2023-06-20 07:35:00 ET
Summary
- Investing in CEFs can be confusing. It doesn't have to be.
- XFLT is buying investments at a discount to PAR, creating a strong upside.
- Having a method can help keep you safe.
Co-authored with Treading Softly
When I was a kid, there used to be a TV commercial about water safety in the winter. It was designed by the government to encourage people not to do boating or water activities near hydroelectric dams. One would think that it would be obvious that swimming or boating close to a dam that produces electricity for the city would not be a wise choice. Unfortunately, common sense often did not prevail - especially in the wintertime.
At the end of the commercial, the would-be boater explained that his boat was sucked under the ice and water in what they called a conundrum wrapped in a paradox, covering a fluffy layer of he doesn't know what!
For many new investors or retail investors, a Closed-end Fund can be almost exactly like that. They know that they're buying shares and that the fund will pay them. But what the fund invests in, how the expenses work, and what the yield really is, can be confusing. Not to mention people like to throw around terminology like Z scores and expect you to understand them!
What can also compound the problem is when the fund invests in securities that are often misunderstood and highly illiquid. Now you're taking something that's already confusing, adding another layer of complexity on top of it, and expecting the average person on the street to know what they're getting themselves into.
At High Dividend Opportunities, we not only point out what we think are great investments, but we spend time with investors to explain what they're investing in and how they work. This way, we're not sending people in blindly but empowering them to understand and grasp concepts and investments.
Today, I want to focus on one high-yielding fund that invests in highly illiquid investments. We'll dive a little deeper into what it does and explain why we think it's a great opportunity to buy here.
Let's dive in!
Floating Rate and Alternative Income?
XAI Octagon Floating Rate & Alternative Income Term Trust ( XFLT ), yielding 15.7%, defied the expectations of many doubters in May, hiking its monthly dividend by over 16%. It did this even as its NAV is near 52-week lows.
How is it possible for XFLT to hike its dividend as NAV declines? XFLT invests in debt of various types. It invests in "leverage loans", CLO debt tranches, CLO equity tranches, and even a few high-yield bonds. Many investors get wrapped up in the fact that higher yields lead to lower prices for debt. If yields go up, loan prices come down, so if you have a portfolio of various types of loans, that portfolio is less valuable.
Of course, the price of something only matters if you are planning on buying it or selling it. If you are holding it and neither buying nor selling it, then the price doesn't matter to you. A concept that an amazingly large number of investors struggle with. Only two prices matter to your total return: The price you buy at and the price you sell at.
What is XFLT doing? XFLT has been buying. Source
Even as the price of XFLT's holdings has declined, XFLT has been "buying the dip" to maintain a similar dollar value of holdings from when debt prices were high in Q4 2021. In Q4 2021, XFLT had $405 million in holdings valued at an average of 94.2% of par. This implies a par value of roughly $430 million. In Q1 2023, XFLT had $401 million in assets priced at an average of 84.9% of par, implying the portfolio has a par value of $472 million.
The interest that the borrower pays and the amount of money they owe is based on par value, not market value. So as prices decline, the yield that XFLT receives goes up.
Today, loan yields are over 10%, nearly double their historical average.
While default rates are still below their historical average, the bottom line is that the lower loan prices are, the more cash flow XFLT gets for its investments. Dividends are paid out of cash flow, not from the market price of loans. Most of XFLT's loans will be held until maturity, at which point the borrower either pays it or files for bankruptcy. If the worst happens, XFLT's loans are senior-secured, putting them first in line to get a recovery at the expense of the company's equity holders, junior debt holders, and unsecured bondholders.
Most companies repay their loans. Every time one does, XFLT's $85 becomes $100. Being able to buy loans at such a steep discount to par, in an environment where defaults are low, is pushing XFLT's cash flow higher. That's why they raised their dividend.
Low prices are bad for sellers, but they are great for buyers. XFLT is a buyer of loans, and we are buyers of XFLT!
Conclusion
Investing in the stock market is not a game that should be played by the uninformed and uneducated. Unfortunately, so many investors receive the distribution from their 401k and immediately start trying to manage their own portfolio without having an idea of what's going on. The most dangerous individual in the field is the one who thinks they know what they're doing but knows nothing.
This is why we spend countless hours at High Dividend Opportunities, writing educational articles and spending time in chat with our members. We want to take novice retirees and develop them into professional income investors who are able to make great decisions with their portfolios to meet their specific income goals. When it comes to investing in a closed-end fund like XFLT, knowing what's going on can give an investor confidence to hold through price gyrations when an uninformed investor jumps ship early.
In the dead of winter in Canada, it's exceptionally important to know what's going on under the ice. You don't walk out on a frozen lake or a frozen river unless you have the utmost confidence that what you're doing is going to be safe - or better yet, you just don't do it at all. Over time through years of experience, you develop a method to know when it is safe or not.
In the stock market, I have developed my method - my Income Method. It does just that. With a portfolio of +45 dividend stocks and an overall yield of +9%, I always sleep well at night, having recurrent income in good and bad times.
For further details see:
Earn +15% By Buying Assets At A Discount: XFLT