Inside the Income Factory: credit asset investing with Steven Bavaria

0:09Hey, everyone. It's Daniel Snyder from Seeking Alpha. Thank you so much for hanging out with us today. We are going to dive into the conversation with Steven Bavaria. He is the investing group leader behind Inside the Income Factory, talking all about some sweet, sweet yield for you, hopefully, in the years to come. Steven, great to have you on the program today. Hi, Daniel. Thank you. It's a pleasure to be here. Well, the primary asset classes that I focus on are credit assets. I also, I mean, you can use high yielding stocks, you know, like utilities and infrastructure shares, especially if you buy them in, say, closed end funds, where you can often buy them at a little bit of a discount if you wait for the right entry points.

0:55You can get high-yielding utilities and MLPs and things and earn 7%, 8%, 9%. Then in the high-yield bond market and the senior loan market, you can get, again, and I like closed-end funds because it's an easier way to hold, you can hold more complex illiquid assets in a closed-end fund and not have to worry about runs on the fund so much. as that's why ordinary mutual funds are less likely to be quite as aggressive in some of these areas. But you can get, you know, eight, nine, 10 percent in a whole host of high yield bond funds, senior loan funds, many of which have been around for years, are run by really responsible, experienced investment shops.

1:49And then another area, which is also is not really well known, but has a very good investment record is the business development companies, which are called BDCs. And they're actually like little mini banks. And there are a couple of ETFs that actually are like funds of funds that own a whole bunch of BDCs that I use. One's an actively managed ETF called PBDC. It's run by, it's Putnam, BDC. And then there's another one, BIZD, which is the VanEck BDC ETF. And it's been around for a long time. And I mean, the PBDC is newer. BIZD has been around for a long time and has a really good record. You know, 9%, 10 % returns over, or more, well, over the last five years.

2:43Those are the main asset classes. And then people will often say, well, shoot, aren't high yield bonds and these senior loans, aren't these really risky? You know, they've heard of the term junk bond and that sort of thing. And most of these are non-investment grade credits. But what people don't realize is they're not nearly as risky as like the mid-cap and small-cap stock funds that most people own some of in their portfolios, if they're stock portfolios, because the bonds and loans issued by these companies are actually higher up on the balance sheet than the stock that a lot of people have been buying.

3:23So many people say, oh, I'd never touch high-yield bonds. If they look in their own portfolio, you'll see a slew of high yield stocks, mid caps and small caps. And statistically, we know the default rates for these companies. And they might default 1 % or 2 % typically a year on a portfolio basis. And they virtually always get back 50 % or more principles. So if you have a 2%, 3%, 4 % default rate, say a 4 % default rate on a portfolio and you get back 50%, you've lost 2 % of your principal and you're earning 7%, 8%, 9 % in interest each year. So you can take the principal you've lost right out of your income and it doesn't even touch your own capital.

4:15So these are much more predictable and stable than a stock portfolio would be. Imagine in a recession where you might have defaults of 6%, 7 % or 10 % or 11 % in the big recession we had about 17 years ago. But imagine, so if you had 10%, 12 % defaults and lost 5 % or 6 % of your portfolio, you'd still be way ahead of how stock portfolios would be doing in those same periods. So yeah, nothing's without risk, but it's a much more predictable and stable risk. with an income factory approach, I think, than with the typical ups and downs of the stock portfolio. Hey, Stephen, real quick, since you mentioned PBDC, I've held it up here on Seeking Alpha.

5:03We were kind of like looking through the symbol page here and looking at the holdings. And as you mentioned, we do see all of the Blue Owl and Aries and Blackstone, as you mentioned. How do you think about these expense ratios being at 13.94 % for a fund like this? Oh, I'm glad you mentioned that. That throws a lot of people off when they see that. The expenses of the fund itself are only like 0.4%, 0.5%. Under the accounting rules, if you're a fund of funds, and for some reason it applies to BDCs in this particular way, they have to take all the expenses of the underlying BDCs that they own and then add them up and make them part of their own expense ratio.

