It’s been a fallow decade or so for income investors, with first the financial crisis and then the pandemic taking short-term interest rates near zero. Easy money has fueled the economy and kept stock markets rising through these periods of volatility, but the yield-hungry have been left to scrape for crumbs.
After reaching a closing low of 0.51% during the pandemic, 10-year Treasuries were paying out less than 1.5%, as of June 10. The investment-grade bond market offers just 2.1%, compared with about 6% 20 years ago, according to ICE BofA indexes. The high-yield bond market is anything but, with junk-rated bonds paying 4.1%, still near the record low hit earlier this year, compared with yields above 10% in the early aughts. And forget about traditional safe holdings, such as money-market funds and certificates of deposit, which yield almost nothing.
But yield does exist in some corners of the markets, and not just in relative terms. A handful of asset classes pay out 7% or more, and some investment vehicles offer yields in the double digits. What’s more, with inflation beginning to percolate, some higher-yielding and floating-rate investments might insulate portfolios against rising prices and offset, to some extent, the danger that the Federal Reserve will tighten policy to combat them.
To get these yields, however, investors must search harder—and be willing to take on more risk.
“In environments like this, investors have a tendency to take risks. That’s OK, but it has to be measured,” says Leslie Falconio, senior fixed-income strategist with UBS Global Wealth Management. “If you’re earning a yield that’s much greater than [what’s available elsewhere], there has to be a reason for it. So you have to do your due diligence.”
Higher-yielding investments available to individuals include business development companies and closed-end funds that invest in collateralized loan obligations, along with more widely followed assets, such as real-estate investment trusts that invest in mortgages. At the lower part of their yield range, these vehicles offer around 6%, and they can pay up to 11% or more—almost unheard-of in today’s markets.
But as Falconio says, trade-offs are required to earn hefty yields. Most of these vehicles use plenty of leverage, charge higher fees, and are less liquid than traditional investments, and many delve into riskier credits than conventional bonds.
Complexity is an issue, too. Some of the highest yields available, including those from CLOs, BDCs, and mREITs, require investors to do extra research to ensure that they are managed well. In fact, management’s track record should be a prime focus, as these vehicles play in opaque markets.
Another important consideration is the economic cycle. Many high-yielding options benefit when the economy is growing, liquidity is robust, and defaults are falling, as is the case today. But if the expansion were to be on its last legs, these income plays might not have as much staying power as hoped.
The bottom line: Double-digit yields aren’t solely the realm of large institutions. Individual investors can get them, too. They just need to know what they’re buying, and how manager selection and diversification within asset classes can offset risks.
CLO Closed-End Funds: 8% to 14%
Collateralized loan obligations are certainly complex. But they are among the few investments that can offer yields at or near double-digit levels. The vehicles buy a pool of leveraged loans, or floating-rate loans to junk-rated companies, and issue a series of debt and equity with claims on the payments from those securities. Holders of AAA-rated CLO tranches are paid first, and in exchange get the lowest yields, less than 1.5%. Lower-rated tranches get paid later, at higher yields, and equity tranches are paid last, at still-higher yields.
Individuals can play the market through closed-end funds and a couple of exchange-traded funds. Only a few CLO closed-ends have long track records. Two of them focus primarily on the risky high-yielding equity tranches popular among professional investors. Their yield comes at a cost, however, with management fees of 2% to 3%, plus incentive fees.
One of the two is Eagle Point Credit (ticker: ECC). It cut its dividend by more than half in the pandemic, but plans to raise its monthly payout by 25%, to 10 cents a share, starting in the third quarter. That would give it a yield around 8.6%, as of June 10. The second is Oxford Lane Capita l (OXLC), which yields around 10.7%; it cut its payout during the pandemic and hasn’t raised it.
The XAI Octagon Floating Rate & Alternative Income Term Trust (XFLT) takes a slightly different approach. It invests in collateralized loan obligation equity and debt, and directly in floating-rate loans, as well, though it has increased its allocation to CLO equity over the past year. The fund, which yields about 9.7%, temporarily cut its payout for six months during the pandemic, and doesn’t charge an incentive fee.
“ In environments like this, investors have a tendency to take risks. That’s OK, but it has to be measured. If you’re earning a yield that’s much greater than [what’s available elsewhere], there has to be a reason for it. So you have to do your due diligence. ”
The strength of the recovery from Covid-19 should be a boon to CLO equity, strategists say. This year has brought record issuance, according to LCD, a division of S&P Global Market Intelligence. CLO equity managers contend they will benefit from that demand, thanks to CLO debt refinancings. All else being equal, lower CLO debt costs mean that more of the underlying loans’ interest payments are left over for equity.
As with any high-yielding investment, collateralized loan obligations come with risks. One of the biggest today is refinancing in the underlying loan portfolio. Loans are generally callable, so when they trade above par borrowers can refinance at a lower interest rate and reduce payments to the loans’ holders, such as CLOs. However, only about 42% of leveraged loans are trading above par now, Citigroup says in a June 10 note. Repricing waves usually begin when about 60% are above par, Citi adds.
Over the longer term, the threat of default and downgrade is always present in leveraged markets. And although CLOs buy more liquid loans from larger companies, they can be volatile in times of stress, such as after the onset of the pandemic in the U.S. last year. For those who want to earn a solid CLO-linked income without CLOs, the funds also issue bonds and preferred stock. Eagle Point has preferred shares outstanding and sold an exchange-traded baby bond (ECCW) this year that yields 6.5%. Oxford Lane has two series of preferred stock classes and one bond outstanding: its preferreds yield more than 6% to maturity, though its 2024 preferred is callable in July. And the XAI Octagon fund has preferred shares (XFLT.PRA) that yield more than 5%.
