Hidden Gem, 9.8% Yield, Inflation Protection: XFLT
Summary
- XFLT is a floating-rate loan and CLO fund, and mostly an overlooked CEF.
- CLOs today are the hottest sector to be in, with the system flooded with cash and heading towards inflation and a red-hot economy.
- XFLT is one of the rare solid CEFs still yielding over 9%.
- It is a strong buy at this price with great upside potential.
- It also has a high insider ownership of 6%.
- Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Learn More »
porcorex/iStock via Getty Images
Co-produced with Beyond Saving
Investing is a lot easier with a time machine, or is it? Let's go back in time and say it is February 1, 2020. You have a choice to invest in a U.S. Treasury ETF, an ETF that holds "investment-grade" corporate bonds, an ETF that holds non-investment grade bonds, or a fund that invests in "leveraged loans" with B/B- ratings and equity positions in "collateralized loan obligations".
Without looking, which do you buy? Check out the end of our article to see how your choice fared.
We bought XAI Octagon Floating Rate & Alternative Income Term Trust (NYSE:XFLT) which pays a monthly dividend yielding 9.8%.
Source: XFLT Fact Sheet
XFLT pays us a substantial yield and it does so by investing in a portion of the market that is difficult for retail investors to access. We love XFLT because it provides us with a high monthly income, is guided by an exceptional management team, and provides us with protection from inflation. This "hidden gem" is often overlooked, operating in a niche that many do not understand.
With inflation pushing over 5%, it is crucial for investors to ensure that they are not losing the race. With Treasuries, investment-grade bonds, and even "junk" bonds, investors are seeing their buying power decline as they fail to keep up with inflation. With XFLT you gain exposure to the highest position in the capital structure, and you gain a yield that beats inflation.
Let's take a look at how XFLT generates such a high yield.
"Leveraged" Loans
Senior Secured First-Lien loans are the core of XFLT. These are loans that are issued by banks to corporations. Most of these borrowers are publicly traded or owned by private-equity firms, so we are talking about borrowers that have access to significant capital.
These loans are "senior" and "secured", meaning that they have priority over other debt and have the "first lien" on the company's cash flow and most assets. This puts XFLT at the top of the capital stack. These loans are often referred to as "leveraged loans" and on the borrower's balance sheet you will usually see them identified as a "term loan".
Source: Zolio
Being at the top of the capital structure means that the debt XFLT holds is the top priority for the company.
XFLT's focus is on corporations with credit in the "B/B-" range. Why does XFLT focus here? Because it provides the most attractive returns.
Here is a look at total returns by credit rating for the Credit Suisse Leveraged Loan Index:
Source: TCW
As we can see, the B to Split B range provides a larger total return. This is for a very simple reason, the lower the credit rating, the higher the rate that the borrower pays. This is a basic principle of debt investing.
Debt with higher credit risk is priced lower (yields higher) because investors are assuming a certain level of defaults. If the market were perfectly efficient and knew for certain exactly how many defaults there would be, then the total returns across ratings would be identical. However, the market is not perfectly efficient, and investors do not know how many defaults there will be.
High-yield credit has been outperforming because defaults have been very low. While last year, many experts predicted that default rates would spike up above 10%, the actual default rate never broke above 5% and is now at 7-year lows.
Source: S&P Global
In short, lower-rated debt performed better because the market was wrong about what the impact of COVID would mean for default rates. Defaults were very low, and primarily among borrowers that were already viewed as at-risk prior to COVID.
CLOs
The other major segment of XFLT's assets is "CLOs" or Collateralized Loan Obligations. These are actually very similar in that a CLO holds a collection of leveraged loans, usually with credit ratings in the B/B- range. These are also floating-rate, senior secured, first-lien loans. So, what is the difference?
A CLO is a vehicle that buys a collection of loans and then sells off the rights to collect the payments to investors. It is divided into "tranches" which have different levels of seniority.
