May 24, 2014 Turn Down For What

Risk/Reward Vol. 222

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

“Turn down for what?/Turn down for what?”---lyrics from “Turn Down For What” by DJ Snake
featuring Lil Jon

“Don’t go chasing waterfalls
Please stick to the rivers and the lakes
That you’re used to”---lyrics from “Waterfalls” sung by TLC

“Don’t look back/But if you don’t look back
We’re only learning then
How to make the same mistakes.”---lyrics from “Same Mistakes” sung by One Direction

News on Friday that the housing market improved in April sent the S&P 500 over the 1900 mark for the first time and propelled the Dow Jones Industrial Average over 16,600. Typically, such a growth-oriented stock stimulus would cause bond prices to fall. But on Friday, the price of the bellwether US Treasury 10Year Bond rose and its yield “Turn(ed) Down”. (Remember when bond prices rise, bond yields fall.) This led many to wonder “Turn(ed) down for what/Turn(ed) down for what?” Perhaps the answer lies in a closer examination of the housing numbers. True, existing house sales did improve over March, but they remain 7% lower than in April, 2013. Equally discouraging was a report earlier in the week that despite low mortgage rates, 40% of all homes are either 1) worth less than their outstanding mortgage or 2) have insufficient equity to cover the cost of the mortgage plus a broker’s commission should the owner desire to sell. Obviously, the bond market read the data to suggest that the Federal Reserve will continue its efforts to keep interest rates (which directly impact mortgage rates) low for the foreseeable future.

With interest rates so low, income investors continue to search for yield in progressively risky pools, in other words, in “rivers and lakes/That they’re (not) used to.” Indeed the spread between the 10Year Treasury and the lowest rated junk bond (CCC) is at an all time low. One alternative to junk bonds are collateralized loan obligations (CLO’s). CLO’s are a subset of collateralized debt obligations (CDO’s). You may recall that all CDO’s were tarnished by the collapse of the subprime mortgage market which dominated CDO’s prior to 2008. In contrast, CLO’s (comprised of senior loans to reputable mid-sized companies whose balance sheets are too small to warrant investment grade status), for the most part, remained solvent throughout the debt crisis. Moreover, CLO's underwritten after 2009 have performed as advertised. In a nutshell, CLO sponsors acquire senior loans from banks, and re-bundle the obligations into tranches. Tranche A is the most secure because current obligations are paid in full before any obligations to succeeding tranches are addressed. As more payments are received from the underlying senior loans, they are used to defray the obligations to Tranches B in total, then to C, then to D, etc. in what is called a payment “waterfall.” The lower the tranche, the riskier the investment is deemed, even though recently any default "chasing waterfalls" has been rare. Oxford Lane Capital is a closed end fund that invests in Tranches F and lower. I own the preferred shares of it (OXLCO) which currently pay a 7.8% annual dividend on a monthly basis.

For years now (see Vol. 102 www.riskrewardblog.blogspot.com ), I have advised you, Dear Readers, that the optimum time to purchase shares in pass through entities such as business development companies, master limited partnerships and especially real estate investment trusts is at the time any secondary stock offering is priced. The larger the secondary offering, the more dilutive its immediate effect, the greater the stock discount. This axiom is part of my DNA. I “don’t (have to ) look back.” Or do I? With the announcement by ARCP that it was doing a very large secondary offering, I “didn’t look back.” I bought before the pricing. Why you ask? Because the stock’s decline in anticipation of the pricing was precipitous, and I thought that the market had overshot the dilutive impact. WRONG! So I overpaid. The lessons that I have learned these past four years must be observed! “If we don’t look back/We’re only learning/How to make the same mistakes.”

It was a good week for growth and income investors alike. I see a day soon, however, when the interests of these two investment approaches diverge. I am betting that growth stalls, interest rates stay low and income securities benefit. If I am wrong, I will exit before my holdings (in the words of that marvelous lyricist, Lil Jon) “Skeet, skeet/Get low/Get low.”