Building a Passive Income Portfolio

Months before Jack Bogle passed away, he surprised many by saying in the next decade, he was expecting a 4% yearly return in the stock market and a 3.5% in the bond market.  Since then I've been hearing repetitions of this prediction of low single digit market returns regularly on CNBC and from hedge fund managers. Morgan Stanley has reiterated a market return 4.1% for the next decade.  Instead of trusting growth equities to provide payout going forward, I'm shifting to the more reliable payments of fixed income.  Like any lazy investor with passive income dreams, I want to live off perpetually generating dividend income.  The hard part is assessing how much unwanted risk will I swallow for the crumbs of yield in the last throes of a long cheap money credit cycle that is at heightened risk of imploding.

You're gonna get punched in this erratic risk-on
risk-off environment.  Just make sure you get paid.

The last decade has been hugely punishing to savers in the U.S. but at least we did not have negative interest rates like Europe even if inflation did dip real interest rates negative. This trend of lower for longer may not reverse any time soon given the yearly federal deficit growing past trillion and declining GDP with aging boomer demographics.  Because the bank interest rate is below 1.5%, I have to work much harder to scrape yield in this stingy market.

Risks - Sector Rotation/Credit Bubble
Fixed income opens you up to the usual credit and interest risk along with duration risk. Credit risk is something to watch out for at the end of a long credit and economic cycle so I opt for quality and "limit" junk to absolute minimum.  But structurally, ALL the fixed income yields are grinding down lower since the Fed funds rate has grinder down lower.  Unless the credit bubble pops and raises market interest rates dramatically from distressed assets as everyone dumps bonds, we will see this lowering yield tied to the fed funds rate.

A lot of the below options are conservative defensive plays and suffer from additional bogeyman of sector rotation.  When the market swings wildly from risk-off to risk-on environment, everybody sells their defensive positions to buy equities as they did this September/October so munis/utes/preferreds took more than a few punches. But I'm there for the long-term, I have them holding down the fort while paying me.

First I decided to start with roughly half of my portfolio would be devoted to earning dividends in excess of 4%.  5% bank CDs of my youth, I hardly knew ye.   My allocations are in no way a recommendation but just illustrative of what I did to arrive at a particular solution.  After many months of studying fixed income from books, and contributors on Seeking Alpha,  I've made a much more conservative mix which is still higher risk than I am normally used to. The digram below shows my breakdown of income sectors and their expected yields.  

At the top level, my passive income buckets are allocated as per following with the percentages reflecting total of my portfolio.

• ~20% Munis - municipal bonds have lower credit risk than corporate and hence reflect a lower yield.  Given that regular munis yield less than 3%, even with the tax advantage, ~4% isn't  great. I use leveraged muni CEFs to juice the yield. Also taxable BABs(Build America Bonds) give higher rates so I hold them in retirement accounts.
• risks:  
• default risk - Muni defaults are historically lower than corporate and municipalities tend to restructure rather than default outright. However there is the scary overhang of trillions in unfunded pension liabilities unique to municipal debt. The question for the conservative investor is what is the runway we have left?  More than a year certainly and that is why we're not discussing this constantly in the same way we don't talk about our trillion dollar deficit.
• usual interest rate risk as mentioned above
• declining yield, distribution cuts on call risk. These funds hold the older 30-year juicy 5+% bonds which are slowing being called. The replacement muni bonds are very low yield currently so the distributions are grinding down slowly as with all the rest of fixed income options 
• ~8% REITs - Some advisors recommend considering one's home if owned as part of your real estate allocation but I strongly disagree. REITs are a diverse sector reflecting all aspects of the economy beyond residential- industrial, health, gov't, agricultural, retail, hotels, prisons, etc. No retail no prisons for me though.
• risks: interest rate, sector rotation, sensitivity to economic cycle pending subsection
• ~8% Infrastructure, Utilities - strictly from a sector point of view, municipal bonds tend to be already heavy weight utilities/transportation infrastructure- airports, bridge and turnpike authorities, water and power generation. So why add more to my already overweight municipal exposure?  Infrastructure containing the utilities sector is more and more considered a separate asset class in the same level as REITs although there is overlap since many industrial REITs such as cell tower REITs are considered infrastructure as well.  It's a steady income generating sector that provides highly useful services to society. What's there not to like more of...
• risks: overvaluation - there is a serious unsustainable ute bubble, sector rotation
• ~10% Preferreds - combination funds and individual issues. Unfortunately because of the rate cuts, even the lowest investment grade BBB- issues are coming in at or below 4.75%
• risks: 
• interest rate risk
• call risk- this is a problem for funds and has been reflected in the lower prices recently
• dividend suspension risk - Companies have to cut dividends on common before cutting preferreds so there is one level of cushion. For instance, JP Morgan cutting their dividends on the common stock would be a big deal and they did not cut payment to preferreds during the '08 crisis.  Keeping higher quality companies defrays this problem.
• ~2% High yielding (not necessarily junk) blended funds- this is my experimental batch geared to increase my risk tolerance

My concrete investment selections have been tucked away here.

So I increased my passive dividend income by 300% this year and 400% next year which makes me mad at my negligence that I did not take fixed income seriously. I could have easily easily paid off my mortgage with such income. And years past you could have gotten a 7% yielding JP Morgan Chase preferred stock.

Questions you may have: 

• Why no consumer staples? B/c McDonalds/Coke/Pepsi not healthy for human bodies and Walmart no good for employees or small local businesses. 
• Why no DGI dividend equities? They were extremely crowded trades except for big oil. I had a few dividend ETFs which I sold but will get back into.
• Why pay so much in fees?  Well if you pay low fees but get 3% dividend and higher fees for 4.5% dividend on a muni fund, the fees IMHO are worth it.  Yes this is based on leverage.
• Why no individual equities or REITs? To much research work, looking at a few right now.
• Why no emerging market dividends or debt? If BBN(with 75% "A" or better rating, 16.5%BBB, 7% junk)  is giving me 6% same as DVYE, the risk premium on EM is questionable.  Also I've been burned by emerging markets before.
• Why no TLT or EDV? I missed the boat and long duration treasury funds are just too volatile for me right now.
• Why no baby bonds? Still researching them.
• Why no BDC? Too risky for me in late cycle.
• Why no CLO? Won't touch that. If you're asking, you haven't read this blog...
• Why no MLP? I have some minor exposure to natural gas in my infrastructure funds.