2023-11-17 15:35:41 ET
Summary
- XAI Octagon Floating Rate & Alternative Income Term Trust is a closed-end fund that pays out distributions on a monthly basis, with a current yield of roughly 14.5%.
- The fund invests in risky securities, such as collateralized loan obligations (CLOs), to generate strong cash flows and provide high returns.
- However, the sustainability of these distributions is questionable, as the fund has paid out more in distributions than its net investment income and realized gains, and has experienced significant unrealized losses.
Since I began investing in 2006, I have never made a purchase or sale because of the distribution a security offered. Personally, my preference is for companies to reinvest their distributions into growth initiatives. But I definitely am not opposed to owning a stock that pays out a distribution if all of the other criteria for it match what I look for. In fact, in my super concentrated portfolio of only nine holdings right now, four of my holdings currently do pay out. I also recognize, however, that not every investor is like me. There are certain reasons to really like distributions. For instance, receiving payouts locks in cash in a way that cannot be done by simply holding a security that does not pay out distributions. In the event that the security in question plummets, you at least get to keep all of the cash that has been paid out to you over the years that you ultimately retained. Those who are in the stage of their lives where regular income is necessary or desirable might ultimately prefer distributions as well.
For those who are not like me, there are many different opportunities that the market offers, not only in the form of stocks, but also in the form of funds. And some of these can be truly tantalizing. One example can be seen by looking at XAI Octagon Floating Rate & Alternative Income Term Trust ( XFLT ). This is a closed end fund that pays out distributions on a monthly basis. By investing in a variety of securities and funds, including CLOs (collateralized loan obligations), XFLT prioritizes distributing cash to shareholders. In fact, the current yield as of this writing is roughly 14.5%.
This is far above what almost any other security can offer. But it's also important to note that this kind of money does not come easy. Those running the fund make clear that by investing in incredibly risky securities, but mitigating investment specific risk by means of diversification, these types of returns can be achieved. I would argue, however, that the picture is not so clear cut. At the moment, XFLT is paying out quite a bit of capital. But based on my own estimates, these payouts are not sustainable unless something changes in a big way. Because of this, I intend to stay far away from this particular prospect. And I would encourage investors who are considering buying it or who do currently own it to tread cautiously.
Beware cash flows
According to the data that's publicly available regarding XFLT, the fund was established in September of 2017. The end goal has been to generate monthly returns that are higher than what traditional fixed income opportunities offer up. It's also worth noting that this is not a fund that is going to be around forever. Technically, it has a term of about 12 years. At the end of 2029, the fund will wind down unless taken private by management. There is the option to extend its life for up to another 18 months to the end of June of 2031. But after that, investors will no longer be able to participate in this opportunity.
In the meantime, the goal is to generate strong cash flows. And management is attempting to do this by allocating the capital between different interesting investment opportunities. A rather impressive 46% of all the assets within the fund are currently invested in senior secured first lien loans. Conceptually, these are fairly safe investments, even though they might be in companies of questionable quality. The goal behind this kind of asset allocation is to provide some security for the owners of the fund’s assets. But when you dig deeper, you see where the robust yield prospects come from. 30.1% of assets are allocated toward CLO equity tranches, while another 15.7% are allocated toward CLO debt tranches.
In a prior article , I wrote about CLO tranches to some extent. These are basically the same thing as the CDOs (collateralized debt obligations) in the mortgage space that played a major role in the massive economic downturn of 2008 and 2009. This is not to say that these are bad securities. Any security has the potential to have both positive and negative aspects to it and can be used in constructive ways. Basically what happens with a CLO is that you receive a basket of loans that all get packaged together. If you own the entire package, you get whatever return the loans in aggregate receive. But by dividing this basket up into different tranches, you can divvy up the basket in ways that fit the individual interests of different parties. For instance, somebody who wants significant amounts of safety might own the most senior tranche of the CLO debt. This means that they will get paid first, which means that the ultimate risk is quite low. You have different tranches of debt, each one paying out more but also assuming additional risk. And at the very bottom, you have the CLO equity tranche that gets the largest amount of risk since its holders are the first to take losses, but you also receive the highest returns when things go right.
In the market, there are two major types of risk that we need to pay attention to. The first would be systematic risk, while the second is unsystematic risk. Systematic risk refers to general market risk. As long as you are invested into the market, this is something you will have to deal with. It's also what market participants underestimated about mortgages prior to the last big collapse. Unsystematic risk can also be described as company specific or investment specific risk. If I hold all of my money into a single security and that security drops by half, I lose half my money. But if I own multiple securities and one of those drops by half, and that particular security accounted for only 2% of my portfolio, I am down only 1%. This is risk that can be easily mitigated. And that mitigation occurs by means of diversification. That is why XFLT currently consists of 506 different holdings, with the largest being a CLO fund that accounts for 1.59% of the entire portfolio.
Given this diversification, investors likely assume that the 14.5% yield currently available by buying XFLT is safe. In some respects, this is true. But in others, I fear that it is not. Conceptually speaking, a distribution can only be sustainable if cash inflows from the activities it engages in at least match the cash outflows required to cover operations and the distribution. If this test is not met, then eventually the distribution must be cut. In researching this article, I looked at financial data covering the last three completed fiscal years and covering the first half of 2023 . What I found is that, over this window of time, XFLT paid out $17.7 million more in distributions than the sum of its net investment income and its realized gains on investments.
In theory, we can also add to the picture unrealized gains. The argument here is that while unrealized gains are not yet realized, ‘borrowing’ against those gains can allow hefty distributions to continue to be paid out so long as those gains eventually become realized. Unfortunately, this makes the picture look even worse. Over the window of time covered, the company saw aggregate unrealized losses totaling $50.8 million. In fact, it was only because of $225.2 million worth of share issuances that the company was able to cover its distributions. This might also go some way toward explaining how the net asset value of units has dropped from $9.78 since the fund’s inception in September of 2017 to the $6.54 per unit today.
Takeaway
I would love for there to be a fund that offers up significant distributions that are of a sustainable nature. But time and time again I run into issues on this front. What seems to be happening is that the companies are able to attract additional investors who buy new shares based off of the hype associated with the hefty yields. Existing unit holders receive attractive payouts in the near term. But the downside is that the underlying value of their investment ultimately struggles. That is why the annualized net asset value of units (inclusive of distributions) has gone up only 4.6% since the inception of the fund. In the long run, all this will likely do for investors is lead to subpar returns that meaningfully underperform the market. And that is being accepted in exchange for near term cash flows. Personally, I view that as a bad trade off. And because of that, I have decided to rate XFLT a ‘sell’ at this time.
For further details see:
XFLT Is A Value Trap With An Unsustainable 14.5% Yield