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Don't Wait For The Fed, Act Now; Our Top Picks With +7% Yields

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In a euphoric market, one asset class is trading at deeply discounted valuations: fixed-income. Thanks to a two-year run of rising interest rates, these income-oriented securities are cheap, but we don’t expect this to be the case for long, with likely rate cuts on the horizon. Despite market perceptions, both these asset classes continue to have robust fundamentals and are delivering what investors expect from them.


Fixed-income investments, particularly preferreds, continue to pay the stated dividends to shareholders despite volatility in their prices. The ICE Preferred Security Index continues to sport yields significantly above the ten-year average.


We note that fixed income performs well after tightening cycles end, and buyers at current prices are well-positioned for excellent total returns. The Bank of Canada was the first of the G7 central banks to cut rates, and the U.S. Federal Reserve isn’t far behind. I am locking in these massive yields for my long-term income needs.


Pick 1: DFP - Yield 7.1%


Flaherty & Crumrine Dynamic Preferred and Income Fund (DFP) is a CEF. Flaherty & Crumine has a long history of managing CEFs. Since the firm's inception in 1983, its expertise has been preferred securities for institutional clients and investment funds.

DFP holds 210 securities, with ~49% of the fund’s assets deployed in investment-grade securities, and ~79% of the fund composed of banking and insurance sector preferreds. These are highly regulated institutions with strict regulatory capital requirements and often demonstrate double-digit coverage for their preferred dividends. Source


For FY 2023, 99.8% of the CEF's distributions were QDI, making them highly efficient from a taxation standpoint for eligible investors. We note that due to its high exposure to the financial services sector, the fund typically achieves a high +80% QDI for its shareholders.

DFP is a leveraged CEF operating at 39.5% leverage. The fund has a 91% fixed-to-float exposure, with the floating component carrying a SOFR + 0.9% interest rate on the borrowed balance. DFP’s effective weighted average duration of debt stands at 2.9 years, with an average coupon of 6.93%. This eats into the fund’s bottom line, resulting in declining distributions amidst a record pace of rate increases.

Let us review the effects through the chart below. Observe the steady rise in TII (Total Investment Income). This means DFP’s assets are earning more through active management of fixed-income securities in the hawkish environment, but all of it isn’t translating into shareholder distributions due to rapidly rising interest expenses.



Given DFP’s floating-rate exposure, higher rates almost immediately reflect on the fund’s expenses, shrinking the NII (Net Investment Income), and resulting in a decline in quarterly distributions. With rates almost at their peak, we don’t expect interest expenses to decrease until the Fed pursues rate cuts materially. And rate cuts will directly translate into higher NII and growing distributions. It is a question of time, and DFP ensures you get paid to wait for this.

This rate uncertainty-driven sell-off is a buying opportunity for the rate-agnostic investor, to ensure excellent total returns when rates decline.


Pick 2: UMH preferred – Yield 7%


UMH Properties Inc. is an internally managed REIT that owns and operates a portfolio of 136 manufactured home communities with ~25,800 developed homesites. These communities are located in New Jersey, New York, Ohio, Pennsylvania, Tennessee, Indiana, Maryland, Michigan, Alabama, South Carolina, and Georgia. The REIT also owns ~2,100 acres of land for the development of new sites. In addition, UMH has a joint venture relationship with Nuveen Real Estate to operate two communities containing 363 sites in Florida.


Raging inflation has caused rents and home prices to soar. And The Fed’s restrictive policy has resulted in higher mortgage rates, incentivizing homeowners not to move, and prospective home buyers to wait and consider rental options. High inflation is pinching pockets, specifically around the shelter, with rents and mortgages soaring. Manufactured homes are economical to build and significantly more affordable than site-built homes. On average, a manufactured home costs ~$127,000 (or $85 per square foot), whereas a site-built home costs over $413,000 ($168 per square foot). The current macro-economic picture bodes well for UMH which benefits from selling manufactured homes and from renting out properties.


During Q1 2024, UMH grew its rental income by 11% YoY, and its Community Net Operating Income by 16% YoY. The REIT also reported a 10% YoY increase in Normalized FFO to $0.22/share. Since 2009, UMH has maintained a steadily growing common dividend. In April, the REIT announced a 4.9% increase in its quarterly common stock dividend to $0.215 per share, reflecting a 5.7% yield at current prices. According to data from S&P Global Market Intelligence, UMH achieved the highest yearly increase in Q1 same-store net operating income (15.6%) among publicly traded equity REITs.


One of the biggest strengths is UMH’s ownership of 2,100 vacant acres available for the future development of ~4 sites per vacant acre at an estimated cost of $75,000 per site. That is almost 8,400 homesites, and management has engineered the expansion of 3,069 sites over the next five years, positioning UMH to grow internally for the foreseeable future.


UMH maintains a healthy balance sheet with 92% fixed-rate debt with a weighted average interest rate of 4.56% and a weighted average term of 5.1 years. The company’s debt schedule has adequate flexibility, with limited maturities this year.


We also note that insiders own 6.9% of the common stock, indicating excellent prospects of alignment between management strategy and shareholder returns. We choose to invest in the higher-yielding UMH preferred that trades at an attractive discount to par.


  • 6.375% Series D Cumulative Redeemable Preferred Stock (UMH.PR.D)


UMH-D trades post call date, and currently yields 7% and offers ~10% upside to par. During Q1, the REIT generated $19 million in net cash from operating activities while paying a $13.5 million common stock dividend. Notably, $4.6 million was spent on the quarterly preferred dividend which is subtracted before the net cash from operating activities was calculated. UMH ended the quarter with $49.2 million in cash and cash equivalents, providing adequate liquidity for the firm to execute its strategic objectives.


Conclusion


I see the fixed-income market offering yields that have come down a little but are still much higher than average over the past decade-plus. Given the potential risk of a recession, fixed income remains the area where I have been doing most of my buying. At High Dividend Opportunities, we have been making several new preferred and bond additions to our model portfolio and are fortifying our bond ladder amidst the uncertainty and anxiety over interest rates. If you haven't constructed your own bond ladder, I encourage you to create one. Fixed income is both defensive in the event of a recession while also being attractively priced and an appealing asset class even if the mythical "soft landing" is engineered. This is the beauty of income investing.


 

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