Sleep Well With 2 Great Income Picks

Co-produced with Treading Softly

I’ve never experienced true deep poverty. I grew up in a solidly middle-class family and what we were going to eat was always a question, but never if we were going to eat. Having food was a given.

I distinctly remember attending a college class where the guest speaker grew up profoundly impoverished and commented that a person cannot know true poverty until they genuinely do not know when they will eat again. That is a level of poverty for which I have no frame of reference.

I do know that many fear financial duress during an economic slowdown. I have experienced large sell-offs in the market. I’ve invested through times when making a profit in the market becomes very difficult and many people are losing fortunes.

The fear and concern that many investors feel during these times is something I can relate to. True, most of us could lose 100% of our portfolio, and we would still eat every day. Yet, the pressures of monthly bills that need to be paid, rising costs, and the fear of whether or not our retirement portfolio is sufficient to maintain the standard of living we are used to are still real.

We’ve been examining and tracking economic indicators and inflation in our weekly market outlooks, which are available only to members of High Dividend Opportunities or our HDO Lite newsletter. We’ve seen a steady beating on the economy by the Federal Reserve via rate hikes. This is weakening the economy and helping propel it into a recession.

How bad of one? That becomes anyone’s guessing game.

So what are we doing within the High Dividend Opportunities Model Portfolio? We are proactive in our management style. We do not like to make sudden changes or adjustments, but we pivot over time to capture benefits from being aware of the horizon.

Today, I want to cover two picks that will help you be prepared for a weaker economy tomorrow but also provide outsized income today.

Let’s dive in.

Pick #1: BTO – Yield 7.8%

At HDO, we have spent a lot of time the past few months discussing recession risk. As the Fed keeps hiking into a weakening economy, the risk of a recession is rising. So it isn’t a surprise that one of the most frequent questions I receive is how a certain sector responds in a recession.

Well, the answer isn’t so clear. “Recession” is a very generic term and doesn’t tell you which stocks will be better than others, there are no easy answers. Every recession has its own flavor. What was horrible to hold in one recession can be the best investment in another and vice versa.

Consider John Hancock Financial Opportunities Fund (BTO), a CEF that invests primarily in banks. Here is what happened from January 1999 through December 2005:

Note the weakness in 2000, when the S&P 500 remained relatively strong. When the Dot-Com crash began in earnest, BTO was rallying. Through the recession (2001-2003) BTO materially outperformed the S&P 500. This led some investors to believe that banks are “recession-resistant”.

Anyone who started loading up on banks going into the Great Financial Crisis would be sorely disappointed. In the year leading up to the recession, BTO was down. During the recession, banks collapsed, dramatically underperforming the S&P 500. They fell more, and BTO remained down much longer than the S&P 500.

So are banks “recession-resistant”? The answer is “sometimes”. In some recessions, owning banks has been among the safest and highest-returning investments. In others, notably the GFC, owning banks was an unmitigated disaster.

Patterns easily persuade investors. Yet, we need to be aware that patterns don’t necessarily repeat. When approaching banks, many investors are gun-shy.

While the Dot-Com crisis is something that many of us remember, it was over 20 years ago. For a very large portion of Wall Street, it is ancient history. The recession that is fresh in everyone’s memory is the GFC, where banks were toxic.

So when approaching a recession, our primary goal should be to make sure we buy at a good price. The higher a stock is, the further it has to fall. Here is a look at the forward PE ratios of BTO’s top five holdings:

With PE ratios at 8-10x, these companies are going into 2023 at very reasonable valuations. Over the past year, bank valuations have struggled in the face of Fed uncertainty. The wild variations in the bond markets have been a challenge for lenders of all stripes. This has put downward pressure on bank valuations.

Going into 2023, at the minimum, the Fed is slowing down its hikes. The likelihood of a pause continues to increase as inflation in the back half of 2022 was substantially lower than inflation in the front half. More certainty in interest rate policy will make the environment much more hospitable for banks.

Additionally, we do not see the borrowing excesses associated with the GFC. Corporations and consumers are relatively healthy, with many taking time during COVID to repair their balance sheets and refinance debt at historically low interest rates. This starkly contrasts with 2007-2008, when consumers were leveraged to the hilt.

For these reasons, any recession is likely to be very mild for banks, while bank valuations have plenty of room for upside as the interest rate environment stabilizes. Every recession is different, but we believe the upcoming recession will have much more in common with 2001 than 2008. Bullish on banks and BTO is a great way to gain exposure to them, while also generating a high yield.

Pick #2: ACRE – Yield 13.6%

Common sense would have an investor believing that because interest rates are rising, investments with significant exposure to variable-interest loans should carry high valuations.

The thing about “common” sense? It isn’t all that common, and “the market” doesn’t have it. Ares Commercial Real Estate Corporation (ACRE) invests in floating-rate commercial mortgages, 98% of their loans are floating-rate.

ACRE also entered into some hedges that don’t expire until late 2023, which fixes a significant portion of their debt. Rising interest rates are fantastic for ACRE’s earnings. Source

Thanks to higher interest rates, ACRE’s earnings have climbed throughout the year after dipping in Q1. Going into 2023, earnings will continue to enjoy strong tailwinds as the Fed rate hikes push revenue higher.

ACRE is on pace to cover its dividend by 1.1x in 2022.

This provides room for a dividend increase or additional supplemental dividends in 2023. This shouldn’t surprise anyone because ACRE owns floating rate debt in an environment where rates are climbing. Yet the market has responded to the hawkishness of the Fed by selling everything debt and asking questions later.

This has created an opportunity for investors to buy investments like ACRE, that are seeing rising earnings at a steep discount to book value. ACRE is trading at the lowest price to book value since Q4 2020:

With ACRE, we benefit from a high yield today, a strong possibility of a dividend hike or special dividend in 2023, and there is ample room for capital gains as the price recovers to book value ($14.09/share).

Conclusion

With BTO and ACRE, we can be prepared for a coming recession while also benefitting greatly from the current rate-hiking environment. This two-pronged approach allows an income investor or retiree to have a clear picture of their income today – and to come in the future.

I want you to sleep well at night. I think we all love that mental picture. I also know that often this terminology is used when tied to low-yield investments. I would say it’s hard to sleep well at night if you’re left in financial duress and hungry. So, for many of you, you’ll sleep much better at night if you adjust your income returns higher and remove those financial worries from your mind.

Retirement should be a time of ease, relaxation, and enjoyment. I want that for all of you as we get 2023 underway. 2022 was mired with high inflation, the war in Europe, and a late-to-the-game-but-overzealous Federal Reserve. Yes, as we enter 2023, there will be risks. Share prices could continue to fall, and recession could instill fear into the markets. Many retirees will fear for their future.

They don’t have to. You see, the economy of the United States of America has been the greatest wealth generator in the history of the world. The stock market is the means through which we have an opportunity to purchase a slice of the U.S. economy and other developed economies. As income investors, we aim not to sell such a powerful wealth generator, we aim to own more of it. While others are panicking about the price of this stock or that stock, we won’t because we are not interested in selling. We are looking to buy more so that we can collect dividends that are generated by earnings, even while we sleep.

Let’s achieve that in 2023 with income investing.