Co-produced with Treading Softly
The market was a lot of things this past year, but a friend to debt investors was not one of them.
MBS – Mortgage-backed securities – and bonds saw a steep decline in value which mirrored much of the general market. Debt investments are typically impacted by very different economic factors than the overall market, often going in the opposite direction. Last year, they faced the same challenge that equity markets faced.
Debt faces credit risk, interest rate sensitivity, and inflation risks. Last year, interest rate risk and inflation risks were front and center, negatively impacting many equities and debt.
A bond that matures decades from now sees its value eroded by record-high inflation and is sensitive to rapidly rising interest rates. If you can get a higher interest rate, older, lower-coupon bonds are less attractive. So in the mid-term, its “value” is adjusted so new buyers can get a desirable yield and return. Long-term holders can wait for the bond to mature to receive the full value back. However, someone must be selling and someone else buying for current trading prices to exist.
As we approach a recession, driven heavily by aggressive rate hikes, debt investments are once again starting to become more attractive. Investors would be wise to be forward-thinking. The time to buy fixed-rate debt is now before rates stabilize or fall again.
So with fixed rate investments near all-time lows due to the recent rate hike and high inflation environment, I want to go bottom fishing to lock in excellent yields before others flock in and their value climbs rapidly again.
Let’s dive in!
Pick #1: PDO – Yield 11.2%
PIMCO Dynamic Income Opportunities Fund (PDO) is an early favorite to pay out a substantial special dividend in 2023. Many investors were surprised when PDO increased its monthly dividend in July and followed that up with a $0.96 special dividend in December.
It is no secret that 2022 was a terrible year for bonds. In fact, it was the worst year in modern history. As a fund that invests in bonds, PDO was hardly exempt from the pain. PDO’s price and its NAV fell significantly. Yet, even as prices fell, PDO paid out an increasing dividend.
The reason is that lower bond prices increase forward returns for bond investors. At maturity, bonds pay back the face value. Whether the investor bought the bond for $80 or $120, they receive $100 at maturity. Therefore, it is better for a bond investor to buy at $80!
If prices are falling because of concerns that borrowers will not repay at par, that is one thing. Yet the prices falling in 2022 had much more to do with the Fed hiking interest rates than concerns that borrowers won’t repay. As of November 30th, PDO’s average bond was priced at $82.51, providing a lot of upsides as borrowers repay at $100.
PDO has approximately 1/3rd of its portfolio maturing within a year. Those bonds will be repaid at maturity and reinvested into higher-yielding opportunities. Source
Many are expecting the Fed to pivot in 2023. At the very least, the Fed will likely stop hiking, reducing the headwinds on PDO’s NAV.
2023 will be a great year for PDO to increase its income, reinvesting at the highest yields seen in decades. It also has the potential to experience a significant rebound in NAV and price as borrowers repay at par.
Pick #2: NLY – Yield 15.6%
Investors often believe that you must choose between high-yield or dividend growth. This isn’t always the case. Annaly Capital Management, Inc (NLY) is in a prime position to raise its dividend in 2023. NLY invests in “agency MBS”, which are mortgages that are guaranteed by the “agencies” Fannie Mae or Freddie Mac.
NLY has been through two recessions, and its dividends surged during both of them. Here are NLY’s dividends through the dot-com bust:
And through the Great Financial Crisis:
The reason for this is simple: Agency MBS is a zero credit risk investment, and investments with zero credit risk do best in recessions when investors fear credit risk. NLY makes a highly leveraged investment, often leveraged at 7-10x equity. So when MBS prices rise, NLY is a huge winner.
As a REIT, NLY must pay out substantially all its taxable income. So when its earnings boom, the dividend has to be hiked. For much of the past decade, investors have soured on NLY because its dividend declined from GFC heights. Few have paid attention to the dynamics that caused that decline.
Have you ever made a “spread trade”? This is where you have one long position and a short position in another investment that you expect will be very similar. The profit is based on the spread between the two assets. This is what NLY does with agency MBS and U.S. Treasuries – long MBS and short Treasuries. It was a losing trade in 2022 as spreads widened to the highest levels since the 1980s.
Note that NLY’s rising dividends in the dot-com bust and the GFC were periods following when this spread got very wide. As the spread between MBS and Treasuries reverts back to normal levels, NLY stands to have significant gains. A large portion of those gains will be passed along to investors as dividends.
With PDO and NLY, I can profit from recovering MBS and bond values to see a boost in my capital gains and a pick-up in profit. Both PDO and NLY must pay 90% of their taxable income in the form of distributions. So when their bonds and MBS mature at PAR after being purchased at a discount, I win twice over – once with the rising in their NAV/Book Value and again as income pours into my account in the meantime.
Often debt investments are confusing for the average investor because they’re impacted by different economic factors. What may be good for Growth could be toxic for MBS – like low-interest rates and easy monetary policies. So when they underperform when the market climbs, recency bias shows readily in retail investors.
On the other hand, astute income investors who are more frequently exposed to credit products and investments can bottom fish and lock in excellent income for their retirement.
If you need me, I’ll be on the lake, bottom-fishing for an excellent income. There is plenty of room for you to join me.