Your Cash Is Trash: Buy Fixed Income Today

Co-produced with Treading Softly

Cash. Mr. Ben Franklin himself.

Cash has a valuable use day to day. We use it to barter, buy and tip.

Sadly, some even use it for sitting on and hoping it stores value. The risk here is that trillions of dollars were injected into the economy during COVID. The supply of money in the economy skyrocketed.

A significant increase in supply makes the existing supply less valuable – a basic tenant of supply and demand. We call this loss of value inflation, and boy, has the government cooked up a great recipe for making that happen.

With inflation rates hitting 8.3% in April, we see the contagion of injected cash continue to hurt the average person. Those who most benefit from inflation are the government and those in debt. But I repeat myself.

Inflation eats away at the purchasing power of cash. It has dramatically impacted the valuations of many stocks that were valued based on expected future cash flow. In an inflationary environment, future cash has a lower value than cash today.

So what should you be doing with your cash right now? Many investors are streaming into commodities and physical stores of value. A great place to be… if you’re already there. If you’ve been reading my writings, you were preparing for inflation last year.

Now what?

Buy fixed income. Fixed income has been on sale over inflation fears and rising rates. Ironically, the fears create a massive opportunity with many bonds, preferreds, and the funds that hold them trading at discounted values. So now you can buy them for a great yield today and get a capital gains kicker as bonds mature, preferred are called, or recession fears rise. If you’re worried about a recession, fixed income is historically lower volatility and a safer place to be.

We are told that fixed income is terrible to own when interest rates rise and when inflation is surging. So investors sell. Yet when investing, we need always to be looking to the future. It is a mistake to assume that the current conditions will continue forever – they never do. The only thing certain is that tomorrow’s conditions will be different from the conditions today.

I often buy what the market is throwing away as trash. Finding the treasures that are paying high yields, that are sustainable. Then when the market realizes the treasure, it comes rushing back, begging to buy it back.

So today, I want to highlight four such places where you can put your cash to work. What if inflation gets worse? These picks all are paying yields over 8.5% today and are paying you monthly! Cash deposited in your account each month will ensure you have the flexibility to spend or reinvest as you see fit.

Let’s dive right in.

Pick #1: PFFA – Yield 8.5%

Virtus InfraCap U.S. Preferred Stock ETF (PFFA) is a fund that invests in preferred shares. Fixed-income started rallying last week, driven by market expectations that the Fed will be far more dovish than was previously priced in.

Here is a look at what Fed Futures are pricing in for December 2022 compared to just one week ago. These are the probabilities that the market is pricing in as to what the Fed’s target rate will be in December:

Note that last week, the market was pricing in a 60% chance that the Fed’s target rate would be over 2.75%. One week later, it is now pricing in a 65%+ chance that the target rate will be under 2.75%. As a reminder, the last Fed “dot-plot” from March suggested that the Fed officials projected a rate of 1.75%.

We’ve been banging the drum that the Fed will be unable to raise rates as aggressively as many in the market were predicting. For a little bit, the idea that the Fed might raise to 3% or higher was gaining traction in minds on Wall Street. Those who believed that would happen were dumping preferred shares hand over fist.

This created a buying opportunity among preferred shares that we haven’t seen since March 2020. One issue with “loading up” on preferred shares is that they are not terribly liquid. It can take a long time to build up large positions, and it is even harder to sell large positions. This is where PFFA is an invaluable tool to have in your kit.

PFFA is a much more liquid option that you can buy or sell at very close to NAV at a moment’s notice. It provides diversified exposure to numerous preferred shares, which is the best way to invest when an entire class of investments is on sale.

PFFA is unique. While technically an ETF (exchange-traded fund), it has many features that are more similar to CEFs (closed-end funds). The main difference between an ETF and a CEF is that an ETF adjusts its shares outstanding to demand in a way that maintains a very tight relationship between share price and NAV. CEFs, on the other hand, have a fixed number of shares outstanding that trade independently. As a result, the share price for a CEF can drift a very long way from NAV, sometimes 20% or even more. This difference exists by definition.

Yet other differences exist more by custom. ETFs usually do not use leverage, and CEFs often use leverage. ETFs usually are passively managed. They buy or sell stocks based on a predetermined formula, often following an index fund. No person is deciding what to buy or not to buy. The fund is set on autopilot. CEFs are usually actively managed, with a team doing due diligence and choosing positions.

PFFA is an ETF by definition, but in spirit, it has adopted the practices of CEFs. It is leveraged, usually 20-30% of assets, and is actively managed. The managers make decisions about what to buy, sell, and even actively trade positions throughout the month as opportunities arise. The results speak for themselves. Here is PFFA compared to a more traditional ETF peer PFF (PFF) which is not leveraged and is passively managed:

PFFA has dramatically outperformed, all while paying out a substantially higher dividend. PFF only yields 4.8%! PFFA has outperformed as headwinds brought preferred shares down across the board. PFFA will benefit from using leverage and continue to benefit from active management on the way back up.

The rebound in fixed-income is just getting started as the market realizes the Fed will be more Dovish. Plus, if there is a recession, as many fear, fixed-income is the place to be. Adding PFFA is a great way to take advantage of the recovery in preferred shares.

