2023-04-17 15:08:26 ET
Summary
- XFLT is a term limited CLO focused fund.
- It was advertised as a strong, fully-covered, high yield fund.
- Total returns have lagged the yield and so has the NAV.
- The yield has now ballooned to 13.3%.
- We tell you why Treasury bonds handily beat this one and update our outlook.
A year back we wrote about XAI Octagon Floating Rate & Alternative Income Term Trust ( XFLT ) and examined why the fund was a beacon for yield chasers. Our opinion was that the fund's best case was to deliver 6% annual total returns. In other words for practical purposes, the yield would not be "covered". Our suggestion was to throw the common shares out and just stay in the safety of the XAI Octagon Floating Rate & Alternative Income Term Trust - 6.50% PRF (XFLT.PA).
For those admiring the asset class, you might be able to get your 6% plus returns here with far lower risk using the preferred shares. These are term preferred shares with a maturity date of March 31, 2026. They also have a call date of March 31, 2023. The current stripped (next ex-dividend is in the middle of April) yield is 6.37%, and the shares remain well-insulated from interest rate risk thanks to the short-term maturity. We think these are better for risk-adjusted returns and should outperform S&P 500 ( SPY ) and SPDR Bloomberg Barclays High Yield Bond ETF ( JNK ) type ETFs.
Source: 10.3% Yield But Mediocre Total Returns
That has worked out well. XFLT.PA has trashed the three and has taken XFLT to the cleaners. Below we show price returns, but XLFT.PA was the only one to deliver positive total returns.
Yahoo Finance, Returns Since April 2022
XFLT's price return of negative 21.26% was halved with the distributions but was still easily the worst of the bunch. We look at why the fund has been struggling and why your return prospects are a bit better from here.
You Came To The Wrong Asset Class
CLOs have often been touted as excellent diversifiers. They have also been credited with delivering great risk-adjusted returns. We cannot disagree with either of those claims. But what they cannot do is deliver anywhere close to the returns that these funds tend to pay out in distributions. XFLT has been around for about six years and has delivered 2.87% in total returns since inception. Note that the returns are till March 31, 2023.
XFLT
But what is more interesting is that even their own benchmark is at 3.51%.
“Price” is based on the closing prices of XFLT on the NYSE at the end of trading on the last trading day of each period. “Benchmark” is the S&P/LSTA U.S. Leveraged Loan 100 Index, which is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market.
Source: XFLT
This benchmark which all funds in this space use, has a pretty long history. Its annualized returns are pretty eye-opening.
S&P
3.31% annual returns over 10 years must make a couple of things clear. Either these funds are not designed to deliver double digit total returns, or they are using the wrong benchmark. We think that it is a bit of both. CLOs are generally going to make about as much as junk bonds (plus/minus 1%), with slightly less risk. If you don't believe us, have a look at what JNK and the junk bond index did over the last decade.
JNK
Junk bonds did slightly better than CLOs over the last decade and it is a coin toss where the next decade goes.
XFLT of course started off with a near 8.9% yield at inception. What were the odds they would be able to deliver that while preserving NAV and tracking the S&P/LSTA U.S. Leveraged Loan 100 Index? Zero. One way they do try to get there is by taking a lot more risk than the index. If you see what the index is made up of and compare to XFLT you will get the higher level of risk you see here. Of course that is hindsight, but we told you that one year back as well and instead of switching to XFLT.PA, investors took time to tell us what our "misconceptions" were about this fund.
You Came At The Wrong Time
With these funds, "timing the market" matters a lot more than the "time in the market". Below we show XFLT price which is a general proxy for its NAV, versus the BBB effective yield. While XFLT wades into far murkier and riskier instruments, this is one proxy of how enticing the market is at any given time. BBB effective yields were just over 3% when XFLT came into existence.
So you had poor absolute yields and even poorer spreads to risk free rates. Obviously if you buy a credit fund at those times, you deserve to make really poor returns, and that is what happened.
You Ignored The Fees
In an era of 0.1% annual expense ratios, XFLT's fees definitely stand out.
CEF Connect
Yeah CLO management is expensive and we get that. In their defense, XFLT is hardly the worst here either. OCCI was running a 12.5% expense ratio last we checked. When bulls are asked, the general response is that the distributions are paid after the fees. That is of course true and the yield stated is accurate. But the more accurate question to ask is this:
How are we generating 13% returns (today's yield) after 6% fees, when their benchmark which has no fees, does less than 4%?
It is tough, right? Logically, they would need 19% before fees to get there. So you have to believe in the Easter bunny to go down this rabbit hole. Yes there is leverage involved but we have already seen that in the last six years it has not worked for XFLT.
Verdict
These are much better times to invest in CLOs than what we saw when the fund came into existence. These are even better times than one year back. So investors can hold their chin up and they are likely to get better total returns from here over longer time frames. We would venture to say about 6%-7% annually. What about that distribution yield?
You will collect that for now, but it will be cut eventually. In the interim, the NAV will drop, impacting your total returns. When the fund started the 9% yield was apparently "covered". Yet, here we are six years later with less than 3% annualized returns.
Over shorter timeframes we remain skeptical even towards those 6%-7% returns as a recession will complicate things. We have the tailwind of better pricing balanced by the headwinds of more bankruptcies.
Piper Sandler
XFLT.PA as a term preferred still remains the safer choice here, at least over the next 12-18 months. For our part, we are sticking the quality bonds maturing in about one year that yield close to 7% . We don't want to take too much credit or duration risk at this stage so we are foregoing some potential returns for better portfolio stability.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
For further details see:
XFLT: CLO Fund Delivers 3% Annual Total Returns Since Inception, Here Is Why