather negative on Europe, which makes no sense since Europe is the major beneficiary of lower oil prices – it imports 88% of the oil it consumes!

In addition, consumer goods companies should benefit from the extra money flowing into consumers’ pockets, while makers of large automobiles should benefit from a renewed thirst for gas guzzlers.

That makes Daimler AG (DDAIF) the beneficiary of a triple whammy, being a German manufacturer of large, powerful automobiles and trucks. As I mentioned last week, DDAIF benefits from a 3.7% yield and trades at a 9.7x forward P/E.

How Will Interest Rates Affect Us?

The other “megatrend” I see in 2015 – the slow rise in interest rates – should turn us off of mezzanine finance companies, which make their money by investing in junior debt and preferred stock of small- and medium-sized companies.

Even if it’s delayed, the rise in interest rates will make it more expensive for these companies to finance themselves.

Plus, in this part of the credit cycle – when the economy is close to a peak – lenders are exceptionally aggressive. Business is scarce, and borrowers’ valuations and business plans are exceptionally optimistic. You may not see the result of this fully in 2015, but in 2016, mezzanine loans will start to go sour in large numbers, affecting the asset value of these leveraged entities.

Thus, even the most solid mezzanine finance company, such as BlackRock Kelso Capital Corporation (BKCC), is riskier than it was earlier in the cycle and should be avoided.

The rise in interest rates is even more dangerous to residential mortgage real estate investment trusts (REITs), such as Annaly Capital Management (NLY), which invest in fixed-rate residential mortgages on a leveraged basis. They lose twice, because their income declines when the “spread” between short-term and long-term interest rates rises, and their capital value declines when long-term interest rates follow short-term rates upwards.

On the other hand, commercial mortgage REITs don’t have so much interest rate mismatch (because most of their mortgages are at floating rates). That means companies like Resource Capital (RSO), which currently sports a 15.6% yield, should continue to do fine until a recession arrives.

Finally, a year with lower oil prices, an expanding economy, and more money in consumers’ pockets ought to be good for real estate prices. Combine this with the aging of the baby boomers, and you have a positive outlook for the Senior Housing Properties Trust (SNH), a REIT that invests in hospitals, nursing homes, and senior housing. SNH pays a quarterly dividend of $0.39 per share for a yield of 6.9%, and its dividend has been steadily increasing over the last 15 years, roughly keeping pace with inflation.

Hopefully, 2015 will be as good a year as people expect. In any case, the above selections should enable us to receive solid dividends, and maybe come out a little ahead on capital.

Good investing,

Martin Hutchinson