When the borrowers pay, the funds are collected and then distributed to the investors by seniority. The senior "A" tranches get paid first, and only when they are fully paid, the "B" tranches are paid, and so on down the line until you get to the "equity" tranche which collects the remainder.
The debt tranches won't miss out on any payments until defaults are so high that the equity tranche gets nothing, the senior "A" tranches will not miss out on any payment until every other tranche gets $0. As a result, the A tranches are very low risk and sell for very high prices (low yields). No A-tranche has ever defaulted.
The equity tranche is at the other end of the spectrum. It receives "whatever is left". It is the very first to realize any losses if borrowers default, and in exchange pays a very high yield.
When defaults are low, the lower tranches have substantially higher total returns. This is what we have seen over the past year.
Source: TCW - (LTM = Last Twelve Months)
XFLT has significantly increased its exposure to CLO "equity" positions which sold off considerably as the market feared a spike in defaults. Those defaults never arrived. In fact, CLO defaults have been incredibly rare with only 0.36% of CLOs defaulting since 1996.
Source: S&P Global
Those defaults all occurred in CLO generation 1.0, CLOs that were issued before substantial reforms were made due to the Great Financial Crisis. So far, there have been zero defaults in CLO Generation 2.0.
Why are defaults low? As we noted above, this debt is at the very top of the capital stack. It is the priority for borrowers to pay back.
Outlook
History is informative, but what really matters is where we go from here. Will leveraged loans and CLOs continue to outperform?
Despite the current high liquidity environment, XFLT's holdings are still priced below par.
Source: XA Investments
Even though XFLT has recovered from 2020 lows, it is still attractively priced. In a world where most debt is trading at a premium to par, even a lot of "high-yield" bonds, it is hard to find opportunities below par.
XFLT's investments have thrived because defaults were much lower than expected during COVID. Even with the spike, XFLT's quality management navigated the crisis without any permanent impact on NAV (net asset value). XFLT's NAV is higher today than it was before COVID.
Historically, defaults slow down after a major event-driven spike, and that slowdown usually lasts 2-4 years.
Source: S&P Global
One way of thinking about it is that the companies that were weak and likely headed for default anyway had their situations accelerated. So, in 2008/2009, many companies that might have defaulted in 2010-2013 defaulted more quickly. This is certainly consistent with the types of companies we saw default in 2020, which were primarily retail and oil companies that were already facing downgrades prior to COVID.
Historical patterns suggest we won't see defaults return to "normal" until maybe 2024 or even 2025. For XFLT, this means that returns for the next 3-5 years should be materially higher than they were before COVID.
Additionally, we must not forget the Bubble of Liquidity in our financial system. Defaults are usually caused in environments where credit is tightening. When lenders are unwilling to lend and when investors are unwilling to buy.
New CLO issuance is over $129 billion in September, the highest issuance for an entire year was $127 billion in 2018. Institutions are lining up to buy tranches in CLOs, making them one of the hottest markets right now. This is only set to continue as institutions face the reality that Treasuries are trading at negative real rates and search for yield.
Additionally, there is a lot of capital that is looking to be deployed into the economy.
Source: TCW
Consider Private Equity (or PE), PE companies have been building up cash and are sitting on record levels of "dry powder". What do PE companies do? They buy out companies that can be restructured profitably, as a result of those buyouts, the existing loans are either incorporated into the healthier company or refinanced. Either way, it is a win for the senior secured lenders like XFLT.
The high amount of liquidity in the financial system helps ensure that XFLT's borrowers have refinancing options available to them, and the high amount of dry powder in private equity will create opportunities for new loans and pay off old loans. With this kind of liquidity, leveraged loans and CLOs will continue to have very healthy fundamentals.
High Insider Ownership
Over the past 3 years, we see a high level of insider piling up on XFLT stock, including the CEO. Insider buying in 2021 has exceeded that of the previous year indicating management confidence in the fund and bullishness over the business of leveraged loans during this time of economic recovery.
Source: MarketBeat
XFLT has almost 6% insider ownership indicating management alignment with the shareholders in long-term value creation (source: Fidelity).
