9.20% Yielder With Expert Management And Upside Potential

Summary

Bond investments are not the sexiest nor the high fliers that many individual investors are interested in.

So far this year, bond investments have been lackluster and not provided the expected returns.

Do not use that as an excuse to become more aggressive and move more into equities, increasing the risk of the portfolio at this point in the cycle.

This is a risky investment idea but less so than most common stocks, given the placement on the capital structure and diversification.

A version of this report was released to members of Yield Hunting nearly 2 months ago at more favorable prices.

Introduction

Bond investments so far this year have not fared well as interest rates rose substantially. The 10-year yield opened the year at 2.41% and has hit as high as 3.10%. Given the CPI data out on June 12th, it appears highly likely that we re-test that level and surpass it.

10-Year Treasury Rate data by YCharts

We did a report on interest rate sensitive investments versus credit-sensitive investments recently, which highlighted the differences in different sectors of the corporate bond market. As the chart below indicates, high yield (credit sensitive) has significantly outperformed investment grade (interest rate sensitive).

 

The Backdrop For Our Latest Addition To The Core Portfolio

Our Core Portfolio focuses on an income production and we primarily look at areas of the fixed income market that we think are insulated from the risks we foresee in the near future. While we hold both credit-sensitive and interest-rate-sensitive investments, over the last year we have been significantly overweight credit given our outlook for the economy.

One of the latest additions (April 1 for members) is KKR Income Opportunities (KIO) which is a credit-oriented investment. That means that the fund is more sensitive to default rates and the economy as opposed to interest rates like U.S. treasuries and municipals.

For credit investors, this is a solid fund that has done well in the face of higher interest rates and should perform well in the current economic environment. Leading economic indicators remain strong, one of our favorite indicators for credit spreads. Other indicators that we are following include:

  • The Price of Oil: Much of the high yield market centers around the energy sector so the price of the commodity can affect bond pricing significantly as it did in 2014-2016.
  • Default Rates: Credit defaults remain at or near the lows of the expansion and while leverage has been increasing, we currently do not see any reason to be lightening up.
  • Corporate Earnings Remain Strong: Earnings are growing double-digits aided by the tax reform bill in 2017. That leaves more cash flow to service levered balance sheets.
  • Ratings: While we place less emphasis than most on credit ratings from the ratings agencies, we do look at aggregate upgrades/downgrades. In the last 6 months, upgrades have far-outpaced downgrades.

While credit spreads are tight, we do not foresee a recession in the near future (next 9 months) that would crater this fund. In addition, the fundamentals of KIO do not indicate a need to reduce the distribution causing a price decline. We believe we can capture the high yield plus some upside from the rising NAV and discount closing.

KKR Income Opportunities Fund - Yield 9.19%

 

This is a combination high yield bond and loans portfolio (and even 5% in stocks), so this is not an ultra-safe fund. However, during the downturn for high yield in 2014 and 2015, the fund did well losing only 3.6%. The out-performance has been incredible with the blue lines below well outpacing the orange lines which are the category averages.

 

Investment Strategy:

The Fund seeks to achieve its investment objectives by employing a dynamic strategy of investing in a targeted portfolio of loans and fixed-income instruments of U.S. and non-U.S. issuers and implementing hedging strategies in order to seek to achieve attractive risk-adjusted returns. Under normal market conditions, the Fund will invest at least 80% of its Managed Assets (as defined herein) in loans and fixed-income instruments or other instruments, including derivative instruments, with similar economic characteristics (the “80% Policy”). The Fund expects to invest primarily in first- and second-lien secured loans, unsecured loans and high-yield corporate debt instruments of varying maturities. The instruments in which the Fund invests may be rated investment grade or below investment grade by a nationally recognized statistical rating organization, or unrated.

Fund Details:

  • $474M AUM
  • 2.6% Expense Ratio
  • Manage by KKR Asset Management
  • Discount: -7.33%
  • Distribution: $.125 Monthly
  • Yield: 9.20%
  • Leverage 31.0%

Portfolio Holdings

As we noted above, the fund is 50/50 between high yield bonds with fixed coupons and levered loans with floating coupons. That mix helps to reduce the duration (sensitivity to changes in interest rates) of the portfolio to just 2.4 years.

 

Nearly all of its investments are below investment grade issues. In addition, the credit ratings of the bonds are decidedly towards the junkier side of the spectrum. The fund has over 40% in CCC- rated debt which we liken to "diet equity" or "equity-lite." These securities are going to be fairly correlated to the equity market in general which we are currently bullish on seeing new highs in the near future.

