Co-produced with Treading Softly.
Welcome to April! What a year it has been in the market so far. Between the Federal Reserve’s continued battle of inflation, banks starting to crumble under the weight of unrealized losses on their hold-to-maturity portfolios, and a looming debt cap battle in Washington, investors have a lot to be worried about. The Fear and Greed index shows Fear is ruling the day: Source.
So, as we enter into a new quarter, what should investors be doing? Cashing out and piling gold coins around their house? Perhaps they should double down on Growth investments thinking they can pick the ones whose high rates won’t clobber? Or should we do nothing different?
Historically, I have been a net buyer of the market. I don’t like to play games or roll the dice, thinking I can time its bottom and top. I have learned that the classic saying “time in the market beats timing the market” has been accurate in my experience.
This doesn’t mean I blindly buy anything at any time. I take time to review the current situation and take a look at the horizon to see what may be coming and buy the best opportunities presented at that moment in time.
My team and I provide weekly market outlooks to our members of High Dividend Opportunities (“HDO”) and bi-weekly market outlooks to HDO Lite members to enable them to get a bird’s-eye view of what’s brewing outside of their immediate surroundings and help them determine which opportunities may be the best for their personal risk tolerance. For an income investor, knowing is half the battle.
The other half? Buying excellent income.
Let’s look at two picks we think will be prime opportunities for April and well worth holding as we move towards tomorrow and beyond.
Pick #1: GHI – Yield 8.6%
Greystone Housing Impact Investors LP (GHI) is a company with a very unique niche. GHI’s core business is “mortgage revenue bonds” or MRBs. These are bonds that are issued by government housing agencies to support the development of low-income housing. Qualifying developers, who dedicate a portion of their development to low-income housing, have access to these mortgages. Investors are incentivized by the government by making the mortgage interest tax-exempt.
As a result, MRBs tend to correlate strongly with municipal bonds but tend to be higher yielding because the money is being borrowed by the developer, not the government.
While some of the bonds are floating rates, GHI generally benefits from lower interest rates. Every 100 bps increase in interest rates creates a $0.022/unit headwind on earnings.
Last year, GHI was able to more than make up for this headwind through its “Vantage” joint venture. The Vantage JV develops apartments that don’t have a low-income component. GHI’s partner builds the properties and then leases them up before selling a stabilized property to investors. GHI provides the capital in exchange for a preferred return, plus additional upside when the property is sold.
This strategy has been very successful for GHI, and it is expanding it. Two properties have already been sold this year, four properties are already operating, and another seven properties are at various stages of development. Source.
This will ensure that GHI has a steady pipeline of properties that could be sold. Since the strategy depends on selling properties, which can be unpredictable, the gains tend to be lumpy and unpredictable.
Last year, we enjoyed a few supplemental dividends thanks to gains from the Vantage sales. This year, we expect to collect the regular $0.37/quarter distribution.
GHI sold off along with most financials in the wake of the failure of Silicon Valley Bank and is now trading at very attractive prices. GHI is attractive for the regular distribution alone. The potential supplemental/special distributions in the future are just the cherry on top.
Note: GHI issues a K-1 at tax time and may not be best for non-U.S. investors.
Pick#2: PDO – Yield 12.3%
Despite the wailing and gnashing of teeth the past few months, the PIMCO bond funds we hold have managed to realize net investment income that covers their distributions. We are bullish on several PIMCO funds, but perhaps one of the best buying opportunities of the moment is PIMCO Dynamic Income Opportunities Fund (PDO). PDO is trading at a discount to its net asset value.
For the past several months, PIMCO’s UNII Report showed a freefall in coverage. From September to December, this measure deteriorated considerably. For example, PDO had an undistributed NII of $1.05 and 3-month coverage of 163%. By December, PDO had undistributed NII of $0.00 and 3-month coverage of only 45.78%.
These numbers have improved, and for February, 3-month coverage was up to 82.64%, with UNII still at $0.00. In essence, PDO has precisely matched its dividend in January and February.
The collapse in coverage left many investors wondering “what happened” and has created fear of PIMCO’s ability to achieve its dividend payout. Some have gone so far as to suggest that PIMCO is somehow “hiding” its ROC. Let’s take a closer look at what UNII is telling us.
