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Gordon Pape: Higher rates have hurt my high-yield portfolio

At my Toronto Money Show workshop two weeks ago, I was asked what income investors should do in the face of rising interest rates. My answer was to stick with your plan.

It's no secret that when rates rise, income-sensitive stocks tend to decline in value. All things being equal, the ones that fare best are those companies with a long history of dividend increases and a strong commitment to future hikes. But even they can see a price retreat.

The important thing to remember is that you invested in these securities for cash flow. As long as the dividend/distribution appears to be secure, don't worry about the day-to-day or even month-to-month movement in the share price.

We are seeing an example of the inverse relationship between interest rates and share prices in my Income Investor High-Yield Portfolio. It outperformed its target by a wide margin in its first five years but in the latest six-month review period it suffered a setback.

The portfolio was launched in March 2012 for readers who wanted above-average cash flow and could handle a higher level of risk.

It invests all its money in stocks, so it is best suited for non-registered accounts where any capital losses can be deducted from taxable capital gains. Also, a high percentage of the payments will receive favourable tax treatment as eligible dividends or return of capital.

The initial value was $24,947.30, and I set a target average annual rate of return of 7 per cent to 8 per cent annually. Here is a review of the securities we own and how they have performed in the six months since our last review in March. Results are to Sept. 7.

The Keg Royalties Income Fund (TSX: KEG.UN). The units are trading at about the same price as they were in March, having pulled back from a mid-year high of around $23 due to pressure from rising interest rates. We continue to receive monthly distributions of 9.17 cents per unit. The yield is 5.5 per cent at the current price.

AltaGas Ltd. (ALA-T). This stock was added to the portfolio a year ago with the purchase of 100 shares at a price of $33.46. Unfortunately it has been downhill since, with the shares hit by a double-whammy of rising interest rates and softness in the energy sector. However, we continue to receive dividends of 17.5 cents per month and the yield is up to 7.6 per cent as a result of the price retreat.

Vermilion Energy Inc. (VET-T). This is another energy stock that was hard-hit in the past six months, as the entire sector has struggled through a bear market. However, the monthly dividend remains unchanged at 21.5 cents. The yield is now up to 6.2 per cent.

Exchange Income Corp. (EIF-T). This stock has been under intense short-selling pressure from a U.S. investor in recent months. The price dropped as low as $25.80 in late July but has since rallied somewhat on strong second-quarter earnings. We are still ahead by 27 per cent from the time this company was added to the portfolio. At the current price, the yield is 6.6 per cent.

Premium Brands Holding Corp. (PBH-T). This specialty food manufacturer and distributor was added to this portfolio in October 2013 and has shooting out the lights ever since. It was such a strong performer that we had to trim to trim some of our position last year at this time. But the stock just keeps roaring higher. It rose another $20 and change during the latest six months, bringing our total return to date to 445 per cent. That's great, but the continued run-up in the share price has pushed the yield down to 1.7 per cent. However, the yield based on our original purchase price is 8.6 per cent.

Morneau Shepell Inc. (MSI-T). The shares are up $1.23 since the last update, which is a big move for this stock. We continue to receive good cash flow from the monthly dividend of 6.5 cents (78 cents a year), however the yield has dropped to 3.8 per cent because of the price increase.

Pembina Pipeline Corp. (PPL-T). Pembina shares slipped a little during the period, pulling back $2.16. This was despite the fact the company increased its monthly dividend by a penny, to 17 cents per share ($2.04 per year). The increase combined with the share price pullback means the stock now yields just over 5 per cent.

Sun Life Financial Inc. (SLF-T). After a big gain in the six months to March 18, the shares gave back a little in the latest period, losing $2.81. On the good news side, we received a 3.6 per cent dividend increase, to 43.5 cents per share quarterly ($1.74 per year). The increase plus the price retreat pushed the yield up to 3.7 per cent.

Chemtrade Logistics Income Fund (CHE.UN-T).

Chemtrade is one of the few income trusts still remaining. The price is down 51 cents since the last review but we received distributions of $0.60 per unit, so we did slightly better than breakeven. The units pay a 10-cent monthly distribution ($1.20 a year), to yield 6.4 per cent.

Medical Facilities Corp. (DR-T) This is another addition from last September that has not fared well. We bought 170 shares in at a price of $21.85, but they have since pulled back to $14.70. The shares pay a monthly dividend of 9.375 cents ($1.125 per year), to yield 7.7 per cent at this level.

We earned $21.93 from the cash we deposited in an account with EQ Bank that paid 2 per cent at that time.

The table below shows what the portfolio looked like as of the close of trading on Sept. 7. The weighting is the percentage of the market value of the security in relation to the total market value of the portfolio. The gain/loss shows the performance of the security since inception, or since it was added to the portfolio. Sales commissions are not taken into account, and the U.S. and Canadian dollars are treated as being at par for ease of tracking.

