2023-09-29 05:16:46 ET
Summary
- XFLT invests in senior loans, CLO equity, CLO debt tranches, high-yield bonds, and secured second lien loans.
- XFLT offers diversified exposure to strong, growing dividends with a 13.3%.
- An overview of the fund follows.
Long-time readers know I'm bullish on senior loans and CLOs , due to the strong, growing dividends offered by these securities. The XAI Octagon Floating Rate & Alternative Income Term Trust (XFLT) offers investors diversified to these investments, and a strong, fully-covered, growing 13.3% dividend yield. The fund is a buy, but on the riskier side of the senior loan or variable rate market.
XFLT - Overview
XFLT is an actively-managed ETF investing in senior loans, CLOs, and assorted floating-rate credit instruments. Asset allocations are as follows:
XFLT
Senior Secured First Lien Loans
Senior secured first lien loans, or senior loans, are corporate loans which generally have the following characteristics.
Loans are variable rate loans, and so see higher coupon payment when the Federal Reserve hikes rates, lower when the Fed cuts.
Loans are senior to other debt, and prioritized in the case of bankruptcy or broader financial difficulties.
Loans are secured by company assets, increasing recovery rates in the event of default.
The Invesco Senior Loan ETF ( BKLN ) is the largest senior loan index ETF in the market, last covered here .
CLO Equity
Some contexts first.
Senior loans are sometimes bundled together in CLOs. Each CLO is divided into tranches. Income from the senior loans is used to make payments to all tranches. Senior tranches get paid first, junior tranches get paid last. Investors can buy into these tranches, and receive income (from the CLO / bundle of senior loans).
CLO equity tranches are the junior-most tranche. Investors in these tranches get paid last , receiving whatever income is left after paying back all other tranches. Payments are very risky and volatile, but potentially quite lucrative as well. Payments are partly dependent on senior loan income, which is dependent on interest rates.
The Eagle Point Credit Co LLC ( ECC ) is one of the largest funds focusing on CLO equity tranches.
CLO Debt
CLO debt tranches are senior to CLO equity tranches. Investors in these tranches get paid before equity tranche investors, which means payments are less risky. Specifics vary. Payments are effectively always variable rate.
CLO debt tranches are rising in popularity, with several ETFs focusing on these. The Janus Henderson AAA CLO ETF ( JAAA ) focuses on the safest of these, the Panagram BBB-B CLO ETF ( CLOZ ). I last covered JAAA here , CLOZ here .
High-Yield
High-yield bonds are generally fixed-rate bonds issued to non-investment grade corporate issuers. XFLT invests a small portion of its portfolio in these, currently 3.8%. From what I've seen, it is common for senior loan ETFs to invest in a couple of securities classified as high-yield bonds which, nevertheless, behave as senior loans or floating rate securities.
Secured Second Lien
Same as senior loans, without the seniority.
Leverage
XFLT is a leveraged ETF, with an effective leverage ratio of 38.4%.
XFLT
XFLT's use of leverage boosts dividends and returns, but also risk, volatility, and losses during downturns and recessions.
Overall Portfolio
XFLT invests in a lot of different types of securities, which different characteristics and structure. Importantly, the fund's income and returns are almost entirely dependent on senior loans, either directly or indirectly (CLOs). As senior loans are variable rate securities, so is the fund, which benefits investors in several key ways. Let's have a look.
XFLT - Benefits
Strong, Growing 13.3% Dividend Yield
XFLT benefits when the Fed hikes, and the Fed has hiked quite aggressively these past two years. Rates have increased from effectively zero in early 2022 to 5.25% - 5.50% as of today. Further hikes are possible , although definitely not certain.
Data by YCharts
XFLT itself has seen its dividend yield increase from around 9.7% in early 2022, to 13.3% as of today. It is a very strong yield on an absolute basis, and quite a bit higher than that of the average bond and most bond sub-asset classes.
Data by YCharts
Dividends were also more than fully covered by underlying generation of income, as per the fund's latest semi-annual report.
Fund dividends have increased since said report, as have interest rates. Although the net effect is unclear, I have no reason to believe that distribution coverage ratios have significantly declined these past few months.
XFLT's strong, growing, fully-covered 13.3% dividend yield is a significant benefit for the fund and its shareholders, and its core investment thesis.
Low Rate Risk / Outperformance When Rates Rise
XFLT's underlying holdings see significant, swift increases to their interest rates / dividends when rates rise, boosting their returns during the same. Higher dividends boosts investor demand too, reducing any potential capital losses from higher rates. Due to this, XFLT tends to outperform when rates rise, as has been the case since early 2022.
Data by YCharts
Importantly, the fund outperforms when rates remain higher for longer too, or when the market believes so. This was noticeble in the days after hawkish guidance from the Fed was released.