BDCs: 6% to 11%
For investors who don’t mind sacrificing some liquidity for yield, business development companies provide a chance to dive into an increasingly popular area that’s normally reserved for professional investors: the market for private debt.
There are more BDC options for individual investors than CLOs, with nearly 40 in the Cliffwater BDC index. Over the past year, that index experienced a sharp slide in its share price, losing as much as 50% at the worst of the selloff, but it’s since rebounded above prepandemic levels. Net asset values didn’t fall as much, dropping just 12% at their lowest point before reviving. That isn’t because of low credit risk, but because the market in which BDCs operate is different from the one in which CLOs put their cash to work. Business development companies tend to make direct floating-rate loans to mid-size firms, and those loans aren’t easily traded.
That means that lenders can negotiate directly with companies more easily, potentially limiting defaults. At the same time, because BDC managers do more direct lending, they can’t offload a loan to a troubled company as easily as a manager of more liquid loans could. Fees can be high in this market as well. Most managers charge a base fee, and then add a hurdle fee—levied if a specified return target is hit—on top of it.
This market’s characteristics—and the large number of choices available to investors—make manager selection crucial. In some cases, picking BDCs with the highest yields might not be the best option as they may have heightened risks in their underlying portfolio. “History matters, and there are some BDCs that have just put up really good records, have been very nimble, and have made the right calls,” says Michael Petro, manager of the $257 million Putnam Small-Cap Value Fund.
Timing matters too, says Petro, and now should be a good time for some business development companies with riskier portfolios. He owns PennantPark Investment (PNNT), which is trading at 0.75 times book value. That is partly because, as of March 31, it had more than 30% of its portfolio in equity, with some of that a result of restructurings. Given the speed and pace of the economic recovery and equity-market rebound, Petro argues that the firm should be able to find buyers for those stakes.
Ryan Lynch, an analyst with KBW, also names PennantPark as one of his top picks, with similar reasoning. While its 7% yield is on the lower end of the sector’s range, if its price-to-book value rebounds, it can still provide a solid total return. Petro also likes Crescent Capital (CCAP), which pays 8.9%.
Across most of the sector, optimism about the economic recovery has boosted valuations, with the Cliffwater BDC Index’s price trading at a premium of 1.1 times its net asset value as of June 9, the highest since late 2013. But that shouldn’t be a deal breaker, Lynch says. The premium pricing likely reflects investors’ belief that the value of the loans on business development companies’ books will continue to rebound.
That bodes well for BDCs with more conservative positions, too, and for investors who are uncomfortable betting on firms with large equity positions. Their choices could include Ares Capital’s BDC (ARCC), which yields 8.1% as of June 10, and Oaktree Specialty Lending (OCSL), which yields 7.7%.
Mortgage REITs: 5% to 10%
The mortgage market might not sound like a place to earn yield right now, with new 30-year home loans recently at an average rate of around 3%. But real-estate investment trusts that own mortgage debt are a different story: They yield 5% to 10%, because they generally use leverage to boost payouts. In simple terms, mortgage REITs buy mortgages and borrow against them, using either overnight loans or longer-term structures, such as collateralized loan obligations.
The sector experienced a scare at the start of the pandemic, when banks called in short-term loans made to a handful of mortgage REITs. But the recovery in mortgage-backed securities’ valuations, plus the strength of the short-term overnight markets in which some mortgage REITs get their leverage, have made the sector look far healthier. More than 20 of the 25 vehicles in the MVIS U.S. Mortgage REIT Index trade around or above book value as of June 10, according to FactSet.
It’s still important for investors to pick the right vehicles, however, because another event is looming: The Fed is starting to discuss plans to reduce its pace of Treasury and agency-backed mortgage purchases. While it is doing so because of U.S. economic strength, the decision could still remove a pillar of technical support from mortgage valuations, leading to volatility in mortgage-backed securities guaranteed by government-sponsored enterprises.
The sector’s leverage could amplify that move. Analysts at Credit Suisse wrote recently that the PennyMac Mortgage Investment Trust (PMT), which yields around 9.1%, is their top pick within the group because of its lower sensitivity to interest-rate volatility.
For now, investors may want to look instead at mortgage REITs that have higher exposures in nonagency mortgage-backed securities, says Stephen Laws, an analyst with Raymond James. “The real-estate [non-agency mortgage] portfolios are positioned to perform well as we move forward, especially with the strength we’ve seen in housing,” he says. Laws is bullish on Redwood Trust (RWT), which yields around 6.1%.
For investors who don’t mind taking on risk in commercial mortgages, a handful of real-estate investment trusts can offer healthy yields as well.
Laws is especially bullish on the TPG Real Estate Finance Trust (TRTX). He believes that it could soon boost its dividend, after it reduced its financing costs in a preferred-stock sale. It yields more than 5.7%. Another possibility: Previous Barron’s pick KKR Real Estate Finance Trust (KREF), which has low exposure to Covid-stressed sectors, at around 6% of its portfolio, according to a June 8 note from the analyst. It offers a 7.7% yield.
Write to Alexandra Scaggs at [email protected]
