Eye-Popping Double-Digit Yields, Fully Covered Opportunity

Co-authored with Treading Softly.

When it comes to building a portfolio, it can usually be divided into two types of portfolio designs. The first is someone who focuses solely on having quality investments. They will have very few holdings, but every single one of them, they will believe, has diamond-like qualities. The second is someone who believes you need to have a wider range of holdings to achieve success and so they hold a vast array of holdings, believing that even though some of them may not be very good quality, the total quality as a whole will benefit from their inclusion.

The issue here is that both individuals are right in various aspects. You see, you can have a quality portfolio of a few names that does very well up until one of those quality names has an issue. If you had a portfolio with only ten names in it, and one of them was Hawaiian Electric (HE), this past month has proven to you why having diversification is extremely important. However, if you had a wide-ranging portfolio filled with junk names that all relied on low interest rates to survive – the past three years have been absolutely disastrous for you. The key is that you need to build a portfolio, in our humble opinion, that is both wide-ranging and of a significant level of quality. This way, if a black swan event occurs, it does not knock out your portfolio, but you’re also not gambling on junk forever with everything.

When we look across the entire span of debt available from every single company in the market, and in the U.S. economy, the largest portion of that is not held by financial institutions. The largest portion of the U.S. and economic debt is actually held in structures called collateralized loan obligations, or CLOs.

CLOs are collateralized structures that take hundreds of loans and bundle them together. They then sell off debt tied to those loans in a payment waterfall pattern, allowing those who want to take less risk but still have diversification to receive less to allow them to receive payment first, but also to receive less reward as in a smaller payment. Those who are willing to take on more risk are able to buy lower-down tranches of the CLO – the bottom one is the equity tranche. This tranche has the least amount of protection but also receives the highest reward and often has double-digit eye-popping yields. The yields in this tranche and risk are not for everyone. It takes a careful portfolio manager to pick out the right equity tranches to buy, and even then, returns are not always guaranteed because nothing in life is guaranteed.

Today I want to take a look at two different unique ways in which you can invest in CLOs to get a wide-ranging exposure to the U.S. economy. We’ll look at one that’s a little more risky and one that’s a little less risky, giving everyone an option to invest today.

Let’s dive in!

Pick #1: ECC – Yield 16.9%

Eagle Point Credit Company LLC (ECC) is a Closed-End Fund (“CEF”) that invests in Collateralized Loan Obligations. Source.

ECC is focused on the equity level of a CLO. This means that they are looking at the riskiest level of investment in this capital stack and using that to earn returns. Three-quarters of the entire fund is invested in this level, and they’re seeing yields of upwards of 27% on their positions. This is largely because there is a low trading volume in CLO positions – so they’re able to buy them at large discounts to their actual value. But this also means that the volatility as far as trying to price their positions when giving it an asset value can vary greatly. Therefore, often ECC’s NAV can be extremely volatile, moving up and down. Adding to this is the fact that the managers of ECC frequently like to issue new shares at a premium, allowing them to buy new positions, which typically have a 2-3 quarter drag before providing new cash flow.

What we can see is that ECC’s cash flow flowing into their accounts is far exceeding the payments that are flowing out of them. This last quarter, ECC earned over $0.90 per share in cash flow, which allowed them to easily cover their dividend and their operating expenses and have excess. However, when we start applying GAAP metrics to a CLO position, it has a forced expectation of amortization, meaning that it assumes, just like a mortgage, every payment is a portion of interest and principal being returned. Because of this, ECC failed to cover their most recent distributions under their GAAP requirements.

Currently, ECC is also issuing monthly supplemental or extra dividends, meaning that between what they’re actually receiving in cash flow and what the GAAP numbers are, their taxable income exceeds what their distribution is and therefore is requiring them to pay out extra. It is important to remember that a CEF’s dividends are governed by their taxable income, as they’re forced to pay at least 90% of it as dividends to avoid taxation. So what this is telling us is that management is clearly signaling that they are receiving more taxable income than they’re able to cover in the regular dividends, so we’re getting a little bit extra every month because of that.

ECC continues to buy new equity positions to continue to see its portfolio of holdings grow. There are over 1000 different companies that ECC owns a portion of the debt of; thus, no single company can cause their entire portfolio to collapse. This is one reason why we enjoy strong dividends month after month.

Pick #2: EIC – Yield 13.7%

Eagle Point Income Company Inc. (EIC) is a CEF that also invests in CLOs. Not to be confused with its older sibling ECC, EIC actually invests in CLOs but in a completely different way. Source.

EIC is more of a specialized bond fund. This is because it invests in debt tranches of CLOs which are, in essence, bonds issued by the CLO itself. This provides a higher degree of safety but also a lower level of yield. To avoid having yield that is too anemic, EIC invests in the junior grade rated debt – this would be the BB or B- rated debt. It allows their overall portfolio to have a yield of somewhere between 12 to 13%. Previously, EIC was paying a regular dividend at $0.48 per share per quarter, broken into monthly payments. This is strongly covered by their $0.49 per share of GAAP earnings. Unlike ECC, which has more of a black box style of financials having to factor in amortization, EIC is simpler because these are strictly bonds and it’s very clear cut. EIC receives $0.50 worth of cash flow which becomes $0.49 of GAAP earnings because $0.01 is taken away per share due to management expenses.

EIC announced for the coming quarter, its dividend is rising to $0.18 per share, meaning management is seeing continued strength from their portfolio. This is a lower risk/lower reward to benefit from a wide-ranging exposure to the U.S. economy.

Conclusion

With EIC and ECC, we can gain a way to have wide-reaching exposure to the U.S. economy with varying levels of risk in our portfolio. One fund takes the maximum risk, maximum reward approach and has done so from its beginnings. The other newer fund, operated by the same management team, takes a lower risk, lower reward approach and is continuing to incrementally increase its dividend as its earnings have grown.

Both allow you to have wide-ranging exposure to thousands of different companies. However, if you are a less risk-tolerant individual, EIC is a better fit for you. Taking a lower-risk approach by using the same methodology. If you have a higher risk tolerance, ECC is perfect for you, allowing you to take that little bit higher risk for a high level of return.

Both of these funds offer eye-popping double-digit yields, earning their distributions through their cash flow. One fund has lower volatility than the other.

When it comes to your retirement, you want to make sure that your portfolio matches your risk tolerance. We recommend that no investor has any more exposure to a company than 2% of their total portfolio. We call this our Rule of 42, because it requires you to end up having at least 42 investments within your portfolio. You’ll be amazed how a little exposure to these income catalysts can cause your income stream to grow exponentially!

That’s the beauty of my Income Method. That’s the beauty of income investing.