Outlook (Or Maybe It’s ‘Look Out!’) For 2023

[This article was shared with my Inside the Income Factory® members on January 1st.]

Buckling Up For 2023: Hoping For The Best; Planning For The Worst

Our new year – 2023 – may repeat themes we are familiar with from 2022. Political, economic, and financial volatility, inflation, recession, etc. But I think most companies will manage to muddle through, survive and pay their debts, even if their stock tanks. That’s why, in times like this, I focus on credit, rather than equity, and am happy to collect 10% in cash while waiting for the recovery.

My strategy worked pretty well in 2022, compared to the traditional buy-and-hold equity strategy. Equity investors had a rough time in 2022. The S&P 500 Index ETF (SPY) had a yearly total return of -18%, while yielding 1.5%.

History has demonstrated that long-term equity investors, with the iron discipline to sit and wait patiently through turbulent periods like this one, invariably come out just fine because the market eventually turns around and resumes the progress it has shown for the past century or so.

Unfortunately, I have learned from past experience that I don’t have the iron discipline to just sit through all the volatility required to enjoy the eventual benefits of a long-term equity growth strategy. That’s why I personally evolved to the “create your own growth” through reinvesting and compounding strategy, that I later named and trademarked as The Income Factory®.

In 2022, I pursued my strategy, as well as writing about it. My own personal portfolio, which includes all the funds, BDCs and ETFs that are included in our model portfolios, as well as other positions that I own and report on to my readers and subscribers, had a total return of -16.8%, pretty close to the -18% total return of the S&P 500.

But the difference is that I was collecting a cash yield of 10% throughout the year on the capital I started with at the beginning of 2022, which I could continually compound at bargain prices and reinvest at sky-high yields. That allowed me to sleep better at night knowing that while I was enduring “paper losses” my income was actually growing steadily over the course of the year, so it’s now over 10% higher than it was at the beginning of 2022. That’s better than owning a typical portfolio of “growth” stocks that dropped steadily in price all year while generating puny cash yields of only 1 or 2%.

Credit investments also provide another benefit, especially for investors who are using their distributions, in whole or in part, for income to live on (because they may be retired, etc.). Because high yield bond and loan funds, business development companies (“BDCs”), and other fixed-income credit asset classes support their dividends and distributions largely or totally with their own cash income from interest and dividends (i.e. what’s called net investment income or “NII”), it means they don’t have to sell off their core assets to make distribution payments. Their core portfolios remain intact to continue to produce the same income stream month after month, even if the price of that core portfolio may move up or down.

That is a significant difference to equity funds that choose to maintain distributions when markets are depressed (so-called “managed distributions” as discussed here) where they have to sell off assets from their portfolios (at what may be market bottom prices) in order to make distribution payments. Similarly retirees who live off equity portfolios and have to sell off stocks at “inopportune times” (i.e. market bottoms) to fund their retirements from low-yielding stock portfolios.

While our Income Factory portfolios may drop in market value just like the rest of the market, we can keep and spend part or all of the income our portfolios generate, if we want to or need to, without touching the capital base that is generating that income. In other words, “paper losses” only become real if we sell the assets, and we don’t have to do so if that capital base is generating income at a high rate. I have described as “selling off their seed corn” (link here) the practice of equity funds of trying to maintain distribution levels that they are not really earning, when they continue to make generous distribution payments during market downturns with no capital gains to support them.

Bottom Line, and Closing Thoughts

From my perspective, my portfolio has done its job this year, provided me with a continuing “river of cash” that I’ve been able to use to reinvest and grow my income for the future, despite the paper losses in the value of the capital generating that income. If you believe, as I do, that an asset’s value is ultimately determined by the amount of income it generates over time, and that markets, imperfect as they are, eventually recognize that and incorporate it in market prices, then the economic value of my investments has continued to increase during the past year, as my growing monthly investment income demonstrates.

This is not a radical idea, although it goes against the grain of our current investment theme (supported so much by the media) that “market growth” is the be all and end all of investing. It is based on the work of the classic economist John Burr Williams, and is the basis for much of our modern corporate finance theory, as described here.

Although I’m playing it safe in many respects, betting on credit more than on equity, I don’t want to miss the upturn when it finally comes. But I don’t think we will miss it, even if we are largely in credit assets instead of equity. That’s because credit, just like equity, has been heavily discounted as interest rates have risen and, especially, because of market concerns about recession and expectations of increased recession-driven default levels. In fact, we’ve had “double discounts” because the loans and bonds themselves have been discounted in the markets down into the mid to low 90 cents-on-the-dollar range (or lower), so that’s the price they are carried at in determining the NAVs of the closed-end funds that hold them.

Meanwhile, most of the closed-end funds that we hold or are considering are themselves selling at discounts from their NAVs. (This is true of high yield bond funds as well). This is why funds that hold loans and bonds that would have paid yields in the mid to high single digits a year or so ago are paying us the 10% and higher yields we now see.

So just as I expect equities to eventually recover from their lows, I also expect a pick-up in market price of our credit funds at some point when the overall market improves, interest rates drop and credit yields don’t need to be as high as they currently are in order to attract investors.

Defaults vs Losses

As we have discussed in many articles and comment strings, headline default levels, while they scare readers and make good fodder for journalists who love to write Chicken Little “the sky is falling” sorts of articles, tend to overstate the real losses that will be suffered by loan and bond investors.

What those writers and readers ignore or don’t realize is that corporate loans are secured by collateral and have historically recovered about 65 to 75% of their principal when they default. Even unsecured high-yield bonds have typically recovered 40-50% of principal. So default rates of, say, 5%, which is actually higher than most economists who expect a recession are predicting, would result in portfolio losses on loans that were only about 2% or less (i.e. 35% losses times 5% defaults = 1.75%). (Higher for unsecured bonds, perhaps losses of 3%; i.e. 60% losses times 5% defaults = 3% overall portfolio losses)

For loan funds like Invesco Senior Income (VVR), Apollo Senior Floating Rate Fund (AFT), and Ares Dynamic Credit Allocation Fund (ARDC), all of which are in our model portfolio and pay out 10+% distributions, that sort of loss level would depress their yields somewhat, but not even touch principal. Meanwhile, the sort of conditions (recession, etc.) that would cause a 5% default rate, would almost certainly hurt an equity portfolio much more severely.

As noted earlier, my goal is to make an equity return of about 10%, but not to be a hero doing so. That’s why I prefer credit bets to equity bets when markets are so spooked they are paying me 10 & 11% yields to take credit risks that would have only paid 7 or 8% a year or so ago. As most readers know, credit is an easier bet to win than equity. All an issuer has to do is stay alive and pay its debts, versus equity investments where the company not only must stay alive and pay its debts, but also grow its earnings and ultimately its stock price. Current credit markets are overcompensating investors for perceived risks, so there are lots of opportunities to earn an “equity return without equity.” That’s the essence of our Income Factory® strategy, which has proven itself in 2022.

Many thanks to all of our readers and subscribers, old and new, for your support and all the thoughtful comments and messages throughout the year, and best of luck in 2023.

Steve