2023-09-18 07:35:00 ET
Summary
- Investors often make one fatal mistake in their portfolio's performance.
- We use XFLT to examine how this mistake would have led to massive losses.
- Income investing is an essential way to avoid this fatal mistake.
Co-authored by Treading Softly
One frequent mistake that humans make is assuming that their perspective is universal. It's hard for many to envision another person's perspective simply because they've never lived in that person's reality.
I'm not talking about all truth being subjective. Unfortunately for some, I'm one of those people who is not afraid to share with you that I think that truth is very objective. However, when it comes to perspectives, I recognize that everyone has their own unique perspective. It can be very hard to shift our viewpoint to someone else's perspective.
When it comes to money and making money, many people get stuck in pure math and fail to recognize that each person's unique situation brings with it a unique perspective and likely a unique solution that may not be strictly what's on paper. I'm not saying that we magically erased any losses, but I do recognize that some people out there fail to realize that they can have greater gains while having to endure losses in the interim. The idea that every mountain you climb will only go higher and that there are no valleys between mountaintops is a foolhardy mistake that many retirees and investors simply try to live by. They try to cut losses and not travel through the valley but somehow catch up on the climb on the other side. That rarely works for most investors, and that's the reason why so many investors fail to outperform the index.
Today, I want to walk through a great example of how our Income Method can radically change your perspective.
Let's dive in!
"You were wrong! Apologize, Rida!"
XAI Octagon Floating Rate & Alternative Income Term Trust ( XFLT ) currently yields 14.6%. When I first wrote about XFLT, it was in May 2019, and a pandemic like COVID shutting down the world belonged in Hollywood movies. Everyone was up in arms over the "trade war" with China, and the Federal Reserve was just months away from cutting interest rates. These were the events that everyone expected to be the defining news for the stock market.
My, how the world has changed.
Things changed for XFLT too.
XFLT is a CEF (Closed-End Fund) that invests in floating-rate debt, primarily through a mix of senior secured loans, CLO (Collateralized Loan Obligation) equity, and CLO debt. Source
While this mix has shifted a few percent either way over the years, it isn't materially different than when we first bought XFLT. Essentially, XFLT is a fund that invests in floating-rate senior secured loans. The CLOs that XFLT invests in also invest in floating-rate senior secured loans. These are loans made to corporations that have publicly rated debt and carry a B/B+ rating. COVID caused default rates to spike up to 4.5% in 2020, the highest default rate experienced in leveraged loans since the GFC (Great Financial Crisis). Current projections suggest that default rates could be similar in 2024 due to recession risks.
Let's look at how XFLT has performed since we added it to our portfolio. Here is a look at the share price since May 15, 2019:
In 20/20 hindsight, the timing couldn't have been more poor. The price struggled right off the bat, and then when COVID hit, it collapsed. Today, it is still well below our original investment. Indeed, many people have demanded over the years that I "apologize" for recommending XFLT. I should have recommended that retirees put their money into something "safe" like iShares 20+ Year Treasury Bond ETF ( TLT ). I'm sure the retiree who decided to follow that advice feels a lot more comfortable...
When investors focus on the current share price, they are missing most of the story. As an income investor, I don't really care what price people are willing to offer me at this moment. Since I first bought XFLT in May of 2019, the price offered for those shares has ranged from around $4 to just under $10. I didn't panic and sell at $4, nor did I "take my gains" when it was pushing $10. I'm not likely to sell next year either, whether the price is higher or lower than $9. I am investing for the income, and I am happy to sit here collecting it.
What has my income looked like? Source
In 2020, the dividend was reduced for six months, resulting in a lower total for the year. But then the annual payout increased for 2021 and 2022. This year, the dividend was raised again and is at an annualized rate of $1.02/year.
From an income investor's standpoint, XFLT has been a very successful investment so far. We are receiving the income we expected when we first bought in 2019, albeit with a slight disruption, and are now receiving 16% more. When we bought XFLT, a dividend raise wasn't on our radar any more than COVID was.
This income is extremely powerful. Remember the chart above, showing XFLT and TLT having the same price return? When you factor in the dividends by looking at the total return, the picture is a lot different:
Lower credit risk and lower yield did not translate into better returns. It usually doesn't over longer periods, though it usually does translate into a lot smaller downswings during scary periods like COVID.
XFLT managed to get through COVID, even though the debt markets were entirely unprepared for it. For whatever happens in 2024-2026, the debt markets are going in with much lower prices and much higher yields. The average loan yield-to-maturity is over 10%, on par with what they were during the COVID crash.
The biggest reason for these high yields is interest rates rising. High interest rates have impacted the prices of all debt, including the debt held by XFLT.
With XFLT, we are able to buy at a lower price, receive a higher dividend, and enjoy much more upside potential when the prices of loans trend toward par or they are repaid.
Interest rates won't remain high forever. We won't always enjoy getting a 10%+ yield-to-maturity on loans. I suppose some event could cause yields to spike up, as they did during COVID - but for XFLT, the negatives of COVID and higher default rates were outweighed by the opportunity to buy loans in the aftermath.
XFLT more than tripled in size since 2020, which is one reason it was able to increase its dividend in 2023.
XFLT's growth has continued through the year, and I am ecstatic to let my income grow with it!
Conclusion
I frequently tell income investors that if their thesis is not broken, they shouldn't be selling.
As a professional income investor, my goal is to get great income from the market, and just because of a temporary dividend cut, it does not necessitate that my thesis behind investing in a specific investment is wrecked. As we've seen with XFLT, we are continuing to receive great income, higher than what we originally were receiving upon initial investment. We expect that in the future, there should be a stronger recovery in price, simply when interest rates decline.
Part of being a good income investor is recognizing that other types of investors will not understand what you're doing and may try to disparage or insult your activities because, from their perspective, it's a losing bet even while you're winning.
I love to sit back and observe our culture, and I often see that those who are very successful have the greatest detractors simply because those detractors don't understand what this person is doing and are typically driven by jealousy and greed. They don't understand how that person can achieve success when they have not.
When it comes to your retirement, I want you to have so much income flowing in from your portfolio that you don't have to worry about what the detractors are saying because you're enjoying your day-to-day life with all of the income that is pouring into your portfolio. Financial freedom is not having to depend upon the opinions of others when you're living your life. If your portfolio is paying your way, then it doesn't matter what somebody else thinks because you're set!
That's the beauty of my Income Method. That's the beauty of income investing.
For further details see:
The Key To Unlocking 14% Income - XFLT