What Did You Buy?
When asked what to buy in February 2020, which did you choose? Knowing that the COVID black swan was around the corner, did you "play it safe"?
If you did, you have found that your investment failed to keep pace with approximately 7% inflation since February 2020.
XFLT saw a huge sell-off in March due to unfounded fears. We get it, the leveraged loan niche that XFLT operates in is not very liquid, so prices can have very large swings when there are no buyers. The market piled into "safe" investments. What do they have to show for it? After inflation their buying power today is lower than it was in February 2020.
Ultimately, what XFLT owns is debt that is at the highest level of the capital structure. These are funds that the borrowers have to pay back, and they do. While the market was panicking, XFLT collected payments and grew its assets.
Meanwhile, TLT (TLT), HYG (HYG), and LQD (LQD) have all seen their yields compress, and worse their dividends fall, indicating that future returns will continue to be well below inflation. Since February 2020, HYG's dividend is down 21%, TLT down 24%, and LQD is down 24%. So not only has your principal lost ground to inflation, but your income is down over 20% with all three of these "safe" picks!
When the smoke clears, income speaks. XFLT recovered all of its principal and more. Today, XFLT is paying a yield of nearly 10%, the same dividend it paid in February 2020. While other bond investments all have seen 20%+ dividend reductions. Don't settle for low yield!
Source: Getty
Conclusion
The financial system is awash with liquidity, investors have a lot of dry powder on the sidelines, and the Federal Reserve is very dovish. These ingredients point towards inflation continuing to run rampant, and a hot economy.
It is only a matter of time before more investors start searching for yield that is high enough to beat inflation. Leveraged floating-rate loans, CLOs, and XFLT are set to be the beneficiaries. We see a conservative upside potential to $10 over the next year as investors seek yield. That is a +14% upside, in addition to XFLT's generous monthly-pay dividend of +9%.
Don't wait for all those investors sitting in low-yield investments to realize they are losing to inflation. Make sure your income is outpacing it with XFLT. This hidden gem with a near 10% yield won't last long at the current discounted price. This could be the biggest winner in your high-yield portfolio!
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This article was written by
Rida Morwa is a former investment and commercial Banker, with over 35 years of experience. He has been advising individual and institutional clients on high-yield investment strategies since 1991.
Rida Morwa leads the investing group Learn More.Analyst’s Disclosure: I/we have a beneficial long position in the shares of XFLT either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Treading Softly, Beyond Saving, PendragonY, and Preferred Stock Trader all are supporting contributors for High Dividend Opportunities.
Any recommendation posted in this article is not indefinite. We closely monitor all of our positions. We issue Buy and Sell alerts on our recommendations, which are exclusive to our members.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (279)
I do believe it has not done falling, but "today" it was a much better deal than when this article was written.
NOT a core position and quite speculative. Will add on downturn.
The smokescreen is "river of dividends" as one author puts it, "safe" is another word to give you some comfort!
I want return of my investment before a return. Until you are even you are just getting paid your money back!
The market made about 40 news high!
Rida
XFLT has been very good as follows, 1000 shares bought in last 11 months is up 12.72 %, plus $.073/month/per share.
12-20 300 up 28.50%
1-21 200 up 22.53%
7-21 300 up 1.45%
8-21 200 up 5.42%
I use $XFLT as a place to stash cash and get paid handsomely along the way. Thinking about selling the first 300 after ex div date, thus collecting the dividend 13 times in some 370 days, that should qualify for long term capital gains tax rate.
Then I will have the Jan bunch to consider doing the same. Looking to add a couple round lots in next couple months.
XFLT is not a buy & hold stock, but it can make some great money for us.
All the regular posters know this, but new pholks maybe no so much. Dividend income is a Wonderfull thing. Set a goal, like enough monthly div income to pay your cell phone bill, once that is achieved, raise that bar to include something else
like your monthly cable bill. 2 years ago my monthly divs amounted to about $10, is over $500 now.
Thanks again HDO for putting. my head together back then, I should have listened sooner!