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Absurd, Outrageous, Fully Covered Top Picks: 8% More Returns

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Violeta Stoimenova/E+ via Getty Images

Co-produced with Treading Softly

Recently I remembered a motto I heard in the movie “The Patriot”. In it, a former war hero and now a farmer played by Mel Gibson ambushes a group of British soldiers in the woods with two of his sons. He reminds them of a principle of aim when it reminds them to:

Aim small, miss small

What does it mean? When it comes to accuracy, it’s best to aim for the smallest part of your target, that way if you miss it, you’re still hitting the target in general. So you aim the target at a target, that way if you miss you still hit the target.

When it comes to income investing, I suggest you aim high, miss high. This means that you set your income goal well above the annual income you need, that way if you miss your goal, you will still be well within the realm of a livable income in your portfolio.

Today I want to help you ambush two excellent high yields. They will help your portfolio to produce excellent income, even in small amounts. I like to think of them as revenue catalysts.

Let’s dive into it.

Choice #1: AOP – Yield 8.3%

Many of the finer things in life are extremely rare. Rare things are usually very expensive. People will pay massive bounties for a rare bottle of wine, an old bottle of scotch, a unique gemstone, or a limited-edition painting that is sought after by those with lots of money to spend.

I also like rare things, but you won’t find what I’m looking for at a Sotheby’s auction house, nor will you find me paying dearly for the rarities I seek. One of my favorite rarities to buy is a PIMCO fund that trades at a discount to NAV.

PIMCO Dynamic Income Opportunities Fund (PDO) is one of the newest members of the PIMCO family of funds. PDO is now trading at a 5.4% discount to NAV. Probably, his youth is part of the reason. The PDO in allocations is most comparable to the PIMCO Corporate & Income Opportunity Fund (PTY), the best performing PIMCO fund of all time. PTY has been around for 20 years, and since its inception you can count the number of times it has traded at a discount to NAV on the one hand: shortly after its inception, during the Great Financial Crisis, end 2015, and very briefly in March 2020.

Discount PTY or Premium to NAV
Data by YCharts

Although PTY is a bond fund that has outperformed the S&P 500 since its inception nearly 20 years ago, there are still plenty of skeptics.

“But leverage!!!” is the most common rallying cry of bears. They claim it’s super risky, but PIMCO has operated with much the same strategy for 20 years. During the Great Financial Crisis, thanks to COVID, the leverage that PIMCO regularly uses has not had a crippling impact. Why?

As a percentage of assets, leverage is high, often over 40%. However, CEFs are legally limited to borrowing only 33% of net asset value. The key is that PIMCO primarily uses “repurchase agreements”. These are non-recourse bonds where the securities PIMCO buys are the collateral for the ‘loan‘, this is a very common method of funding bonds and mortgages.

The key is that in the event of default, the lenders only recourse is to take collateral. This is what prevents PIMCO from triggering the 33% debt limit, as PIMCO’s equity exposed to debt risk is quite low. Here is a screenshot of PDO semi-annual report:

AOP funds remaining contractual term of the agreements

PDO semi-annual report

There are two key numbers highlighted here. PDO owes $1.6 billion. This bond is secured by collateral with a market value of $1.9 billion. Then, in the worst-case scenario, the end of the world scenario, PDO returns the collateral. Lose $1.9 billion in assets and erase $1.6 billion in debt for a net loss of $300 million. A total impact of $2.72/share is caused by the leverage effect which is approximately 15% of the net asset value. Therefore, the fund is no more risky than any other bond fund with a modest leverage of 15%.

“What about the rate hike? is the next thing the bears will say. Well, what about them? Here is PTY and PDI (PDI) the last time the Fed started a bullish cycle. See that line at the bottom with the lowest total return? It’s the S&P 500.

Return of AOP funds
Data by YCharts

It turns out that selling PIMCO funds to invest in stocks because rates were rising wasn’t a very smart move.

Even seven years later, the market still hasn’t learned. He’s selling PIMCO funds because rates are going up and it’s supposed to be “bad.” It created a fantastic buying opportunity then, and it still creates a fantastic buying opportunity today.

I like several of the PIMCO funds, and it’s often hard to choose between them. Yet today PDO is trading at a discount to NAV, it is run by the same managers and has a very similar style to PTY but is trading at a steep discount. Learn from history. When quality PIMCO funds are trading at a discount to NAV, buy them.