Income Investor High Yield Portfolio (as of Sept. 7) 

Weight %Total sharesAvg. priceBook valueCurrent priceMarket valueRetained incomeGain/loss %
KEG.UN-T8.7180$15.61 $2,809.30 $20.11 $3,619.80 $267.86 38.4
ALA-T6.6100$33.46 $3,346.00 $27.58 $2,758.00 $192.50 -11.8
VET-T6.870$53.84 $3,768.80 $40.62 $2,843.40 $451.50 -12.6
EIF-T9.1120$27.25 $3,270.00 $31.53 $3,783.60 $369.90 27
PBH-T16.770$19.49 $1,364.30 $99.69 $6,978.30 $465.33 445.6
MSI-T12.9260$12.80 $3,328.70 $20.66 $5,371.60 $110.65 64.7
PPL-T10.7110$30.54 $3,359.35 $40.54 $4,459.40 $116.18 36.2
SLF-T13.4120$25.53 $3,063.55 $46.46 $5,575.20 $381.13 94.4
CHE.UN-T8200$17.23 $3,253.90 $18.71 $3,342.00 $181.30 8.3
DR-T6170$21.85 $3,714.50 $14.70 $2,499.00 $191.20 -27.6
Cash1.1$460.30 $482.23
Total100$31,096.70 $41,712.53 $2,727.55 42.9
Inception$24,947.30 78.1

Comments: The majority of our holdings lost ground in the latest period. Only Premium Brands posted a strong gain, up more than $20 a share. Morneau Shepell was ahead by a modest amount and we did slightly better than breakeven (including distributions) on The Keg and Chemtrade.

Overall, the total value of the portfolio fell by $798.77, or 1.8 per cent. That gives us a cumulative gain of 78.1 per cent in five and a half years, which works out to an average annual compound rate of return of 11.08 per cent. Although this is down from our last review, it is still well in excess of our target.

Changes: Premium Brands has performed exceptionally well for us from a capital gains perspective but I am uncomfortable allocating such a high percentage of the portfolio to a stock with a current yield of only 1.7 per cent. Therefore, we will sell another 20 shares at $99.69 for a total of $1,993.80. That will reduce our position to 50 shares.

We will also sell our position in Exchange Income. It is off its lows but is still under a lot of pressure. We will realize $4,153.50 from the sale, including retained dividends. That gives us a total of $6,147.30 to reinvest.

We will spend $3,444.70 of that to buy 70 shares of Enbridge Inc. (ENB-T) at $49.21. The stock has been in decline recently and now yields 5 per cent. I think the shares have been oversold and any time you can get a quality company with that kind of yield and a long-term commitment to dividend hikes we should take advantage of it. The annualized dividend is $2.44.

We will spend another $2,464.50 to purchase 150 shares of Pizza Pizza Royalty Corp. (PZA-T) at $16.43. The shares have held up reasonably well in the rising rate environment and yield 5.3 per cent on an annual dividend of $0.82 per share.

After these buys, we will be left with $238.10, which will be added to our cash account.

Our poorest performing stocks right now are Medical Facilities and AltaGas. The former bounced off their bottom recently, which is encouraging. AltaGas seems deeply oversold and the yield is very attractive. Therefore, we will hold our positions here for now.

We will use some of our retained earnings to add to a few positions, as follows:

KEG.UN - We will buy 10 more shares at $20.11, for a total cost of $201.10. That will bring our total to 190 shares and leave $66.76 in the cash reserve.

VET - We have enough cash to buy another 10 shares, for a cost of $406.20. Our total position is now 80 shares, leaving us with cash of $45.30.

DR– In hopes that the rally will continue, we will add 10 shares at $14.70, for a cost of $147. That will leave cash of $44.20 and bring our total share count to 180.

Remember, do not do small trades like this unless you have a fee-based account. Otherwise, use dividend reinvestment plans if available.

We now have total cash of $2,323,68, which we will keep on deposit with EQ Bank. Current rate is 2.3 per cent.

Here's a look at the revised portfolio. I will revisit it in March.

Income Investor High Yield Portfolio  (revised Sept. 7)

Weight %Total sharesAvg. priceBook valueCurrent priceMarket valueRetained income
KEG.UN-T8.9190$15.84 $3,010.40 $20.11 $3,820.90 $66.76
ALA-T6.4100$33.46 $3,346.00 $27.58 $2,758.00 $192.50
VET-T7.680$52.19 $4,175.00 $40.62 $3,249.60 $45.30
ENB-T870$49.21 $3,444.70 $49.21 $3,444.70 0
PBH-T11.650$19.49 $1,364.30 $99.69 $4,984.50 $465.33
MSI-T12.5260$12.80 $3,328.70 $20.66 $5,371.60 $110.65
PPL-T10.4110$30.54 $3,359.35 $40.54 $4,459.40 $116.18
SLF-T13120$25.53 $3,063.55 $46.46 $5,575.20 $381.13
CHE.UN-T7.8200$17.23 $3,253.90 $18.71 $3,342.00 $181.30
DR-T6.2180$21.45 $3,861.50 $14.70 $2,646.00 $44.20
PZA-T5.8150$16.43 $2,464.50 $16.43 $2,464.50 0
Cash1.8$720.33 $720.33
Total100$31,096.70 $42,836.73 $1,603.35
Inception$24,947.30

Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca.

Follow Gordon Pape on Twitter at twitter.com/GPUpdates and on Facebook at www.facebook.com/GordonPapeMoney

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