Volatility has taken over, and if you’re like most people, you’re wondering where to find the safe dividends you need to keep your savings – and your income stream – as this pandemic continues.
There is an interesting alternative that you may not have thought of: Senior Loans, also known as Variable Rate Loans. Because they sit very high in the corporate food chain, they provide a layer of security in the event of bankruptcy, which is a concern of all investors these days.
Additionally, senior loans offer yields of 6% on average, which also makes them an income investor’s dream. But do these loans, which I recommend to hold only through a closed fund (CEF)-a purchase today?
Let’s answer that now.
How Senior Loans Protect Your Investment
How Safe Are Senior Loans? Think of it this way: When a business is liquidated, there is a long line of people who will be paid for their investment and a structure as to who gets paid first.
With this structure, senior loan holders are indemnified before owners of a company’s corporate bonds (âsubordinated debtâ above), convertible bonds and preferred shares (âhybridsâ). and common stock (âequityâ). This is why, for example, when American Airlines went bankrupt in 2011 and became the new American Airlines (AAL), the owners of the old AA stock received next to nothing while many of the company’s lenders lost little or no money.
That’s how it works on paper, anyway; the reality is a little more complicated.
The Fed blurs the picture
Now let’s talk about performance and compare index funds covering quality corporate bonds and floating rate loans. For companies, this would be the IShares Investment Grade Corporate Bond ETF (LQD); for variable rates, we will use the IShares Floating Rate Bond ETF (FLOT). We see that both are down by roughly the same amount since the start of the year, but they are much less down than stocks.
These movements make sense. FLOT is less volatile than the bond fund because it is less likely to suffer write-downs due to defaults, and both ETFs fare much better than common stocks because stocks have a higher risk of going to zero when bankruptcies are increasing.
That’s why LQD and FLOT were decent hedges before the crisis – and they’re still good if you think COVID-19 will lead to widespread bankruptcies at very large companies. There is only one problem: The Federal Reserve has made it clear that it will not let this happen. And one of Wall Street’s biggest clichÃ©s is a clear order: don’t fight the Fed!
Why not? Because going against Fed policy results in lower returns in the long run, and betting the Fed will allow bankruptcies to rise over the next year will result in meager returns.
The last time there was a clear situation where the Fed was basically telling you not buy senior loans was in 2013, when the central bank injected more than $ 1 trillion into the economy through its quantitative easing program (which was far less than the more than $ 2 trillion that the Fed and Treasury are currently injecting into the US economy). At the time, fighting the Fed with FLOT yielded virtually zero returns!
Of course, you didn’t lose any money, but you also missed out on the huge gains you could have made by following the Fed line and buying into the economy through stocks. This year seems to be going quite similarly, but with an important twist.
A better alternative
The world today is nothing like it was in 2013; with a global pandemic, simply betting on all the rising stocks when many companies are forced to close will result in a portfolio with many losers mixed in with the winners. This is one of the reasons why, throughout this pandemic, I have been banging the drum for a return to value investing – and funds that know what value investing tools to use.
This is a big reason why in mid-March, I proposed Looking at the Boulder Growth and Income Fund (BIF), which invests in Warren Buffett’s Berkshire Hathaway
Investing in value pays off in times of crisis
This investment fund’s value soared 10% in no time. Today, with a 17% net asset value discount and 4.4% return, the BIF has not attracted as many buyers as it likely will be when investors realize they can. buy a fund that carefully chooses which stocks to buy and which to avoid, without the modest returns of a floating rate fund. It makes a huge difference in the long run.
And you can prepare for the next BIF hike now, without investing in the overvalued companies most likely to go bankrupt due to the pandemic.
Michael Foster is the Senior Research Analyst for Contrary perspectives. For more great income ideas, click here for our latest report “Indestructible Income: 5 windfall funds with safe 11% dividends. “