PDI - Bargain Alert: 2 Big Dividends For Your Retirement

2023-08-09 07:35:00 ET

Summary

• Inflation may be cooling, but its tailwinds on real estate will continue for years to come.
• Intelligent bond investors are buying up bonds trading at large discounts to par value and offering them high levels of income.
• Sometimes investing in forgotten situations can provide you with excellent income that others just simply overlook.
• We discuss two bargains with big distributions, up to 13%!

Co-authored with Treading Softly

I'll be honest with you, I've never been known for having a high level of agility. When I was in college, I used to run seven miles every other day with a good friend of mine. We started out at only running half a mile and continuously built it up until every other day we were running seven miles. I burned through many pairs of shoes during my college career, yet I was never even close to being a competitive runner.

When it comes to the market, I don't like to try and constantly shift to every wind of change or potential outcome on the horizon. I like to take a slow and steady approach. We can't be a rapid trading service. It's not why we exist. We buy and hold great income investments for the long term.

Now that doesn't mean that we never make changes. We do manage an actively-managed portfolio, meaning that we will adjust it at times for various situations. Nonetheless, we make slow and steady changes, adjusting the portfolio and giving it nudges when necessary - no needless rapid changes occur. However, at different times, some opportunities are greater than others because of current market conditions.

Today, we want to look at two great funds to buy because of the current interest rate environment.

Let's dive in!

Pick #1: AWP - Yield 11.9%

abrdn Global Premier Properties Fund ( AWP ) is a Closed-End Fund ('CEF') that invests in REITs around the world. With so much of the global economy revolving around the U.S., it is very easy to have a US-centric portfolio. AWP has just under 40% of its assets invested outside the U.S. Source

Over the past year, neither REITs nor non-US stocks have done well, creating a dual headwind of AWP . AWP's NAV is as low as it was during COVID and in the same ballpark it was during the Great Financial Crisis ('GFC'). Those were two times that were very difficult for REITs and otherwise known as absolutely fantastic times to be buying REIT funds like AWP.

Unlike the GFC and COVID, REITs are fundamentally doing quite well. We are not seeing a credit freeze forcing REITs to issue equity at poor prices, as we saw during the GFC. We are not seeing massive numbers of tenants skipping rent payments like we saw during COVID. REITs generally have strong balance sheets, having taken advantage of the past several years of low interest rates to refinance the bulk of their debt out 5-10 years.

As REITs report earnings, we are seeing inflation having a positive impact on rent. This is expected because real estate rents are reset to reflect past inflation . When inflation goes up, rent doesn't rise immediately. Tenants would have a hard time operating if rent changed every single month! Rental contracts typically will escalate rent once every 1, 3, or 5 years and reflect the inflation rate over that prior period. So from the time that inflation happens to the time it is reflected in a REIT's portfolio, it won't even start for about a year and could take five years to be fully reflected throughout the portfolio. The benefits of high inflation in 2021-2022 are just now starting to be seen and will continue to benefit REIT earnings for a few more years.

The market has taken a negative view towards REITs because interest rates have been rising. Interest rates have two impacts on REITs.

First, in valuation, higher yields on risk-free assets like Treasuries have a negative impact on the valuation of property and theoretically make REIT dividends less attractive to investors.

Second, REITs tend to carry higher levels of debt than most corporate structures. Interest expense is typically their highest single expense.

For these reasons, when interest rates go up, Wall Street tends to sell REITs first and ask questions later. But perhaps Wall Street should be asking more questions. On their own, rising interest rates reduce the value of real estate, but rising rates are not happening in a vacuum; inflation is increasing rents. In a vacuum, rising rents increase the value of real estate for obvious reasons. These two factors mitigate each other, and for REITs which are entities that typically buy and hold real estate for the purpose of collecting rent for many years, higher rent is the more relevant factor. Remember, REITs exist for the purpose of buying real estate, not selling it at lower prices to benefit the buyer.

