Anthony Speciale Stock Market Analyst

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These 4 Funds Are Offering Both Yield and Upside

If you’ve been with us for a while, you’ve probably noticed that we focus on a few key strategies, including cheap assets, cheap earnings, special situations and momentum. But I always like to make sure I talk about income strategies as well, and there’s a reason for that.

Income is critically important to a very large segment of the investing public. You might think that everyone wants growth and large returns, but there are some folks that just want their money to compound at a decent rate of return over time from flows of fixed income or other types of cash flows being reinvested.

And then there are investors who are in retirement and are depending on the cash flows provided by their IRAs, 401Ks and other retirement plans to meet their retirement income needs along with whatever they may get from Social Security or a pension.

For these folks, income is very important, but it’s been very difficult over the last 10-15 years to earn enough of a return on a traditional income portfolio. The rates are just too low, and it doesn’t get the job done. So, I’ve really encouraged people to look to alternative income investments.

These include things like direct lending programs, real estate investment trusts, preferred stocks and other sources of income that will be more volatile than your bank investments but should be less volatile than your stock investments.

We’ve had a lot of success putting these portfolios together over the years, and today I’m going to share with you my hotlist of alternative income ideas that you can buy right now.

Apollo Commercial Real Estate Finance, Inc.

The first is one that we talked about last week, which is Apollo Commercial Real Estate Finance, Inc. (ARI). It’s throwing off about a 9.2% dividend yield, and it has very low loan to value, so there’s a big margin of safety in the lending portfolio. It’s a fantastic business that you should own in your portfolio.

FS KKR Capital Corp.

The second one is FS KKR Capital Corp. (FSK), which is a business development company that makes loans to middle market companies for expansion, mergers and acquisitions activity and financing large real estate transactions in some cases.

FS Capital is one of the largest fixed income and alternative income investors in the country, and KKR is one of the most successful private equity companies in the history of the industry, providing massive returns to their investors for over 50 years now.

They also have a large credit business, and I’ve always said that no one knows more about lending than people who’ve borrowed hundreds of billions of dollars. KKR fits that definition and then some.

There are about 195 companies in the loan portfolio, with 88% of those as floating rate loans, so you are protected to a very large degree against rising interest rates, which is pretty important right now. Most of the loans are also senior secured, so we’re at the top of the capital stack, and if anything does go wrong, we get paid back first. Again, this creates a nice margin of safety.

There’s also been some large insider buying in FSK earlier this year, and insiders own quite a bit of stock. For them to do well, we have to do well, and that’s an equation I’ve always been a very big fan of. I like to be locked in with insiders who have a lot of skin in the game. Oh, and FSK is currently yielding 10.5%, and I think that’s going to keep growing as time goes on.

Special Opportunities Fund, Inc.

The third name on my hotlist is Special Opportunities Fund, Inc. (SPE), which is a closed-end fund managed by Phillip Goldstein of Bulldog Investors. He makes money for his investors by investing in heavily discounted closed-end funds, primarily equity funds but also some fixed income and real estate exposure.

He also does a lot of special purpose acquisition company (SPAC) arbitrage, which is a very cool way to get low double-digit returns with as little risk as you’re ever going to get on Wall Street. Owning this fund gives you exposure to dozens of these positions at a time, and it’s all done by an expert in the field.

SPE gives you an 8.2% yield, and Goldstein is not afraid to be an activist on other closed-end funds. If he thinks management is not doing what it needs to do to narrow the discount, he will try to force them to do it, which is how we wound up running SPE.

Vertical Capital Income Fund

Now, the last name on my hotlist is Vertical Capital Income Fund (VCIF), which does residential mortgage investing. Most funds do this through pools, but VCIF is actually going out and negotiating with warehouse lenders and buying loans directly from them.

They are a number of reasons why a warehouse lender would do this, but the way it works is they sell the loan to VCIF in an auction process. And generally speaking, they’re able to buy these loans for a little bit less than the amount of principle remaining.

Then, they try to work with distressed funds that bought pools that are not paying. VCIF comes in and once a few payments have been made and the borrower is back on track, they will buy that loan from the distressed fund at a discount from the amount of money still owed on the mortgage.

This is a very successful form of investing that gives us not only a nice yield, but there’s a lot of upside as these loans move back up and are eventually paid off or sold at a premium to the remaining balance owed on the loan.

VCIF is trading at a 9% discount to net asset value, it’s paying a 8.9% yield and the portfolio right now is 760 loans with an 85% average loan to remaining balance on the loan. So, there’s a bunch of upside in addition to the very comfortable dividend yield.

Furthermore, if management lets that discount widen out, Bulldog and the other owners will not be shy about leaning on management to reduce the discount. That’s another potential gain for us.

And if the fixed income markets remain low and income remains hard to find, and these guys start turning in a bit of upside performance from collecting on the loan values, we could see this fund go to a premium to net asset value in addition to paying a very generous dividend yield.

So, if you’re retired and you’re starting to draw on your nest egg, you need to consider these four names for your portfolio.