(This is normally part of the Weekly Bull Market Report. It was delayed and we promised that we would send it out as a News Flash. So here it is.)
The most significant news of the week was Black Friday. Amidst all of the noise about the stock market reaching new highs and growing questions about President-elect Trump’s conflicts of interest, cabinet nominations, and so on, the real news is what consumers are doing.
Several studies came out showing that foot traffic was weak on Black Friday. Reuters summarized the story this way: “Early holiday promotions and a belief that deals will always be available took a toll on consumer spending over the Thanksgiving weekend as shoppers spent an average of 4% less than a year ago.” That isn’t just Reuters pontificating, but is their summary of a study by the National Retail Federation (NRF).
Reuters acknowledges several reasons to be optimistic. For one, the U.S. “holiday shopping season is expanding,” with the NRF’s CEO saying early promotions and longer deep discounts are making Black Friday less important than it used to be.
So this isn’t actually horrible news on the surface, but it does tell us that we need to start looking at a new economic catalyst before investing our money. Yes, commodity prices, the Federal Reserve, and export policies are all important, but the U.S. retail consumer is important too and has been overlooked recently. With Black Friday, we should start to change that viewpoint.
Is this really important for high yield investors? Absolutely. Domestic consumption drives many of the small and middle-market businesses that are debtors to BDCs, so shoppers showing up is crucial for the health and safety of their portfolios. The UBS Etracs BDC ETF (BDCS: $22) rose a bit over 1% during the shortened trading week, and is up 9% year-to-date. That pales in comparison to Main Street Capital’s (MAIN: $37) 26% year-to-date climb. The stock hasn’t moved much since our sell recommendation, and was flat this week. Does this mean the momentum in our favorite and reluctantly-sold BDC is coming to an end? We believe so.
Which brings us back to the Retail issue. A broad and weaker holiday shopping season could cause a bit of a sell-off in BDCs that could bring Main Street’s historically astronomical price premium back down to Earth, and in turn motivate us to buy the stock again. We wouldn’t dream of buying Main Street at a discount, but a lower premium would be compelling. Hopefully the market will bring this opportunity to us so that we can bring Main Street back into our group of holdings.
The U.S. consumer is the driver of macroeconomic trends; when the U.S. consumer runs out of money, the entire world suffers. That’s what happened in 2008-2009, with a housing crash in America turning into an employment crisis in Europe, a currency crisis in Asia, a debt crisis in Europe, and a commodity crisis in developing markets. We still haven’t recovered from 2008-2009, which in part has made high yield assets more attractive. Now we need to consider what the future of the U.S. consumer will bring to high yield asset classes.
Beyond BDCs, there’s the Junk Bond question. High yield bonds are broadly based, ranging from issues in America and abroad in every sector imaginable. So you’d think they aren’t too dependent on the American consumer. It’s true that the dependency isn’t as high as with BDCs, but these firms still need a consumer to buy stuff to drive demand for their goods and services. So a strong Retail sector should, in theory, help keep bankruptcy rates in the Junk Bond market from rising too much.
The devil is in the details, however. A stronger U.S. consumer will mean more capital going to stocks in consumer discretionary and Retail sectors - and out of other sectors and higher risk asset classes. This means junk bonds could, in theory, lose demand despite stronger fundamentals. We’ve seen default rates and prices go up for junk bonds this year, so a disconnect between fundamental strength and prices is not unprecedented (arguably it’s quite common with high yield assets). So we can’t just buy junk bonds because the retail consumer is still spending at a healthy clip - and we can’t just buy junk bonds if retail becomes weaker than expected.
So what do we do? Simply put, we need to be judicious and diversified in our junk bond holdings. This is why we continue to recommend the Pimco Dynamic Income Fund (PDI: $28), which rose over 2% in the short trading week. This is partly a correction from being oversold following the Trump victory - the fund is still down 2% over the last month. But the climb is good news, because it brings us back into the green year-to-date. But with a fund like this one, we aren’t buying for capital gains - we’re buying for the dividend.
And now is a more important time to hold this fund than ever, because the fund’s special dividend announcement is just around the corner. This is arguably the most important single event in the fund’s year, and it’s more important now than it’s been in years for one simple reason: there is a lot of money up for grabs.
So far the fund has out earned its dividend by a healthy margin. This means that it has $1.52 in undistributed net investment income. This is cash that is just lying around that is rightly the shareholders’. If we subtract the regular dividend and assume zero coupon payments in December, that still leaves nearly $1.30 in income that is awaiting investors. This is a near 5% dividend payout on top of the over 9% that the fund pays out.
Let’s think about this for a moment. This is a fund that has a 14% annualized dividend payout without depleting its net assets. In fact, the fund’s NAV is over 13% higher than it was when the fund IPO'd.
This is why we have recommended this fund and continue to do so. There are many high yield bond funds out there with the promise of a 12% distribution or higher. Many of these funds have cut distributions in the past or have unsustainable payouts because they are paying out more than they are earning in income. Others may be covering their dividend payments in the short term, but have seen NAV erode over time. In fact, we cannot think of a single fund that pays a yield of over 12% that has not seen its NAV decline over time. Pimco Dynamic Income Fund is the only exception, and that’s why we recommend holding it.
When the distribution is announced, you might see a short-term price boost to the fund. This may be dramatic. The upcoming special dividend may be higher than any we have seen the fund pay out in the past, and that means it could attract a lot of attention it otherwise does not get. Should you sell when this fund shoots up in price? Absolutely not. This fund’s durable income stream is likely to last for a long time, making it the bedrock of any good high yield portfolio.
Finally, let’s touch on REITs because they are prone to the vicissitudes of the U.S. consumer, since so many of them have most or all of their assets in America. The SPDR Dow Jones REIT ETF (RWR: $90, up 1%) had a strong showing in the short week and has seen a slight recovery after its post-Trump slump. The fund is now flat for the past month.
That is admittedly much better than some of our picks over the short term. Omega Healthcare Investors (OHI: $29) is down 7% over the last month on sector worries thanks to poor performance at a competitor and worries that Trump will wallop the industry with rate hikes. That means Omega is now yielding over 8% and is down 17% year-to-date and down 14% since our recommendation. We do not recommend selling despite this poor performance. The company’s ability to maintain payouts with an FFO that is well over its dividend makes it a compelling hold; its ability to steal market share from competitor HCP (HCP: $29) is also being ignored by the market. We consider these facts great reasons to hold the company.
At the same time, we admit that it is likely to suffer if the Retail sector skyrockets. Investors will want to move their REIT allocations from a non-retail focused company to a more retail-focused one. This is why we have Kimco Realty (KIM: $26), which rose nearly 3% to end the week flat year-to-date. Kimco has also been hit hard by Trump jitters; the company was up over 20% at its peak in the summer. Higher interest rates could remain something of a risk to Kimco in the long term, but that risk is far outweighed by its 4% dividend yield, its solid cash flow and dividend coverage, its very low valuation at its current price level, and its growth potential. It’s important to keep in mind that Kimco’s PE (now 21) has remained lower over the past year than it was at any point after the Global Financial Crisis. That makes it a compelling buy, with the uplift from a strong retail season just making it more compelling.
In short, Thanksgiving gave high yield investors a lot to be thankful for. There are a lot of worries and a lot of bad press out there, but don’t let the fearmongering clickbait sway you. High yield assets still provide a lot of high quality income opportunities for the diversified investor.