2 Great Dividend Picks To Retire In Safety And Splendor

Co-Produced with Treading Softly

When I was younger, my father-in-law gave me some advice that, to this day, I find myself putting into practice time and time again. He was a businessman, and he had started his own business after years of working for others. He knew how to get one started, help it grow, and enjoy the benefits of being a small business owner. He also knew the struggles of running a business, the lean times when business was not booming, or the economy was struggling.

His advice was this:

“Buy the best you can afford.”

The problem so many of us run into is we stray to one side of this or the other. Some of us love to own the best version of anything we buy. The fanciest cutlery, the nicest flooring, and the best cars or trucks. Yet often, those who have that proclivity can run into issues when they cannot afford those items! They go into debt, running up credit cards to buy “the best of the best,” which causes harm to themselves in the long run.

The other side of the coin is those who like to get the cheapest things. They dive into dollar stores and dig through yard sales to find the cheapest, most inexpensive items. They often do not consider how often they must replace these things as they break or sometimes don’t even work. They simply look at the sticker price.

I had a good friend like this. His mindset was that he would use tools so infrequently that buying a tool he’d only be able to use once or twice before it broke, and that was no big deal. Every time he had a house project, he would run to the store to replace cheap tools that didn’t last. Meanwhile, others will fill their garage with the highest-end professional-grade tools only to never use them because they cannot afford a vehicle to tinker on.

For your retirement, you should buy the best income you can afford. This will allow you to retire in safety and splendor. Don’t cheap out on low-quality firms that might lose everything when they fail, but don’t buy income so expensive you cannot truly afford it. There are a lot of great companies that only have 1-2% yields. Yes, the companies are fantastic and will last forever, but unless you have $5+ million invested you aren’t going to get a reasonable income from them!

Today, I want to present two gems for your retirement portfolio that will give you income that will overpower your expenses and allow you to have excess to reinvest. The best part is that these companies will withstand the gyrations of the market and the economy.

Let’s dive in.

Pick #1: XFLT – Yield 10%

XAI Octagon Floating Rate & Alternative Income Term Trust (XFLT) is a CEF (Closed-end fund) that invests in “leveraged loans” and CLOs (collateralized loan obligations).

These loans, aka “bank loans,” are senior secured first-lien loans. In plain English, that means that these loans are the top of the totem pole of the capital stack. They are senior to other debt, they are secured by the assets of the borrower, and in the event of a default, they have first dibs on the assets. They get paid before unsecured term loans, before any publicly-traded bonds, and certainly before the equity. In fact, from 2003-2020, 52% of loans that defaulted eventually resulted in a recovery of 91-100%. When lending, it pays to be at the top of the food chain, and leveraged loans are at the top.

CLOs are bundles of leveraged loans which are securitized and sold in “tranches.” For the underlying borrowers, it doesn’t change a thing. They still pay the same amount. For investors, it provides security through diversification. Any particular loan might default, a pool of loans is much more likely to have an “average” number of defaults.

It also provides an option for investors to pay a premium to be paid ahead of others. This is what makes CLOs very attractive for ultra-low risk institutional investors like insurance companies and banks – the same institutions that might buy U.S. treasuries at significantly negative real yields. They can pay a hefty premium to buy the senior tranches that get paid first.

One way to think of it, is the buyers of the senior tranches are paying for “default insurance.” They’re paying extra so that in the event of widespread defaults, they can be confident that they will be paid anyway. Who benefits from that premium? The buyers of CLO equity. While senior tranche investors pay a huge premium to be first in line, CLO equity buyers get a huge discount in return for being last in line.

Have you ever been to a catered event and you see people rushing to be first in line to the buffet table? Those are the banks and institutions paying a premium to be in front. Then at the end of the night, there are piles of leftover food that the host is just trying to give away to those who remained behind. That’s the CLO equity investors like XFLT, in exchange for being last in line, they get “whatever is left,” which is usually enough to eat as much as those who ran ahead in line, plus bountiful bags of leftovers to feed the whole family, including the dogs, tomorrow.

XFLT owns a mixture of loans that they own directly and CLO equity positions where they are last in line but benefit from the huge premiums that the institutions are paying. And when you look at the buffet, the food is plentiful for 2022. In 2021, CLO equity positions earned a total return in excess of 35%, CLO positions on average had total returns of 2.37%.

Clearly, the institutional investors were paying premiums that were much higher than the risk justified and CLO equity and the lower CLO debt tranches were the big winners.

The outlook for 2022 is equally bright. The outperformance was driven by historically low default rates with only five loans defaulting in 2021.