Choice #2: OXLC – Yield 12.6%

Oxford Lane Capital (OXLC) is a CEF that invests in CLOs (collateralized loan obligations). At HDO, we have been extremely optimistic about the CLOs to come in 2022.

CLOs are pools of leveraged loans. These are loans, generally granted by banks to companies with B/B+ credit ratings. These are “senior secure” first rank loans. These loans are at the absolute top of the capital stack. They are superior to any other debt or capital of the borrower.

The CLO aggregates these loans and then sells “slices” based on repayment seniority. At each payment, the A tranches must first be paid in full, then the B tranches and so on. OXLC focuses primarily on the “equity” tranche, this is the tranche that receives whatever is left over.

Since equity cannot collect a dime until payments have been made on all the “debt” tranches, it is in a “first loss” position. If a borrower defaults, it is the portion of capital that is paid less.

So, when monitoring CLO equity positions, our main concern must be default levels. How many borrowers will be unable to pay? How many borrowers need to make their payments to have a good return?

Keep in mind that OXLC earns credit card-like returns. As they pointed out in their Fourth Quarter Investor PresentationOXLC’s cash return on its investments is 29%.

OXLC Cash Yield

Fourth Quarter Investor Presentation

In other words, if all borrowers paid as agreed, OXLC would return 29%! Like a credit card company, you should assume that payment defaults will occur. OXLC collected a 29% return last quarter, but some of that return will likely be offset by future losses should borrowers default. “Weighted Average Effective Yield” is a measure that reflects historical average default rates of just under 3%, which is the effective yield that OXLC can expect to receive if default rates are average over the long term.

Currently, the default rate among leveraged loans is minimal. There has not been a single payment default in 2022 and only three payment defaults in the last 12 months.

OXLC default rate

TCW

Default rates are at historically low levels, and simply getting back to historical averages would require a dramatic increase. This means that the odds are high that OXLC will earn much more than the “effective” return suggests, unless we see a significant increase in default rates.

Yet, despite incredibly strong cash flow, in February the values ​​of the equity tranches fell to $59.60. In other words, the underlying borrowers owe $100 in face value and OXLC pays less than $60. These are incredibly low prices in an environment of default rates close to 0%.

Over the past year, OXLC has grown its CLO holdings by more than 38%, recognized the incredible buying opportunity and supported the truck. He had retained excess cash flow to reinvest and sold stocks at a premium to net asset value to now buy back CLO stock positions as quickly as possible.

Last quarter, OXLC produced a GAAP profit of $0.29. GAAP uses the more conservative “effective return” described above. This covers OXLC’s newly increased dividend of 128%. OXLC’s base earnings were much higher at $0.44, covering its dividend by 195%!

OXLC has great coverage, although a very large portion of its portfolio is not yet generating cash flow. As of December, $382 million in investments, or about 30% of OXLC’s portfolio, had yet to make their first distribution. This cash flow will begin to arrive over the next two quarters.

Equity OXLC CLO

Fourth Quarter Investor Presentation

OXLC today yields more than 12.5%, hedges its dividend 128% by GAAP net income and 195% by cash earnings, and its cash flow will grow at a double-digit pace in the first half. OXLC is an incredible opportunity to earn such a high yield, well hedged and with very high potential for dividend growth.

This is why the CLO sector is one of our favorite opportunities of 2022.

The time of dreams

The time of dreams

Conclusion

Both of these absurd and outstanding returns are available for you in the market today. It’s not often that I can present you with a 12% return or higher that has an extremely high level of coverage – OXLC is a real gem that you’re missing out on if you don’t have one. Don’t let OXLC be your anthrax and seize this opportunity.

With PDO, its coverage was so strong that we got a nice Christmas bonus via a special dividend. I expect PDO to continue to provide me with excellent income month after month. Many of my readers ask for good monthly picks, today I’m giving you two.

Monthly dividends are extremely attractive because most of our bills and expenses accrue on a monthly basis. Every cash dividend is an infusion of opportunity and flexibility into your bank account. I like having flexibility in my life and my wallet. You can have it too.

Aim big, miss big, still end with an exceptional retirement. Welcome to Income Investing.