XFLT's outperformance when rates rise is a significant benefit for the fund and its shareholders. In my opinion, it is mostly a long-term benefit, as it reduces long-term portfolio volatility, and will lead to significant outperformance during the next hiking cycle. It might lead to some short-term benefits as well if rates remain higher for longer, as I think is likely .
Frequent readers might have noticed that XFLT's benefits are more or less the same as those of many other ETFs I've covered, including the Invesco Senior Loan ETF ( BKLN ), the SPDR Blackstone Senior Loan ETF ( SRLN ), the Janus Henderson AAA CLO ETF ( JAAA ), the Janus Henderson B-BBB CLO ETF ( JBBB ), and many others. These ETFs all focus on variable rate loans and securities, and so do, in fact, have more or less the same benefits. XFLT does differ from its peers in several ways. Let's have a look.
XFLT - Differences to Peers
Diversification
XFLT invests in several different types of variable rate securities, while most of its peers focus on one specific class. XFLT's greater diversification somewhat reduces portfolio risk and volatility, although the effect is quite small as these securities are all quite similar to each other. Still, for investors wishing to have exposure to senior loans, CLO equity, and CLO debt tranches, the fund makes perfect investment sense.
Comparatively Strong Dividends
XFLT yields more than most other ETFs focusing on variable rate securities, due to the fund's use of leverage. It does yield less than ECC, and should yield less than most funds focusing on CLO equity tranches, as these securities sport particularly high yields.
Seeking Alpha - Chart by Author
Above-Average Risk and Volatility
XFLT's use of leverage boosts risks, volatility, and expected losses during downturns and recessions. As an example, the fund suffered losses of 42.8% during 1Q2020, the onset of the coronavirus pandemic. Losses were significantly higher than those suffered by senior loans, but lower than those of CLO equity tranches.
Data by YChars
XFLT's losses seemed much higher than expected for a modestly leveraged fund with modest allocations to CLO equity tranches. On a more positive note, XFLT recovered from these losses relatively quickly, and saw reasonable positive returns during the year.
Data by YCharts
Some securities got materially mispriced during the start of the pandemic, and that might have been the case for some of XFLT's holdings. Experiencing +40% losses in a month does not seem warranted for a fund with positive yearly returns.
In any case, XFLT is definitely riskier than the average bond, fixed-income, or senior loan ETF.
Performance Track-Record
XFLT's overall performance track-record seems adequate. The fund has posted very strong returns these past three years, due to higher rates and the pandemic recovery. Long-term returns are much weaker, as rates were much lower in the past. Returns are as follows:
Seeking Alpha - Chart by Author
Although the figures above are accurate, I believe they overstate the consistency of XFLT's performance. The fund does sometimes significantly underperform relative to its peers. It underperformed relative to BKLN in 2018, 2020, and 2022, for instance.
Data by YCharts
Overall Risk-Return Profile
XFLT's overall risk-return profile seems quite weak, with a much greater increase in volatility and losses compared to increased yields or returns. Comparing the graph and tables above shows the situation quite clearly, I believe.
XFLT also compares unfavorably to a combination of funds focusing on its underlying holdings. Specifically, if you compare the following portfolios:
Chart by Author
Both have very similar asset allocations, but XFLT underperformed on most relevant return and risk metrics, in some cases very significantly so:
Portfolio Visualizer
I compared XFLT to other senior loan and CLO ETFs and portfolios too, and the fund's overall risk-return profile did seem quite weak.
Notwithstanding the above, I think it is important to mention that some of XLFT's peers are very young funds, so we can't really meaningfully compare their returns. What information we have available does seem to indicate a very weak risk-return profile, however.
XFLT - Looking Back
I first wrote about XFLT all the way back in early 2020.
XFLT Previous Article
In that article, I argued that XFLT's investors should expect around 7.9% in long-term shareholder returns moving forward, based on prevailing fund dividends, expenses, etc. XFLT has averaged 7.8% in total returns since, broadly in-line with expectations. A combination of higher rates and pandemic losses were responsible for the added returns.
Right now, XFLT's returns are strongly dependent on future Fed policy, which is not really possible to forecast. Due to this, I will not be analysing XFLT's expected returns in any real depth. I will say that investors are looking at double-digit returns, assuming no significant recession or Fed rate cuts. Those are very big assumptions.
As a final point, the hold rating above was not a mistake: fund fundamentals were much worse at the time, and the fund significantly underperformed during the year. The actual mistake was not re-visiting the fund sooner, either as markets recovered from the pandemic in late 2020, or when dividends grew massively in late 2022. I did write about senior loan ETFs at these more opportune times, however.
Conclusion
XLFT offers investors diversified exposure to several variable rate securities, and a strong, fully-covered, growing 13.3% dividend yield. The fund is a buy, but on the riskier side of the senior loan or variable rate market, and with a below-average risk-return profile.
For further details see:
XFLT: Senior Loan And CLO ETF, Growing 13.3% Yield, Low Rate Risk