I Am Bottom Fishing: 2 Great Income Funds

Co-produced with Treading Softly.

It can be hard to shake off recency bias. When you roll by a gas station charging $3 for gasoline, you get excited. That’s way down from $4 or higher that we’ve seen lately!

What we’ve forgotten is that only a year ago $3 was considered by many to be outrageous and upset them considerably.

So what happened? Time passed and prices moved higher, now $3 doesn’t look so bad compared to $4 or even $6 in some places.

Moving to the market, year to date it looks great!

Yet, if we zoom out a little further, we can see that this excitement is misplaced, as the market has a long way to go before it has fully recovered:

Panning out to Jan 1st of 2022, we can see that even though recent gains are potentially impressive, the reality is that we’re a long way off from how 2022 started.

So, I am still bottom fishing for excellent income investments that have not recovered from their prior drops. They still offer excellent income. They still have room to give me large capital gains.

When the market falls 30%, it takes a 60% gain from the bottom to recover. Don’t let recent memory paint reality a new color.

Let’s look at two not-fully-recovered income funds that deserve a home in your portfolio.

Pick #1: BIZD – Yield 10.2%

The macro environment is ideal for the BDC (Business Development Company) business model.

Most BDCs lend floating-rate senior secured loans. These are commonly term loans or revolving lines of credit. Most of these loans pay floating interest rates. Meanwhile, BDCs tend to utilize fixed-rate debt for their leverage, this creates a scenario where BDCs borrow fixed and lend floating. A fantastic dynamic when interest rates are rising.

BDCs service the “middle market,” these are businesses that are not publicly traded and can range in size with annual EBITDA anywhere from $5 million to a few hundred million. Why don’t these businesses just borrow from a bank? Well, the answer is that they used to. In the early ’90s over 70% of middle-market loans were held by banks, this declined dramatically during the Dot-com bust and again on the heels of banking regulations inspired by the Great Financial Crisis. Source.

Businesses didn’t stop borrowing money. They just borrowed from somewhere else. In the early 2000s, publicly traded BDCs started to fill in the gap.

This shift is beneficial for everyone involved.

Banks need to worry about liquidity, and these middle-market loans generally don’t trade on an open market, so they aren’t liquid. Banks aren’t all that interested in putting the manpower into managing these loans.

The borrowers aren’t looking for strict one-size fits all loans, they are running a small to medium-sized business and can often benefit from a lender that is working with them rather than just offering a loan.

BDCs don’t just lend and send a bill for the loan payments, they frequently take an equity interest in the borrower in addition to the debt. This allows for a lower interest rate for the borrower while providing a higher total return potential for the BDC. It also means that the BDC has an invested interest in the success of the underlying company. It is no accident that BDCs usually have close relationships with private equity. Often teaming up with private equity to provide debt and equity investments. The borrower benefits from the cash but, more importantly, gets an active investor that is interested in providing expertise to ensure the success of the company. Being able to provide a combination of equity and debt investments allows the borrower to balance their capital structure in a way that optimizes their success.

With low defaults and rising interest rates, we’ve seen BDCs thrive. When you expect macro tailwinds to benefit all companies in a sector, an ETF can be a great way to get quick exposure. VanEck Vectors BDC Income ETF (BIZD) is an option to gain diverse exposure to the sector to double down on it or in lieu of investing in individual picks.

But what about recession risk? Given that BDCs lend money to private companies, some fear what impact a recession might have on the sector. Yet during the Great Financial Crisis, BDCs held up remarkably well relative to banks and the S&P 500 Index (SP500).

Here is a look at 9 BDCs that existed as of January 2008 compared to SPY and KBE (a bank ETF): (ARCC), (BKCC), (GAIN), (GLAD), (HTGC), (MAIN), (PNNT), (PSEC), and (SAR). Source.

While they fell with the rest of the market, they recovered much more quickly.

BDCs are hiking their dividends and experiencing extremely strong fundamentals. BIZD is a great way to increase your exposure to them.

Pick #2: BCX – Yield 6%

BlackRock Resources & Commodities Strategy Trust (BCX) is a closed-end fund, or CEF, that invests in commodity stocks. Its holdings fall into three major commodity-sensitive sectors: mining, energy, and agriculture. Source.

In these sectors, BCX invests in the largest names. 94% of its holdings have a market capitalization of over $10 billion. Over the past year, we saw BCX rally in early 2022 as investors were obsessed and surprised by high inflation. Then in June, it crashed as the narrative turned to a hawkish Fed taking a stand to stop inflation at all costs.

Since then, BCX’s price hasn’t fully recovered. But BCX’s NAV (net asset value) has recovered.

This disconnect is likely due to many investors having the perception that inflation is slowing down. Inflation is slowing; therefore, they don’t want to own inflation beneficiaries like commodity companies.

Yet when you look at the company level, these companies are doing very well. They are reporting high earnings and bright outlooks. So investors will buy the individual companies because they look at earnings and see the strong fundamentals. Yet they won’t buy the sector through a CEF because of the perception that slowing inflation is bad for commodities.

There is clearly a disconnect. We believe the disconnect is with how people think of “inflation.” Inflation is not a measure of prices. Inflation is a measure of the rate of change in prices. For commodity companies, this distinction matters a lot. When we say “inflation is slowing,” we are not saying that prices are going down. We are saying that the pace of price increases is slower, but prices are still high. Consider crude oil:

Prices have declined from their peak last summer. Yet compared to where oil has been priced in recent years, it is still much higher, around 40% higher than pre-COVID. So even as crude oil becomes deflationary in annual inflation measures, the price to commodity companies is still 40% higher than they enjoyed in the years leading up to COVID.

Commodity companies might enjoy the occasional windfall on a price spike, but the real money is made from prices being sustained at higher levels. For big oil, prices being sustained around $80 for years is far more beneficial than the one-time spike to $110.

This is repeated throughout the commodity sector. Corn, soybeans, iron ore, copper, coal – you name it. Prices are down from last year (deflation) but are being sustained at substantially higher prices than they were in 2019. That’s why you can read about how inflation is slowing down but then go to the grocery store and have sticker shock.

Yes, inflation is slowing.

Yes, prices are still high relative to the past decade.

Both are true at the same time. The market has sold off commodity CEFs like BCX because it reasons that inflation is slowing so commodities are down in price. Yet in the big picture, commodities are still high in price, and that benefits the companies that produce them.

Conclusion

With BIZD and BCX, we can enjoy high levels of income today, while their market prices recovered to pre-2022 levels again. BIZD will enjoy the higher interest rate environment, which is providing a massive boost in income for BDCs in general, and as more money flows into BIZD, more money will flow out to you. BCX’s NAV has recovered, but its market price has not. This dislocation between NAV and market price can allow us to buy holdings at a discount compared to buying the same basket of holdings on the open market.

My retirement is focused on strong income generation potential from my portfolio, and yours can be just the same. Overwhelmingly, financial strain, stress, and disaster can be the main reasons a retiree returns to work. I like to have my financial house in order, so that way I can enjoy a vacation, a sunset in my backyard, or visit loved ones without having to pinch every penny or stress about the cost.

My dividends pay for my retirement, and they can pay for yours as well. Bottom fishing can help you get great investments at amazing prices.

I’ll see you out on the lake!