The average coupon on its debt securities is 11.25% which should be an indication of the 'quality' of the assets that it is purchasing. Most of the issuers are for companies located in the United States (93%). The top 5 industries are as follows:

 

What we like when analyzing those industries is that oil and gas and related services are not a component of top exposures of the fund. Having a volatile commodity being the driver for your bond price, something you have no control over, is not optimal when investing in riskier assets. We like the positioning of the portfolio as having less correlation to oil prices.

Distribution Payments and History

Since inception, the fund has paid the same distribution and even included a special distribution in the amount of 5 cents last December. Maintaining a stable distribution is a significant advantage and should command a better valuation (discount to NAV).

 

We analyze the potential for a rate cut among high yield using several metrics including more recent EPS. We typically shun funds that only report their financial on a semi-annual basis given the lack of transparency. In the case of KIO, the fund has a fiscal year end of October 31 and the N-CSR (semi-annual or annual report) typically comes out approximately 60 days later. We expect the next N-CSR (the semi-annual) to come out the first week of July.

 

In CEFConnect, the data has grown as stale as they get. As the image above shows, the fund was earning 12.72 cents per share as of the end of the reporting period (October 31). That compares to the monthly distribution of 12.5 cents for coverage just over 100%. In addition, UNII is positive (again as of more than 6 months ago) providing some downside cushion.

Our modeling for the NAV performance and EPS indicates to us that the earnings of the fund is likely close to or just above 100% when it reports next month. The High Yield Index is up about 0.82% over the prior six months while levered loans are up 1.85% which should be supportive of the earnings power of the fund.

HYG Total Return Price data by YCharts

The stability of its distribution and our notion that it has the ability to maintain or even grow the payout is a reason why we like the position.

Recent Rights Offering

The fund conducted a rights offering last year which hit the shares hard providing the current opportunity. The discount had closed to just 1% when it hit investors with the offering. The discount blew out to 13% as the offering was completed (and before the NAV adjusted lower so it is a bit of a false discount). Today the NAV has been fairly stable and slightly rising since then.

 

Valuation

The discount to NAV was over 10% (not including the ~14% discount when the rights went through but NAV had not been adjusted yet). One of our co-contributors George Spritzer wrote a report highlighting the rights offering and his thoughts and analysis. He wrote:

The real question is what will happen to the KIO discount after the rights offering is over. Over the last six months, the average discount has been around -5%, but over the last three years, the average has been more like -9%.

The discount has been slowly closing and we think given the performance and the passage of the rights offering, could be headed back to 5%. The 3-year average discount was greatly influenced by the large decline in high yield bonds in 2015 and early 2016 causing widening discounts in the closed-end funds focused on those strategies. As we noted in the introduction above, as long as oil stays above $50 and credit spreads rangebound, this fund's discount should slowly close as equity markets support the shares.

 

The valuation is not nearly as compelling today as it was when we first introduced it to our membership base (March 11) nor when we added it to our Core Portfolio (April 1) but we still believe upside exists in both the NAV movement and with discount closure.

Conclusion

KIO has continued to perform well since it launched the fund several years ago. The management team is stellar with one of the best credit shops in the world backstopping the fund. Of course, investors have to pay for that expertise through a higher-than-average expense ratio. Given the performance numbers that it has been able to put up in the face of higher rates, we think the higher expenses are worth it.

With the rights offering behind us, the fallout from the dilution is now gone and we think the back-drop for junkier high yield will be favorable over the next nine months or more. Given our outlooks for rates and the equity markets, we have positioned our Core Portfolio accordingly and KIO is an example of that positioning.

If you are looking for more timely recommendations and hand-holding in regards to constructing an income-focused portfolio, check out our community of investors at our marketplace service. We have easy-to-follow spreadsheets to mirror along with weekly and monthly commentaries to help explain our positioning and market outlook. For more information, click the link below or message us for a copy of a recent newsletter.

Here are the returns of the Core Portfolio through the end of May:

 

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Yield Hunting: Alternative Income Opportunities For Retirement

Alpha Gen Capital started Yield Hunting in April 2016 with one purpose in mind: to find yield in a yieldless world. While some subscription services will find yield at any cost, we pride ourselves on the fact that our core portfolio can generate a roughly 8% yield while exposing investors to one third the risk of the S&P 500. Our one-year trailing return through the end of November is 20.15%.

We utilize fixed income CEFs, dividend paying stocks, munis, BDCs, baby bonds, among other investment vehicles to generate income while mitigating the risk on the downside from adverse and identifiable risks.

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