With the economy recovering and liquidity being high throughout the financial system, defaults are expected to remain well below historical averages. As a result, the cash buffet is overflowing and XFLT stands to benefit greatly as “whatever is left” is bags upon bags of cash!

Pick #2: AGNC – Yield 9.7%

AGNC Investment Corp (AGNC) is an “agency” mortgage REIT, meaning that its primary investment is in mortgage-backed securities that are guaranteed by government-sponsored enterprises. If a borrower defaults, the GSE will buy back that mortgage at face value. As a result, AGNC’s profits and risk don’t stem from whether or not people pay their mortgages, it’s an interest rate spread investment. They borrow short-term debt maturing within six months and buy mortgages that have 15-30 year terms. AGNC profits from the tendency for short-term interest rates to be lower than long-term interest rates.

The primary dynamics that drive AGNC’s business is the average yield on its assets, which is the yield received from mortgage-backed securities after accounting for the impacts of premiums paid and average prepayments:

Then subtract the “cost of funds,” this is the average interest expense that AGNC owes its lenders:

Simple right? You take your revenue (yield on assets) and subtract your expenses (cost of funds) and you arrive at your gross profit margin, which AGNC calls the “net interest spread.”

While there are other expenses, employee salaries, and operating expenses that are more fixed and the impact is not included in this measurement, net interest spread provides us with a good measuring stick to compare various periods. The higher the net interest spread is, the more profitable AGNC is.

AGNC is 67% more profitable today than it was at the same period in 2019, but the share price is more than 10% cheaper! AGNC’s earnings per share are “only” about 30% higher, and this is entirely due to AGNC reducing leverage from 9.8x equity to 7.5x equity. AGNC is earning more money, with less debt (less risk) and its share price is cheaper!

When the market makes a mistake this big, just buy. Yet people love to worry about the future. We hear things like “but the Fed is going to raise rates this year! Avoid agency MBS when rates are going up!”

Why? Well, they fear that the net interest spread will decline because the rates that AGNC borrows at are highly correlated with the Federal Funds rate. They reason that if the cost of borrowing goes up, that’s bad and AGNC will underperform. How did that theory fare in December 2015 when the Fed last raised rates?

AGNC outperformed the S&P 500 in 2016, 2017, and 2018. In total, AGNC had a CAGR over the period of 11.3% compared to 8.3% for the S&P 500 ETF (SPY). The Federal Reserve had hiked rates nine times during that period. With 20/20 hindsight, the ideal time to rake in profits for AGNC was the fall of 2017 after the fourth hike to 1-1.25%, 18 months after the first Fed hike.

The reason this occurs is that AGNC uses hedges. Specifically, they buy “interest rate swaps” which are agreements with a counterparty where AGNC pays a fixed interest rate and they receive a floating rate. When the floating rate is lower than the fixed rate, AGNC pays the difference. When the floating rate is higher than the fixed rate, the counterparty pays AGNC!

As of the end of Q3, AGNC has just under $50 billion in swaps where they pay a fixed 0.17% interest and are receiving the floating rate of 0.05%. So right now, AGNC is paying 0.12% on $50 billion and these swaps are slightly increasing their “cost of funds” seen above. If the Fed hikes rates to 0.25%, we would expect that floating rate to be around 0.30%. AGNC would still be paying 0.17% but would be receiving 0.3%, netting 0.14% which would be reported as a reduction in its interest expense. If the Fed raises to 1%, AGNC is still paying 0.17%, and now receiving 1.05%.

AGNC would only pay full borrowing rates on amounts borrowed over $49.725 billion until their swaps expire which would happen gradually over many years. This is why we aren’t panicking over the prospect of a few rate hikes that might happen. AGNC’s net interest spread will remain much higher than it has been in over a decade whether or not the Fed actually decides to raise.

AGNC reports earnings on Jan. 31, after market close.

Conclusion

These two excellent opportunities belong in your retirement portfolio. It’s as simple as that. They offer:

• High yields
• Strong dividend coverage
• Easy to buy and sell if desired
• Benefit directly from the Federal Reserve’s delay in fighting inflation
• Both pay monthly!

I enjoy the monthly income provided by both of these companies and will continue to do so. Both companies are cash machines, working hard to navigate the CLO and MBS markets while I can get to work enjoying the best retirement and figuring out where to spend that income.

In the end, your retirement should be relaxing, enjoyable, and filled with an abundance of income, allowing you to enjoy the splendor that retirement has to offer. These two gems will allow you to have all of that and more.