On the expense side, the negative impact of higher interest rates will slowly be introduced over several years if interest rates remain high. Most REITs take out 5-10 year fixed-rate bonds and ladder them so that only 10-20% of their debt is maturing in any given year. Any rise in interest rates will take at least five years to fully impact earnings. Are interest rates going to remain high for that long? I doubt it, but even if they do, REITs have plenty of time to raise rent and offset those rising costs.

The bottom line is that we can expect REITs to surprise the market with stronger than "expected" earnings. Overall, REITs are financially sound and will be able to work with the headwinds of higher interest rates. AWP is a way to gain some international exposure and collect a high yield while we wait for REIT earnings to prove how strong they are or for central banks to start their inevitable pivot. AWP is a bargain at the current price. Don't let it go!

Pick #2: PDI - Yield 13.5%

The Fed has been hiking interest rates at the fastest pace since the 1980s, creating a lot of disruption in the bond markets. Bonds of all stripes have been impacted and are trading at low prices.

One of the most notable impacts is that mortgage rates have reached their highest point in 20 years.

When investing in debt, the price is inverse to yield. Higher yields mean lower prices. So when we see a chart like this, it tells us that mortgages are the cheapest they have been in 20 years. As an investor, when something is cheap, you should consider buying it; especially when it is an investment that produces regular recurring income streams like mortgages.

PIMCO Dynamic Income Fund ( PDI ) is one way for us to invest in mortgages. PDI's portfolio allocation is just under 30% to mortgages, with additional exposure to high-yield credit and non-USD developed credit. Source

The mortgages that PDI owns are primarily pre-2009 mortgages, which means that they have been significantly paid down, and in most cases, the property is much more valuable than it was when the mortgage was underwritten. The market value of these mortgages has declined, bringing PDI's NAV with them, but the inherent risk of these mortgages hasn't significantly increased. When the mortgages repay, they will repay at par. The borrowers don't suddenly owe less money just because the market value declined!

The Fed is widely expected to hike rates one more time and then stop. If that scenario plays out, all debt investments should benefit from the return of stability, especially mortgages, which were quick to price in rising interest rates. PDI is a screaming buy at the current price.

PIMCO is a great asset manager that has steered debt funds through the most difficult times, including the GFC and COVID. We are happy to use PDI as a vehicle to invest in mortgages and other high-yield debt, so that we can reap the rewards as the bond markets recover.

Conclusion

In 2021, everyone was worried about inflation. In 2022, everybody was worried about rising interest rates. It seems like, in 2023, everyone is worried about the coming recession. Yet, with these two funds, you're able to benefit both from the forgotten story of inflation and the continuing story of rising interest rates. Not only are these funds able to benefit from both of those scenarios now, but they will enjoy continued tailwinds from their holdings because of these two situations.

I guarantee you that in 2024, 2025, and 2026 there will be new things that everyone is stressed about. I mean, do you remember Murder Hornets and how they were going to destroy the whole world or Australia being on fire? Some of these news stories and things that everyone was talking about and worried about have come and gone. Yet, the impact on those who live in those serious situations still continue to have impacts, largely forgotten by everyone else.

Just because inflation is starting to cool doesn't mean that its impacts won't ripple through various sectors for years to come, and you can benefit from that, especially if you're a landlord. Just because interest rates will eventually start declining, most likely next year, doesn't mean that those who bought bonds at steep discounts aren't going to continue to collect outstandingly high levels of income from those investments until those investments mature.

The beauty of being a retiree or enjoying retirement, receiving income from the investments you buy, is that if your investments are working for you - there's no need to sell them, especially if it's paying you enough. So why not leverage intelligent portfolio managers who know what good investments are and who are required to pay you strong income and leverage them to pay out income that you need to live on? That way, you can get back to whatever you want.

That's the beauty of my Income Method. That's the beauty of income investing.

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