2 Cheap Fat Dividends to Buy in July
Co-produced with Treading Softly.
July is an exciting time in my home. We have two national holidays – Canada Day and Independence Day – along with two birthdays.
We love a good celebration – between fireworks, backyard barbecues and the grand opening presented, we can look forward to an exciting month!
For many, there is a lull in celebrations from July through September, when Labor Day arrives. I don’t know anyone who celebrates on this day, so let’s look forward to Halloween. Canadians have public holidays on August 1st and Thanksgiving in October before Halloween. What can I say, living in a dual nationality household, we get to party a lot!
However, every month is an exciting time for my portfolio. I regularly receive large injections of cash from my various holdings. Love letters of thanks for my possessions.
This July I have two excellent picks that are worth buying or adding to your portfolio. They will reward you with monthly income – to be able to afford all those celebrations! – and we’re pleased to announce a recent dividend increase.
Let’s dive in.
Choice #1: OXLC – Yield 14.4%
Capital of Oxford Lane (OXLC) operates in a niche market unknown to many investors. OXLC is a fund that invests in “CLOs” or Collateralized Loan Obligations.
What is a CLO?
Suppose you go to the bank and take out a loan to buy a car. The bank guarantees your loan and makes the money available to you, but has little interest in waiting the next 5-7 years to see if you repay the loan as agreed. Instead, the bank sells your loan to investors who are happy to sit and collect your interest payments. In this way, the bank immediately frees up capital so they have the cash to provide the next person who qualifies for a loan, this is how almost any debt works. The originator charges a fee and then sells a significant portion of the loans to other investors who are not in the lending business and are content to wait for interest payments.
So how do you ensure that loans are easily sold in sufficient volume? You need to appeal to a wide range of potential investors. From those looking for very low risk investments to those looking for higher returns. A common practice to appeal to as many investors as possible is “securitization”. Rather than selling an entire loan, the loan owner can sell small portions of the loans to various investors. Selling a $300 million loan is difficult, selling $3 million chunks of a loan to 100 buyers is much easier, especially when many of those buyers are funds that are in turn sold to thousands of investors.
A CLO buys portions of senior secured loans. Specifically, these are loans that are publicly rated with average credit ratings in the B/B+ range. By owning these loan pieces, the CLO collects the interest and principal payments, which it forwards to investors based on their priority.
CLOs typically have multiple “tranches” that they sell, including “debt” tranches in which they have a specific obligation to repay X$ principal with interest. The tranches are further split into “senior” and “subordinate” tranches, just like you see with many companies. They are essentially a debt obligation for the CLO, complete with various covenants that trigger an upfront payment should the CLO assets decline in value or cash flow fall.
Then you have the equity tranche. You know what stocks are, that’s what 99% of the articles on Seeking Alpha are about, stock positions. In other words, you are not contractually guaranteed a return, your return depends on the actual performance of the company or fund. In this case, a CLO is a bond fund and shareholders can collect any profits that remain after the fund has paid its debt costs. This is the equity that OXLC is buying.
OXLC holds positions in over 190 CLOs. This offers significant diversity with exposure to over 2,000 loans and nearly 1,700 individual borrowers. OXLC has an average exposure to a specific borrower of just 0.06% and 0.87% to a single borrower. (Source: Investor presentation quarter ended March 31, 2022).
The “collateral” discussed here are the loans held by the CLOs. When the borrowers pay their debts, the CLO pays the debt and the CLO’s equity owners (which include the CLO manager and OXLC) receive the profits.
These gains were exceptionally high, with OXLC earning a cash return at their expense of 29%!
Note that “effective rate of return” includes estimates of future defaults that increase to historical averages. OXLC is able to support an exceptionally high dividend because it produces an exceptionally high yield. For example, OXLC’s dividend coverage for the last 4 quarters has been 197%.
Looking ahead, it’s probably inevitable that delinquencies will increase and OXLC’s cash yield will decrease. After all, the defaults can’t really go below zero, they can only go higher.
This is more than offset by the significant investments that OXLC has just begun to pay out. As of June 30, OXLC had budgeted $406.8 million in investments for its first distribution.
