To buy! To buy! To buy! These 2 high yield funds

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Recently I have been very active in buying what other people are selling. I don’t buy just to resell and sell for profit. I buy future income. As prices rise and opportunities to move from an income-generating position at another, I will take steps to lock in unrealized gains, but my main goal is to buy income and enjoy it as it comes.

I particularly like investments that provide monthly income.

Few things in life have to be paid annually or quarterly. Most expenses in life are monthly – they are daily when it comes to food!

So when the opportunity arises to buy what others are selling to secure future income, I am happy to do so.

Today I want to share two funds that I buy heavily for their strong performance of future income, knowing that I will be paid by them next month, and the month after, and so on!

Let’s dive into it.

Pick #1: XFLT – Yield 12.5%

XAI Octagonal Term Trust with Floating Rate and Alternative Income (XFLT) is a closed end fund (“CEF”) which invests in floating rate loans. Their bread and butter are corporate “leveraged loans”. These are loans that are senior in the capital structure to all other debt and are the first lien secured by substantially all of the company’s assets and cash flows. Typically, these loans are granted to businesses with a B/B+ credit rating and are issued by banks. If you look at a borrower’s balance sheet, the loan will generally be referred to as a “term loan”. (Source: XFLT Website)

XFLT Website

XFLT Website

XFLT invests in these loans in two ways. Invest directly in these or hold an interest in a secured loan obligation, or “CLO”. A CLO is a company that buys leveraged loans and then securitizes them. Very conservative institutions such as banks or insurance companies will pay a hefty premium to be first in line and ensure they get paid first.

The CLO collects interest and principal payments and then passes them on to investors in a “waterfall” structure. This means that the top bracket is paid in full first, then the next lower bracket is paid, and so on. The CLO equity tranche allows whatever is left to earn the highest yield to be last in line. Here is an overview of a typical CLO structure. (Source: XA Investments CLO Shares Overview.)

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XA Investments CLO Shares Overview

Historically, default rates on leveraged loans have been very low and recoveries have been much higher than what you see with bonds. You would expect that, because leveraged loans are higher in the capital stack than the highest priority debt.

A common criticism of CLO equity positions is that they are “highly leveraged”. It’s true. For every $100 of face value, the CLO equity position can be $10 and is the last to be paid out. Indeed, every 1% of debt that defaults and does not recover results in a 10% reduction in the amount of the recovered CLO equity position. However, remember that the CLO stock position must be 100% paid before a corporate bond earns a penny.

With debt, the relevant question is always whether the reward you receive is commensurate with the risk. CLO equity positions have cash returns well over 20%, and if historical averages of default rates prevail, they will have effective returns in the 15-16% range. Meanwhile, junk bond ETFs like (JNK) are only yielding 5%. If you find a bond yielding 15% or more, it’s almost certainly rated C or even D.

CLO equity is risky relative to CLO debt tranches. No tranche of A-rated CLO debt has ever defaulted. Throughout history, leveraged loans have enjoyed significantly lower defaults than bonds.

Below a chart which compares the default rates of leveraged loans to high-yield bonds.

Guggenheim website

Guggenheim website

This is while benefiting from much higher recovery rates:

Guggenheim website

Guggenheim website

So why do CLO equity positions pay so much more than even lower-rated corporate bonds? The answer is liquidity. The shares of the CLO are not listed on the stock exchange. It is a buy-and-hold-to-maturity style investment that is not widely available to most investors. CLO equity positions rarely trade, and when they do, it’s often at prices very unfavorable to the seller (meaning it’s favorable to the buyer!). (Source: XA investments.)

chart

XA investments

CEFs like XFLT are making this market sector available to retail investors for the first time. We have the added advantage that XFLT is very liquid. We can buy and sell as we please.

CLO equity is terribly undervalued. Is it leveraged? Yes. Does being last in line create a risk? Sure. Does the potential reward compensate for this risk? Absolutely. If leveraged loan default rates are close to historical averages, then XFLT is an absolute bargain. Provide a double digit return that would normally require investing in struggling businesses. As things stand, rating agencies like Fitch project that defaults on leveraged loans will remain well below historical averages for the foreseeable future, even in a recession.

XFLT takes a balanced approach. With direct investments in leveraged loans, CLO debt positions and CLO equity positions. Businesses are more likely to pay their bills than not. That’s the bet you’re making with XFLT, and you’re very well compensated for it.

Choice #2: RQI – Yield 6.5%

Cohen & Steers Quality Real Estate Income Fund (RQI) is one of our favorite CEFs in the real estate investment trust (“REIT”) industry. One of the characteristics we love about CEFs is their ability to produce high returns from high quality investments that typically don’t have dividends that meet our income goals.

FEDs are required to distribute substantially all of their taxable earnings, including dividend income, as well as capital gains. This allows us to apply our income-based investment strategy, while gaining exposure to some of the best companies in the world.

RQI’s top 10 holdings are a “who’s who” of blue chip REITs. (Source: RQI website.)

RQI website

RQI website

I’m sure you recognize most of the names. We have held a few directly in the HDO portfolio, such as Realty Income (O) and Welltower (WELL). This focus on quality has allowed RQI to significantly outperform the Vanguard Real Estate ETF (VNQ) over the past decade.

Chart
Data by Y-Charts

This is a unique period for REITs, their main source of income is rent. Rents are rising thanks to strong demand for real estate and inflation. At the same time, modern REITs have very little exposure to inflation-sensitive spending. It has become common for bills such as insurance, taxes and maintenance to be the responsibility of the tenant in most commercial leases. As a result, most REITs see a rapid increase in same-store NOI.

On the expense side, the largest expense for your typical REIT is interest. Over the past two years, REITs with even decent quality balance sheets have refinanced as much debt as they could at historic lows. The high-quality REITs held by RQI have been able to keep rates low for more than 10 years and few have significant debt maturing before 2024.

As a result, REITs immediately reap the benefits of inflation. Rents are going up right now. The trade-off of higher interest rates they will have to pay is an expense that will not be realized for many years. REITs are experiencing rising revenues while expenses remain weak. This is a fantastic combination for the sector that will lead to several years of strong fundamentals that will boost their cash flow, FFOs and higher dividends. RQI is an excellent CEF to take advantage of this strong sector.

Shutterstock

Shutterstock

Conclusion

XFLT provides us with a significant amount of monthly income to reward us for the risks we take by investing in CLOs. Nothing is ever high yielding and entirely risk free. The question becomes whether you are adequately compensated for the risk you are taking. In the case of XFLT, we believe we are exceptionally well rewarded for the price of entry.

RQI offers us a route to expose ourselves to a strongly backed industry – fundamentally speaking – while gaining more revenue than the other routes available to us.

XFLT and RQI trade close to their net asset value, allowing us to gain exposure without excessive premiums.

In life, bills come in monthly and have to be paid in cash to pay them. I get my monthly money from these two funds. I get more than I need to pay my bills, which allows me to take advantage of other opportunities, or just reinvest in those assets to get more money next month. I love the quick feedback loop when you reinvest your earnings into these holdings, next month you are already seeing results!

Monthly money. Large sums of income without work to be expected. Sounds good, doesn’t it? It should. That’s the joy of income investing!

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