2023-08-24 08:47:52 ET
Summary
- The XAI Octagon Floating Rate & Alternative Income Term Trust is trading at a premium, which requires attention.
- XFLT's overwhelming exposure to cyclical credit is concerning, given the nature of the business cycle combined with the current economic outlook.
- The term premium might or might not come into play, depending on how credit risk evolves.
- Although robust cash flows are likely to sustain, we think there are better risky credit opportunities out there.
Funds such as XAI Octagon Floating Rate & Alternative Income Term Trust (XFLT) can be extremely rewarding as they often provide high returns per unit of risk. However, it is necessary to assess how and when an asset such as XAI Octagon Floating Rate & Alternative Income Term Trust provides optimal risk-return features, as credit exposure is generally used for diversification purposes.
During the past five years, XFLT provided investors with total returns of 13.88%. The asset's price returns have been somewhat disappointing, primarily due to a slump during the Covid-19 pandemic. However, the fund has recovered since the turn of the year, posting more than 8% in price returns and 18.79% in total returns.
With that being said, the asset's historical returns convey its cyclical risks. As such, the question now becomes: Is XFLT still investable after its latest surge?
Let's find out.
The Goal of Today's Thesis
In short, this thesis aims to determine whether XAI Octagon Floating Rate & Alternative Income Term Trust's premium over net asset value is warranted.
To address the problem, I'll take you on the golden thread and discuss the fund's cyclical features. Moreover, I felt that a discussion about credit risk and term structure is pivotal, given the volatile interest rate environment embedded in today's economy.
Let's get stuck in.
XFLT's Premium
The XAI Octagon Floating Rate & Alternative Income Term Trust has historically held a premium over NAV, as it currently does. A basic time-series observation shows that the fund's current premium of 2.86% is relatively small; however, further context is required.
In our view, most of the asset's historical premiums were a result of one of two things, one being low interest rates accompanied by moderate inflation that provided support to bond prices, and the other being best-in-class cash flows in elevated interest rate environments.
It's needless to say that, today's interest rate and credit environment is much different than before, lending the argument that a lower premium is justified. However, the monetary environment is at a potential inflection point, which is why it's worth assessing the potential changes that we might see in the near future.
Cyclicality, Credit Risk, and Duration
I couldn't find the individual credit ratings on XFLT's asset mix. However, at face value, I'd say the portfolio's 2.78% cash exposure is risk-free, and the 42.97% senior secured debt is investment-grade; yet, I think the latter possesses sensitivity to credit risk. Furthermore, the fund's other holdings, such as its CLOs, second-lien, and high-yield debt exposure, likely face both credit and cyclical risk, while its minute common stock exposure brings with it an equity risk premium, which I believe can be ignored.
Credit Risk and Cyclicality
Credit Risk
Although various methods can be used to measure credit risk, I decided to leverage the U.S.'s 5-year CDS values in today's analysis. Credit risk generally influences all sub-sovereign bonds; as such, this credit risk analysis pertains to XFLT's entire portfolio.
CDS values have retreated since their early-year highs, induced by fears of a banking crisis. However, CDS values are seeking direction, as visible in the diagram above. In my view, factors such as weakening corporate interest coverage ratios and rising delinquencies suggest a minor credit crunch is pending.
Furthermore, interest rates remain elevated while disinflation is occurring. This could either result in strengthening real cash flows from bonds or result in a "flight to quality" due to investors' tendency to invest in safe-haven assets in an economic downturn instead of risky credit.
In essence, although I'm not fully expecting weakening credit, I don't think there's substance behind an argument that credit risk will improve anytime soon.
Cyclicality
In our opinion, cyclicality will most likely influence the fund's second-lien, CLO, high-yield, and common stock bets.
As previously mentioned, interest rates remain elevated, disinflation is occurring, and pressure is mounting on credit risk; in addition, manufacturing numbers are coming in soft . Thus, by eyeballing the salient variables of the economy, we conclude that cyclical assets will probably start feeling the heat soon, while risk-off assets might outperform.
Even though XFLT possesses significant exposure to secured debt, it has plenty of ultra-risky credit in its portfolio, which isn't alluring to see at this time.
Duration
Most of XAI Octagon Floating Rate & Alternative Income Term Trust's exposure is long-dated for now, which has its benefits in some ways. Let's assess a few of the benefits and pitfalls.
As shown in the diagram below, the term premium on treasury bonds is trending lower year-on-year.
The abovementioned might support all long-dated bonds as investors become more comfortable holding on to longer-term investments. However, we believe that if credit risk doesn't align, XFLT will not benefit from an abating term premium.
Interest Rates and Variable Exposure
XFLT follows a variable rate strategy, which influences both its distributions and its price level. The strategy has a natural tradeoff; however, the current interest rate environment presents much to cheer about for dividend-seeking investors.
Inflation within the U.S. remains well above its assumed target rate of 2% . Although many believe interest rates will soon recede, our updated view is that the U.S. is set for a "higher for longer" interest rate environment. As such, most of XFLT's returns will likely derive from cash flows for now.
As things stand, XAI Octagon Floating Rate & Alternative Income Term Trust has a trailing twelve-month dividend yield of 12.46%, which is lucrative if looked at in isolation. However, although we think the fund's distribution yield will remain elevated for now, its historical year-end yield ranges between 2.74% and 19.34% , illustrating the cyclical properties of XFLT.
Wrap-Up
Our analysis of XAI Octagon Floating Rate & Alternative Income Term Trust shows that its premium-to-NAV might succumb to credit and cyclical risks in the near term; however, steady cash flow income will likely overshadow such headwinds.
Although there are positives relating to XAI Octagon Floating Rate & Alternative Income Term Trust, we think the PIMCO Corporate&Income Opportunity Fund (NYSE: PTY ), which we covered in an earlier analysis , provides a better risky credit option to investors.
Consensus: Hold rating assigned to XFLT with an indefinite horizon.
For further details see:
XFLT: Is Its Premium Warranted?