Net Investment Income is the net income that the fund has realized. It does not recognize any unrealized capital gains or losses. UNII is “undistributed” NII, which means the amount of UNII recorded that exceeds the dividends paid. There should be no secret as to why PDO’s UNII went from $0.83 in November to $0.00 in December. Investors who were holding PDO enjoyed a $0.96 special dividend which was announced for the purpose of clearing out the UNII that was carried over from the prior fiscal year.
Also, in October and November, PIMCO realized several losses, creating a headwind to NII. This shouldn’t be a major surprise as during that period, bonds of all types bottomed. September through November were very brutal months for bonds, in a year that was the worst year for bonds in history. PIMCO made the decision to sell some bonds at a loss and reinvest in other bonds that we can presume management believed would have better total returns. Whether those changes were good or not is to be determined. PIMCO’s NII was actually negative in November, which impacted the 3-month average NII significantly.
Since December, we’ve seen significant stabilization in NII, with it approximately matching their dividends. Note that this does not mean that PIMCO has had a positive “total return.” With its hedge positions and portfolio holdings, PIMCO can have a positive NII and a negative total return depending on when gains or losses are realized.
If we look at PDO’s fiscal year-to-date total return NAV, which measures the change in NAV and dividends paid, it is down 3%.
What this tells us is that the unrealized losses have exceeded the $2.11 in dividends that PDO has paid since July. NAV has continued to trend downward.
The central question for PDO is whether those unrealized losses are permanent or whether those bonds will recover value either by going up in price or being redeemed at par at maturity.
As of December, according to page 21 of their semi-annual report, PDO had $3.28 billion in cost basis invested in securities which had a fair market value of $2.67 billion. This means their unrealized losses on securities were approximately $610 million or $5.52/share. That is what the upside would be if bond prices went back to prior levels tomorrow.
Obviously, that isn’t going to happen in a day, but it illustrates how much the assets that PDO still holds have fallen. The losses aren’t permanent unless the borrower defaults or if PDO decides to sell.
We know that bonds are down in price right now. So it isn’t a surprise that bond funds are down. It is also true that if PIMCO decided to liquidate PDO right now, there would be large losses that would be realized, and it would result in significant ROC to investors. Yet that is all academic because that isn’t what PIMCO is doing. Management is swapping some investments in an effort to improve future potential gains. That is how PIMCO made its name, backing up the truck on mortgages when others were running in terror during the GFC. Management’s goal is to position PDO and their other funds to have great performance when bond prices recover, as inevitably they will. If interest rates stay high, bond prices recover as maturity approaches, and they are paid at par value. If interest rates decline again, then bond prices go up from interest rate movements alone.
The goal of a bond fund like PDO is to get above-average yield on investments that are mispriced, while avoiding exposure to bonds that default, causing permanent realized losses. It is an exercise that PIMCO management has been very successful at in the past, and that’s why we trust our capital with them.
The month-to-month UNII reports can provide an important temperature check, but you shouldn’t go into a full-out panic over poor results for a short period. If you see a consistent problem, then it might be of concern worth addressing. PDO’s UNII looked poor for a few months, but it has bounced back to normal ranges.
If interest rates start heading back down, bonds will recover, and that will be a great catalyst for bond funds, including PDO.
With GHI and PDO, I can enjoy a strong income stream from my investments. GHI’s focus on Federal Tax-Free investments, combined with the additional income from their Vantage properties, allows unitholders to enjoy income from a predictable source. PDO has been active in the credit market, and PIMCO is legendary for its ability to capably navigate tough waters and reward its investors.
These are only two picks of at least 40 investments that one’s income portfolio should hold. This way, any single pick that may run into issues will not cause a catastrophic problem. We recommend that investors hold no more than 2% on average in any investment. With cash constantly flowing into your account, you’ll always have plenty to reinvest into new picks or expand your holdings in current picks to see more income pouring in the coming month or quarter. With +45 individual picks, the High Dividend Opportunities portfolio currently yields +9%.
Your life does not end when you retire. As a result, the life of your portfolio should not be planned for obsolescence. You should continue to let it live and grow – providing you with more and more income as you kick back and enjoy not having to work to get paid.
You’ve earned it. Our Income Method can help make it possible. I want nothing but the best retirement possible for you, and income investing is the answer I have for you.