This equates to 28% of OXLC’s gross assets! This is a massive tailwind for OXLC’s gains. Additionally, these loans are all floating rate, while the leverage that OXLC uses is primarily fixed rate convenience loans and bonds. Owning adjustable-rate debt and borrowing on fixed-rate debt is an excellent strategy in a rising interest rate environment.
Pick #2: PDO – Yield 10.7%
“If it sounds too good to be true, it probably is.” That’s mostly good advice – sometimes it is abominable Advice. When I was young, one of my first jobs was for a newspaper. My boss gave me the task of giving away the paper for free. just right? Actually it was quite difficult. You see, everyone was immediately suspicious of getting something for nothing. They were sure there must be a catch they just couldn’t see.
Of course, the newspaper company did not give out free newspapers as a charity. The hope was that once customers had a sample, they would be willing to pay for a subscription. Nevertheless, they got papers for free. The only “risk” for the customer was that they would like it so much that they would pay more in the future.
Investors can also be suspicious. If a stock has a high yield, it “must” be super risky. If stock prices fall, it must be “bad.” I often see investors confuse whether a company or fund is “good” or “bad” with stock price movements.
They will refrain from buying something, saying it is “too expensive”. Then, if the price falls, they won’t buy it because it’s “bad,” using the falling price as evidence of that belief.
A great example is the PIMCO Dynamic Income Opportunities Fund (PDO). I’ve seen many times that PIMCO is the best CEF manager for bond funds. By “best” I don’t mean that PIMCO funds outperform every other investment on every time frame. Like any fund, they will have their days in the sun and their rough days.
I contend that PIMCO is the best because they have delivered solid outperformance on a consistent basis over the long term. Consider PDO’s very similar sister fund, PIMCO Corporate & Income Opportunity (PTY):
PTY outperformed the S&P 500. See all of these ETFs below? those are binding ETFs. PTY is a bond fund and these are the ETFs it should be compared to, but there’s no comparison. Because of this, PTY chronically trades at a double-digit premium to NAV. Over the decades it has proven to consistently outperform.
PDO is a newer offering from PIMCO and uses similar strategies and management. It is trading at a 10% discount to NAV. This has pushed PDO’s regular dividend into double digits. While some worry about dividend coverage just because the price is low, we can easily check PDO’s dividend coverage with theirs UNII Report (Net Investment Income Undistributed) (xlsx download).
PDO has $0.82 in UNII, which is income that is distributed. Last year PDO paid a special dividend of $0.49 to reduce its UNII. We assume that this will be the case again this year. It’s also worth noting that dividend coverage was from PDO improvement when prices go up. Here is PDO’s November 2021 UNII report:
In the first 5 months of the fiscal year, PDO’s dividend coverage was 147%. It has been at 192% since November and has strengthened to 258% in the last 3 months. In other words, when interest rates rise, PDO’s dividend has become more secure. That’s why PDO increased its monthly dividend by 8% this month!
It may be hard to believe that the price is lower and at the same time the dividend is safer, being increased, and the likelihood of receiving a special dividend is higher. But that is the reality. This is because the main reason PDO exists is to buy bonds. If you are a buyer, lower prices are good for you. Buying at lower prices will result in higher yields, resulting in higher earnings.
We found last year that PDO was well positioned for rising interest rates, with a significant portion of its portfolio due to mature within 3 years. We can see these benefits in PDO strengthening UNII as it dramatically outperforms its dividend. For income investors, this is a big win and we can buy at a discount!
OXLC and PDO offer you a monthly income to enjoy again and again. Monthly celebrations will rain down on you. Who cares if the market goes up, down or sideways? You get paid to wait. You get paid to hold shares. They get paid while others only count their lashes while their bloated portfolio of non-dividend-paying securities falls from their lofty heights.
In retirement, you want to enjoy every celebration you can. Loved ones won’t always be with us, and you should have the means to see them, spend time with them, and cover necessary expenses – like your electric bills. Having a portfolio that generates large sums of income from your hard-earned money is an essential tool that so many overlook.
Pick up the tool of income investing and build something beautiful with it. Let its beauty flow into your accounts month after month. If you have time to reinvest dividends, do it. You’ll be amazed to see how quickly a trickle of revenue turns into a rushing torrent.