I think we’re in a mentality now where people are selling bond rallies and not buying the dips. There are two sides to every trade; no matter what happens, someone’s going to be buying. Pension funds, Guggenheim funds — they’ve got to put $4 billion a month to work, no matter what happens, and often it’s got to be in income because their directives demand it.
If that’s the case, as rates go up, they’ll keep buying more, averaging their cost all the way up.
For a long-term high-yield income strategy, I want to avoid that kind of bottom-fishing while staying ahead of the curve. I want to plant seeds early in sectors that have not yet moved.
I believe that’s going to be on the short end of the curve, which is why I’ve taken some exposure to adjustable floating rate assets for the eventual rise of Fed funds and Libor and early signs of inflation. We haven’t really seen that rear its head, but when it does, that’s when we’ll see the short end pop. Then, when the Fed starts coming out of the bond program, certainly we’ll see more of that, as well.
Adjustable floating-rate funds generate a high yield by investing in debt and bonds with interest rates that change with market conditions. A recent article from Morningstar explains exactly how floating-rate funds can benefit from the current environment where rates are rising, but the bottom line is that they shoulder little interest-rate risk or default risk, and they’ll benefit as the Fed starts tapering.
At some point, the Fed will start to raise interest rates on the low end as well as the high end. I know this is being artificially kept down, but I want to be well ahead of that curve. When we see the Fed funds go right from 0.25% to 0.5% to 0.75%, these funds will be right smack in the middle of that bullish move.
Prospect Capital: 11.9% Yield
Prospect Capital (PSEC) is one of the “big kahunas” in the business development company (BDC) sector with a market cap of $2.9 billion; 85% of its portfolio is adjustable-rate, and the portfolio overall has a 13.6% annualized yield.
On Aug. 21, PSEC bested estimates by 8 cents — 26.7% higher than what analysts were looking for. Net investment income for the quarter increased 43% year-over-year to $92.1 million. Shares of this top-rated BDC are trading at just 1.06 times book value; they pay out monthly and they rallied almost 10% on the earnings headline (though they did pull back somewhat from the peak). Prospect Capital is a keeper.
Whitehorse Finance: 9.4% Yield
Whitehorse Finance (WHF) is another BDC that focuses on securing loans to middle-market companies. The company is fairly new, having just gone public in December 2012.
WhiteHorse’s senior secured loans and senior notes have weighted average yield of 14%. Adjustable-rate loans comprise 80.1% of the portfolio.
The company paid out its first full quarterly dividend of 35.5 cents in late March (and again in June), then reiterated it for October, for a forward annual dividend of $1.42 per year, which translates to a 9.5% current yield. I’m very bullish on well-positioned BDCs for 2013, and this new entrant with its highly regarded management team (affiliate of H.I.G. Capital) should shine.
It’s been a little long in the tooth in terms of coming, but I still think the floating rate market is going to be a big winner.
Bryan Perry is the editor of Cash Machine, a newsletter focused on high-yield income investing with a the goal of maintaining a blended total yield of 10% across two portfolios. Bryan is also the editor of Extreme Income which uses the power of historically cheap money to create a leveraged “baby hedge fund” strategy that paves the way to massive profits and 4x greater income.
Stay tuned! Bryan is currently working hard on a brand-new strategy that amplifies your income potential by utilizing a conservative options strategy based on stocks you may already own.