Credit Investing Looks More Attractive Than Ever (Turn Off CNBC!)

Summary

• I have often compared CNBC to the ESPN sports network, with panels of experts giving non-stop commentary on the sports or financial worlds.
• Both have the same business model: get viewers addicted so they'll watch all the time, regardless of whatever is happening.
• Unfortunately, it tends to encourage investors to believe that attention to the minute-to-minute, day-to-day changes in prices is the key to successful investing.
• And, obviously, that "growth" in the market price of your securities is the be-all and end-all.
• Of course, our Income Factory® strategy replaces that focus on "price growth" with a focus on "income growth", recognizing that the ability to produce income is what ultimately drives economic value.
• Looking for more investing ideas like this one? Get them exclusively at Inside the Income Factory. Learn More »

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Quick Primer on Credit Investing

I've written for years about the value of "credit investing" where you are betting on companies to merely stay alive and pay their bills; but not expecting or requiring them to do anything "heroic," like increase their earnings, boost their dividends or grow their stock price.

Needless to say, it is a lot easier to win the credit bet than it is to win the equity bet. I often compare it to a horse race, where the credit investors are merely betting on the horses to make it around the track and finish the race. They don't have to win it or even place it near the front, just finish the race.

Equity investors, of course, are betting on their horses to not only finish the race but also to excel and win the race or at least finish somewhere near the front of the field.

What many investors don't seem to realize, is that every equity investment also includes within it all the risks of a credit investment as well. In other words, if you buy the equity of a company, besides taking the risk that the company WON'T grow its earnings, dividends and stock price, you are also taking all the same risks of a credit investor that the company won't survive and pay its creditors, since failure to pay creditors means bankruptcy. And if companies you own stock in fail to pay their creditors, then you might as well paper the wall with your stock certificates. (For younger investors who don't remember "stock certificates," that means say "Sayonara" to your equity value, since it will likely be worthless; although in some complex bankruptcies, senior creditors throw some table scraps at the junior creditors and equity holders just to speed up the process and avoid litigation.)

High Yield Credit (aka "Junk")

One of the great misunderstandings within the retail investment community is that high-yield debt (loans and bonds issued by companies that are below-investment grade; i.e., BB+ and lower) is somehow really scary and risky, compared to other common investments. Much of the misunderstanding relates to the issues just discussed, that "debt" (of whatever kind, high yield or investment grade) is above equity on an issuer's balance sheet and is ALWAYS a safer, less risky investment than the equity below it.

This makes for some strange comments from investors who will sometimes swear that they'd never touch high-yield loans or bonds because they are "so risky." But then when you dig deeper and ask them about the rest of their investment portfolios, in most cases they hold diversified equity portfolios that include mid-cap and small-cap funds and/or stocks. Imagine their surprise when we point out that virtually all mid-cap and small-cap companies are below investment grade, so the stock in these companies is below (and therefore riskier than) the loans and bonds of the same cohort of companies that these investors swear they'd never buy.

Why Is This Particularly Relevant Now?

As I watched CNBC this morning, there seemed to be consensus among the panel of "experts" that the equity markets would be pretty volatile and unpredictable for possibly months to come and it was too soon to confidently call a bottom in stocks. So there were suggestions being made that "maybe investors should look at the higher returns now available in treasury bonds and investment grade corporates" where you could pick up more serious returns (in their view) of 4 and 5%.

As I watched, I wanted to reach through the screen and shake a few people and say: "Aren't you paying attention? You can get yields of 10 and 11% or more on real credit investing in high yield corporate loan and bond funds, or from companies like BDCs (business development companies) that make well-secured corporate loans."

We are at a point where high-yield credit that in more normal times, depending on the credit type and structure, might have paid us yields of 6 to 9%, is now beaten down in price to where it pays more like 8 to 12% (and more in some instances).

Recently I have been reviewing my Income Factory® model portfolios with a view to taking advantage of current opportunities as well as solidifying and maximizing our income stream for the next years, especially with the looming risk of an economic downturn and/or recession. The asset classes that I am focusing on currently are:

• Senior corporate loans, where top-notch loan funds like Invesco Senior Income (VVR), Apollo Senior Floating Rate (AFT) and BlackRock Debt Strategies (DSU), offer well-secured, floating rate portfolios at yields of 9-10% and discounts in the 9-11% range. Besides the funds being discounted, the market prices of healthy loans are also discounted, as are the market prices of the funds themselves year-to-date, so there is considerable potential for capital gains along with the 9-10% yields, when the overall market eventually recovers.
• Business development companies ("BDCs"), where firms like Ares Capital Corp. (ARCC), Barings BDC (BBDC), and Carlyle Group BDC (CGBD) are selling at big discounts and yielding in the 10-11% range. There are lots of other BDCs that are attractive candidates; investors can also buy a well-diversified ETF called VanEck Vectors BDC (BIZD) that currently pays a distribution of 11.4% and is way down in price with potential for substantial capital gains when the market improves (currently at $13 having been at $18 in April).
• High Yield Bond funds, like BlackRock Corporate High Yield (HYT), PGIM High Yield Bond Fund (ISD), and Pimco Income Strategy Funds (I and II) (PFN) and (PFL), all of which are selling way below earlier market prices and at discounts (or close to par for the two Pimco funds), with distribution yields in the 10-12% range.

These are just a few of the opportunities we are finding as we review the credit and fixed income asset classes. Our strategy emphasizes creating our own income growth through reinvesting and compounding high-yield distributions. This has the advantage of:

• Not being dependent on the market to provide our growth, so that during periods of market price stagnation or decrease (like this year) our income keeps growing while equity "growth" portfolios with puny 1-2% yields are dead in the water.
• Credit funds generally cover their distribution yield with their own "net investment income" (which is the cash interest and dividend income the funds' own assets generate, minus their expenses); this means credit funds don't have to turn their "paper losses" in market value into REAL losses to generate cash to pay distributions through a bear market, the way equity funds do. (Link here for more info on that.)
• The risk/reward trade-off in our favor is we can earn what is historically an "equity return" of 9-10% or more by investing in credit rather than equity.

If all our issuers (the hundreds or thousands of corporations that issue the loans and bonds our funds hold) have to do during the challenging and volatile environment that we are currently experiencing is muddle through, stay alive, pay their debts and "finish the race," then I will sleep better than if I were mostly holding equities where my issuers had to not only survive but also excel and achieve more "heroic" results in order for my investments to pay off.

Disclosure: I/we have a beneficial long position in the shares of AFT, HYT, ARCC, BBDC, CGBD, ISD, BIZD 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.