Pick #2: PIMCO Funds

PIMCO Dynamic Income Fund (PDI), yield 11.7%

PIMCO Dynamic Income Opportunities Fund (PDO), yield 9.4%

PIMCO Corporate & Income Opportunity Fund (PTY), yield 9.5%

One concept that seems very difficult for investors to grasp is that rising bond prices are bad for bond investors while falling bond prices are ultimately good. Investors are trained to automatically assume that prices going up is objectively a good thing and that going down is objectively a bad thing. This little bit of “common sense” is absolutely wrong.

Back in February, when rates were starting to rise, I wrote on the impact of changing rates on bonds and why we weren’t selling. It was a controversial position as many authors suggested that people should dump their fixed-income, especially PIMCO funds.

It is true that PIMCO funds have generally come down in price. However, it is an age-old problem. If you sold these funds, what did you do with the money?

We can see that of our favorite PIMCO funds, only PDO underperformed the S&P 500 ETF (SPY).

Prices are down, but that can be said of most stocks in the market. Prices move around. It’s what they do. If you want to be in the business of concentrated risks in one or two sectors and betting that you can perfectly predict the future – knock yourself out. It’s a strategy that works great up to the day that you predict the future wrong. Then, you lose a lot of money because all your money was on one bet.

When you are on Wall Street betting OPM (other people’s money), and you bet wrong, you close up shop and open a new one under a new name to raise new capital. That isn’t how I roll. I’m investing my own money, and I’m wise enough to realize that I will never be 100% right 100% of the time. This is why I diversify, and I hold sectors through the good times and the rougher times. My focus isn’t the share price, it is the income. Since I’m not selling, I don’t really care what Tom, Dick, or Harriet are willing to offer to buy my shares.

My question in February was not whether the price would go up or down but whether the dividends would keep coming. Lower bond prices mean that every bond that PIMCO buys has a higher yield. At the end of the day, that is what supports the dividend. Last year, PTY had to reduce the dividend because bond prices were too high for too long.

When a bond is paid off, the lenders receive par value. Not a penny more, not a penny less, no matter what the bond was trading for yesterday. The change in the trading price of a bond has zero impact on the amount that the borrower has to pay. The bond fund then has to redeploy that capital and will collect a new yield based on the prevailing interest rates when it invests.

So as interest rates rise, the amount of interest a bond fund collects goes up! While there might be a negative impact on the book value in the near term, those bonds trading at a discount will be redeemed at par and invested at the new higher rates, and ultimately, cash flow goes up. Since I am not selling the fund, cash flow going up is a positive. We are starting to see this happening with PIMCO funds now.

Here is the UNII (undistributed net investment income) report, which shows how much NII these funds have in excess of their dividend payments. (Source: PIMCO UNII Report)

Note that the past 3 months’ dividend coverage for PTY and PDI were in the 140%s and PDO at 195%. In the prior 3 months, dividend coverage was 117%, 121%, and 150%, respectively.

So the price of all three came down, but the dividend coverage is much higher. When it comes time to pay a special dividend, the UNII is the number that management will be looking at to determine the appropriate size. As of December 31st, all three were at $0.06-$0.07 in UNII. The rest has built up since the beginning of the year.

Some might be surprised that PIMCO has had better dividend coverage and has built up extra UNII “despite” bond prices moving lower. The reality is that this happened because bond prices moved lower. These funds have more secure dividends and will have larger special dividends come December because bond prices came down.

When investors are running around saying “sell fixed income because the prices will come down,” I guess that makes sense if your plan is to get your profits from price movements. My plan is to get my profits from collecting dividends.

Why would I sell if the dividend is more secure and future special dividends will be larger? I wouldn’t. I’m a buyer, and I can use a portion of those hefty dividends to reinvest and buy even more shares while the price is low before the market realizes that PIMCO funds are still the same cash-generating machines they’ve been for decades.

Conclusion

PFFA has outperformed its sector and peers strongly. It’s an undeniable fact:

Year to date, PFFA has outperformed the largest passive preferred fund (PFF) as well as the market in general (SPY).

Furthermore, we’ve illustrated that the PIMCO funds – PTY, PDO, and PDI – are strongly out-earning their distributions. I find it interesting that so many focus on the leverage of the PIMCO holdings without sharing all its repurchase agreements secured by assets – unlike many CEFs using unsecured leverage that have a history of biting-them-in-the-butt sell-offs. PIMCO has structured its funds to ride out storms without the NAV-destroying consequences many funds suffered in 2020. We can see how PIMCO’s older fund, PTY, survived and thrived through several cycles, including the Great Financial Crisis and COVID.

Your cash can be put to work, earning you more money today – while it is still valuable. It can be tied to discounted assets – creating the option to realize gains later.

Bear markets are when you want to set the foundation of your wealth in the future. It is a time to look for opportunities to buy at an attractive price. Those who sell out at a loss and pack up were destined to only transfer their wealth to the patient and be careful.

High Dividend Opportunities members can be comfortable and patient simply because we receive recurring dividends and buy for income. We don’t need to be gamblers on price, thank you very much.

I want everyone to succeed in the market. Cash is a losing proposition when inflation is eating its value away. Trying to “flip” stocks, buying one day hoping to sell at a higher price later, only works if others are willing to pay a higher price when you want to sell. Instead, focus on buying up income-producing assets that will fill your portfolio with a growing stream of cash flow.

Oh, one more note before I go, as it’s a common question and confusion. This doesn’t mean you shouldn’t have an emergency fund. I do, and yes, it’s cash. It serves a specific purpose outside of my portfolio and is not included in what I invest.

Cash sitting idly in your portfolio with no purpose is wasted potential for money that you have already decided in your personal budget is designated for investing.