5:53But other mutual funds don't do this. And these are operating companies, too, that they own. I mean, a BDC is not just a fund. And it's actually an operating company. So the operating expenses of Blue Owl and Blackstone and all of them, Aries, that's what they report as their expenses in the same way that every corporation has expenses paying for its office and its staff and everything else. So no, those aren't the real expenses of the fund. By buying that fund, you could go and buy all those individual companies yourself. those BDCs, but it only costs you about 0.4 % more to have it done by professionals who run the fund.

6:43All right. Thanks for clarifying that. Just wanted to make sure, because I know people see that and they sometimes freak out, because in the world of VTS, we're so used to seeing those expense ratios get lower and lower. Let's talk about, before we dive in, you gave me a couple tickers that we're going to run through here in a moment, but you set up, how do you think about CLOs? That keeps coming up in the chat as well. Are you a big believer in CLOs? Do you think they fit in the portfolio? Is that something that you look to for yield? Well, yeah. For those who don't know what a CLO is, that stands for collateralized loan obligation.

7:18And they were started about 35 years ago. I remember writing a few articles as a reporter about some of the early ones, sort of explaining what they were. And there's also some confusion in the minds of a few people. We try to stop it all the time. There was something called a CDO that was made up of like really fraudulently underwritten home mortgage loans and home equity lines. They were done literally, you know, like 20 years ago. And they were one of the big culprits in bringing down Lehman Brothers and some of these banks that went bust and causing the great crash of whenever it was 2008 or so.

8:03They are not CLOs. CLOs are structures that hold loans, what they're called broadly syndicated loans to major companies. They're all rated and well-known firms. And so they've been around since the late 80s and have a great record, actually. And you can, they not only, you can buy the equity of them, which is like buying the equity of a bank, because the equity is leveraged 10 to 1 in a CLO, the way it's leveraged about 10 to 1 by JP Morgan or Citibank or any other big bank. If you buy the equity, you're buying a kind of leveraged bet on default rates not getting out of hand and on the management of the CLO's ability to kind of manage around that as well.

9:00I am a believer in CLO's in that they've got a great record. Institutions have done brilliantly holding CLO's for the last 30 years. They've made it through all the, you know, the great recession. They've made it through the COVID crisis, you know, and done well. CLOs have only been owned by retail funds for about the last, well, one of them, OXLC started about, yeah, about 11 years ago or so. And then a few others have joined since. So now there are half a dozen CLO funds and a couple of ETFs. The jury is still out, let's put it that way, on how well they will do in the retail format. They're being held.

9:45They're held mostly by closed-end funds, a few ETFs. The problem is because closed-end funds, unlike banks, cannot create an accrual to accrue for future loan loss because you always have loan loss. Even healthy portfolios always have some losses. Because with CLOs, individual CLOs are kind of like annuities, and they wind down over six, seven, eight years. They pay out all of their cash flow to their owners, usually pension funds, but now including closed-end funds. They pay out all their cash flow to the owners. And then at the end of each CLO's life, when they kind of wind down, you kind of find out what their losses have been in terms of loan losses, credit defaults, loan losses.

10:36And it's always, the point is that they've always paid out to their shareholders, including the closed-end funds, more than they've actually earned because you kind of have to give some of it back at the end when they don't get back all the money they originally invested. If they were a real bank, they would have created a reserve for this and hit each year's earnings a little bit, so it never piles up. But as a closed-end fund doesn't have the option to do that, closed-end funds are forced to pay out more distributions than they end up actually making. So you see some of these closed-end funds like OXLC and Eagle Point Credit, ECC, that are like big owners of CLO equity, and they'll end up paying out like 20 % distributions, which looks terrific.

