Summary
- More rate hikes are coming. It's a juggling act between the rising cost of goods from inflation and the rising cost of debt.
- Retirees are caught in the middle, all while balancing a fixed income.
- We look at yields up to 12% as we dig deeper into this issue.
Co-produced with Treading Softly
I've always hated when the goalposts keep getting moved.
Imagine if you started training for a 5k run. You spend hours running, training, and building your endurance.
On race day, you discover they decided at the last second to make it a 10k. Okay, you know your training will not meet the new goal but you give it a go. As you approach the finish line, having achieved what you previously thought was impossible, they move it to the 15k mark.
Frustrating right?
I'd say so.
For countless Americans, inflation and rising interest rates have created the perfect storm of rising costs on their daily spending, while also adding more interest to their credit cards, lines of credit, and other floating rate debt.
For retirees living on a fixed income, the double-whammy is felt even harder than it is for others.
So what are we to do? One thing we can do is invest in funds and companies that will benefit from rising rates. This way as rates rise so too can our income generated from them.
Let's look at two such opportunities today. Let's dive in!
Pick #1: BRSP - Yield 9.1%
My favorite kind of investment is where management does what they say they are going to do. I love when a management team creates a nice clear plan and executes it. Tell me what you are doing, and then do it.
That is exactly what the new management at BrightSpire Capital, Inc. ( BRSP ) has been doing. Nothing makes me happier than when I can go back in time, look at an old presentation, and see that plan has been executed over the past two years.
In November 2020, BRSP (fka CLNC) was in a strong liquidity position. CEO Mike Mazzei took over in April 2020 and immediately reacted by deleveraging, increasing liquidity, and reducing recourse debt. (Source: Investor Presentation Nov. 2020 )
Then management laid out a straightforward plan:
The plan was to reinvest in senior loans so that loans were 80%+ of their portfolio. Exit low-yielding and PIK (payment-in-kind) investments like development loans. Increase earnings and reinstate the dividend.
Fast forward 20 months and BRSP is doing exactly what it said. (Source: Investor Presentation 2022 )
Loans now make up 82% of BRSP's portfolio, earnings are growing, the dividend was reinstated in Q1 2021 and hiked every quarter since, and BRSP has disposed of substantially all of its non-core assets.
The hard part is done. Now BRSP can simply keep doing what it has been doing. Originate high-quality loans, manage its balance sheet and keep increasing earnings and dividends. BRSP was able to keep raising its dividend by growing its portfolio, and now it has an additional tailwind: rising interest rates. Since 100% of its senior loans are floating rates, rising interest rates increase BRSP's earnings. ( Source: Supplemental Financial Report )
BRSP management has stuck to the plan over the past two years. Doing exactly what they said they would do. This has turned BRSP from a struggling mREIT, to a growing mREIT with significant potential.
BRSP is growing its earnings and growing its dividend. An mREIT that has such strong fundamentals should not be trading at a 25%+ discount to book value. Yet BRSP is, maybe it is because it is less known. Likely, the past mismanagement from Colony Capital is still weighing on sentiment. We are thankful to have this extended opportunity to invest in a very high-quality mREIT at such a steep discount.
Pick #2: XFLT - Yield 12.4%
XAI Octagon Floating Rate & Alternative Income Term Trust ( XFLT ) is a CEF that invests in leveraged loans. "Leveraged loans" are loans that are originated by banks and then sold to investors to free up capital. These are floating-rate loans, typically to corporations with credit ratings in the B/B+ range at the time of origination. All of these loans are publicly rated, and often the borrowers are publicly traded. If you look at a financial statement, these loans are usually identified as a "term loan".
XFLT invests in these loans through a variety of vehicles. They invest directly in loans, CLO equity positions, and CLO debt positions.
CLOs are bundles of leveraged loans that are "securitized" into several tranches. This allows investors to invest at a risk/reward profile that suits their needs. The senior tranches pay a premium and get a lower yield in return for being first in line. When the underlying borrowers pay, the senior tranches are paid first. After the senior tranches are paid, the junior debt tranches are paid. The junior tranches receive a higher yield while being in the middle of the line.
The equity tranches are the highest risk. At the end of the line, they are the first to absorb any losses. However, they also get the opportunity for extreme gains. Equity CLO tranches currently have cash yields in the high 20%. Unlike the debt tranches with a defined principal balance that has to be repaid at a defined coupon, the equity tranches get everything left over.
XFLT is a bit different from other CLO funds in our portfolio like Oxford Lane Capital ( OXLC ) and Eagle Point Credit ( ECC ) which are primarily invested in CLO equity. XFLT's diversification into debt and directly into leveraged loans helped provide its cash flow with superior stability in 2020. XFLT only had to reduce its dividend for 6 months.
The first half of 2022 was brutal for debt investments. Plain and simple. Everything debt sold off, whether Treasuries, bonds, or leveraged loans. Fears of inflation and what the Fed might do in response to inflation destabilized the Treasury markets and every debt market.
It is not a coincidence that XFLT's NAV is inversely correlated with Corporate B Option Adjusted Spreads.
This is the "spread" that B-rated corporate debt is trading at in relation to U.S. Treasuries of similar maturity after adjusting for the debt's options, like being prepaid. When this measure goes higher, it means investors are requiring a higher yield (lower prices) on B-rated debt, which is what XFLT owns directly and indirectly.
Many things can cause this spread to spike up, sometimes it is fear of defaults. Often it can be caused by changes in Treasury rates or perhaps more accurately, expectations of changes in Treasury rates. It appears very clear to us that the current volatility is firmly grounded in the market's evolving predictions of what the Fed will do.
We are happy to buy XFLT while it is cheap and paying such a high yield!
Conclusion
When the Federal Reserve meets again to discuss rates and battling inflation, you don't need to be afraid of them hiking rates further. You can instead be prepared for additional hikes by having a portfolio designed to benefit from such moves.
Retirement needs income to cover the expenses. As much as I'd love a retirement where I made a single large payment and everything was free from then on out, we don't live in such a reality. In this world, we need recurring income to cover recurring bills and costs. Interest rates and inflation play a meaningful role in changing how many basic goods and debt cost. So going out and investing in income that will rise over time with interest rates simply makes sense to offset the impact of rising costs.
I invest for income so my retirement can be one of relaxation and exploring new opportunities. What do you want your retirement to be like? Take steps today to curtail the chance of being stuck at home worried about how you'll pay your bills. Instead, unlock the opportunity to have less stress and more enjoyment.
I believe in you. Now it's your turn to believe in yourself!
For further details see:
Rates Hiked? Income Hiked