11:34And some people buy it just for that. But what they don't realize is then they kind of erode their price and their net asset value every year by a few percent or more because of loan losses that are taken later in the life of some of the CLOs they own. So this is a lot of inside baseball that maybe everybody isn't as interested in. But as a result, I just say you have to be really careful with CLOs. I own some of the members of my group, my inside the income factory do. But it's not for the faint hearted. You wouldn't want to put a lot of money into them. I think the jury is still out on how they're going to do over the longer term.

12:20I've got an experimental portfolio. Part of what I do with my group is for certain things, we'll set up like what I call live models and I'll create a piece of my own Fidelity account and buy a bunch of funds. I've got one that's just CLOs that we're following to see how it's going to do. I just started it a couple of months ago. And, you know, the jury's still out on how it's actually going to do compared to more dull and boring funds that pay lower yields, but might do better in the long term. Let's go ahead and dive into Barron's Global Short Duration High Yield Fund. Well, this is a high yield fund that focuses on not taking much interest rate risk, which is good if you think rates are coming down.

13:15What I like about it, one, it's owned or it's managed by, sponsored by Barings, which is the name that MassMutual now uses. Barings was an old merchant bank that eventually went bust some years ago, but its name was bought up by MassMutual. MassMutual is an insurance company, of course, and it's been doing private credit, what we used to call private placements when I wrote about them years ago. But it's been doing it for generations and is really good at it. So I like, you know, I like their funds. BGH is the one that is still at a, you know, and I think it's close to a discount. I haven't checked it today, but it's right.

14:07It's selling right around its right around par, right around its net asset value. It's got two sibling funds that I couldn't put up when I made this list because they're actually too expensive now, but they're MPV, you ought to watch for these, and MCI. They're both mass mutual funds that were started years ago that are between them. They're the number one and number two funds in the high yield closed end fund category. And I would have had them on this list as well, but they've risen to premiums because they've done so great. But they're also in the private credit sort of field, which is Bering's global short duration is partly in high yield bonds, partly in private credit.

14:57It's all run by the same credit platform. and all three of them are great funds. MPV and MCI are worth watching. If they ever come down close to net asset value, I'd snap them up. All right, let's jump on over to ARIES Dynamic Credit Allocation Fund. Yeah, ARIES Dynamic Credit Allocation is sometimes it's listed as a senior loan fund, sometimes as a high yield bond fund by different entities. And that's one of its advantages, it's run by Aries, which is a terrific credit and investment platform, you know, lots of experience. But it also, its mandate is to kind of go both ways. So it will invest in high yield bonds.

15:44It will invest in senior loans. And that's good because senior loans are, they're secured, they're top of the heap as far as protection, but they're also floating rate. So when rates are lower, you know, they're not going to earn as much, say, in income as a high yield bond fund, which has fixed rates. So they don't drop, but they also, if rates go above them, then the price can be hurt. But the beauty is that Aries Dynamic Credit, their management are, you know, they're prepared to move either way. So they've got a portfolio that really is dynamic in that sense. They actually will also, they also buy some CLO equity and CLO debt, not enough to make it particularly dangerous, but enough to spice up their earnings, I think, and their yields.

16:39So I really, yeah, I really like ARDC. Yeah, I don't know if I would want to take that on personally. So it's nice having the smarter people out there do it for you. Oh, absolutely. Yeah, that's why I only buy funds, basically. because, you know, I'm a portfolio manager. I'm a writer. You know, I've got a lot of experience, but I don't claim to be an analyst. I look at other Seeking Alpha people who write these articles in depth about a lot of things as my analytical staff, frankly. Don't we all? I mean, that was one of the big things that attracted me to Seeking Alpha was like, it's like having a hedge team analyst team in your pocket at all times.

17:17Just a reminder, anything you hear on this podcast should not be considered investment advice. This is for entertainment purposes only, and you should seek advice from a licensed professional before investing. If you enjoyed the episode, leave a rating or review on your favorite podcasting app. And we'll see you soon with a new episode.