Turning Troubles Into Opportunities | Seeking Alpha
Co-produced with Beyond Saving
It has been an incredibly volatile month for the market, driven by panic selling, liquidity concerns and the great unknowns of COVID-19. We know that most consumer-facing businesses are closing for a period of time. What we don’t know is how long. Many announcements have been only until the end of March, but many estimates are that closures will remain in place for over three months.
This is going to put a cash strain on many businesses. We already have seen companies drawing down their credit lines to have cash on hand. At High Dividend Opportunities, our income is our top priority. With over 120 picks, we know that being perfect is not going to be possible, some picks will reduce their dividends – some already have.
Yet our income is down nominally compared to the greater sell-off in the market. Many of our picks have announced unchanged dividends this past week. While some sectors remain at an elevated risk, other picks are poised to increase our income.
Fortunately, with everything sold off, there are opportunities to swap into or reinvest into lower-risk investments while getting yields materially higher than we could have gotten in our highest risk investments last year. The dividends we set aside to reinvest today can buy substantially more income than they could buy last year with lower long-term risk.
The most troubled sectors today are hotels, oil, and retail.
Hotels: Hotels saw a huge reduction in occupancy last week, with the average decline of 24.4% compared to last year. In some major cities, declines were more than 50%. This is going to increase, and we will likely see many hotels close completely. Since businesses often plan reservations well in advance, we expect that the drag will continue even after things reopen for business.
Oil: Oil prices have been hit by the one-two punch of lower demand due to worldwide shutdowns combined with Saudi Arabia and Russia starting an all-out price war. Being mostly political, it’s very difficult to determine when oil will rebound. We know that $20 oil is devastating to both countries, but it’s devastating for American producers as well.
Anything oil is at high risk of dividend cuts. On the other hand, there’s significant capital upside for the survivors. There are numerous potential catalysts that could aid American oil companies, discussions of embargoes, a potential settlement, a government bail-out or low-interest loans, and a reduction in supply from the U.S. and other countries could all help oil prices recover. Whether these events will occur and exactly when is an open question.
So we expect that most producers are going to slash their dividends and try to increase their cash positions. Midstream companies are somewhat better positioned as they often have fixed contracts for a portion of their business. However, even those contracts will be at risk if/when we start seeing bankruptcies in the industry. Most companies will survive, but there’s an elevated risk of dividend reductions until the oil market recovers.
Retail: Retail stores are closing down and we all know that malls have had a tough time already. Long outperforming their peers, Simon Property Group (SPG) gave in to gravity and has fallen to join the others.
The last time SPG and Macerich (MAC) dropped this low was December of 2008. In hindsight, it was a spectacular time to buy.
Despite both cutting their dividends in early 2009, they went on to dramatically outperform the market over the next two years. Many investors look at losses and ask “can it recover it is down x%”? History has shown us that yes, common equities can and do recover from these large sell-offs.
Right now the question is whether tenants will pay rent or whether landlords will negotiate concessions. Anything that happens will be temporary. MAC already has cut their dividend to the REIT minimum to ensure they have liquidity. SPG has not yet announced their dividend policy in this crisis, investors today should anticipate a cut. For total return, that likely is not a bad thing.
So far, no retailers have announced cancellations of their plans to open new locations late in the year. Additionally, retail closures remain well below the pace of prior years. The weakest retail companies already have gone under. There’s a risk that this stress pushes struggling companies over the edge. J.C. Penney (JCP), for example, might be seeing another nail in its coffin. Yet when malls reopen, the REITs will be right back on track to backfilling their properties.
In the picks that we hold, we remain confident in their long-term outlooks. There will be more near-term pressure, but these quality companies will rebound. Unfortunately, a troubled sector means that the smart decision for these companies is to retain cash.
So let’s take some look at some large income opportunities in the market.
Agency mREITs are one of the best opportunities in our portfolio. These mortgage REITs saw their prices collapse and are now trading at historically low levels.
Annaly Capital (NLY) is trading at a 19% yield. This despite holding a special call on Monday informing investors that their book value was only down approximately 10%, putting BV around $8.70. This is in-line with what has been reported throughout the sector – book values are down around 10% due to the volatility in the treasury and MBS markets. For the most part, these are unrealized losses and will recover when the markets stabilize. In the meantime, mREITs are trading at historically high discounts.
Additionally, their investment spreads are widening, meaning that NLY is going to be bringing in additional cash. We highlighted last year how lower borrowing costs would be a huge catalyst for NLY. Many were doubtful, NLY proved the market wrong with Q4 earnings, sending the price rocketing.
Now Mr. Market is making the same mistake again. Focused on relatively small headwinds like losses in their hedges from Treasuries rallying or increased prepayment speeds.
These headwinds will have an impact, but they will be blown away by the tailwinds of cheap borrowing. mREITs borrow a lot of money, so interest is their largest expense.
Yes, borrowing costs are dropping over 150 bps. In just the past month, the overnight repo borrowing rate has declined from 1.66% to 0.108%- 155 bps! NLY is borrowing over $100 billion, so borrowing costs dropping 150+ bps means saving a cool $1.5 billion/year in interest payments.
Since NLY negotiates debt in 30-90 day increments, and they have various interest-rate swap agreements they use to hedge against fast moves, it will take some time for the full benefit to be realized. As prior agreements expire, new agreements will be based upon current rates, and NLY’s cost of debt will trend down substantially. We expect NLY to maintain their dividend in the first half, and will likely raise their dividend in Q3 or Q4.
We saw this happen back in 2007, as the 10-2 spread increased, NLY substantially increased their dividend.
This is because, after boiling down all the complications, agency MBS investments thrive from a steepening yield curve. Low short-term borrowing rates, and higher longer-term rates.
The yield curve has steepened dramatically. While this creates some one-time costs due to hedging, the steeper curve is going to provide materially larger cash flows.
Preferred shares have been our safe-haven of choice. For those looking to preserve their income, there are some fantastic deals.
We have been warning investors away from the common shares of hotel REITs for over a year, preferring instead to keep our hotel exposure at the preferred equity side. This strategy has been vindicated as several hotel REITs have announced reductions in their common dividends, while all of them are still paying the preferred dividends.
RLJ Lodging Trust, $1.95 Series A Cumulative Convertible Preferred Shares (RLJ.PA) has long been our favorite pick in the sector. RLJ-A is attractive for a number of reasons, the biggest being that it cannot be called. Investors have not had an opportunity to invest in RLJ-A this inexpensively since 2009.
Source: Seeking Alpha
Back then, RLJ-A was a preferred share for Felcor, a hotel REIT that RLJ bought in 2017. Dividends were actually suspended, and were resumed after the crisis. Since the dividends are cumulative, shareholders received 100% of the accumulated distributions.
RLJ is in a much stronger position than Felcor was. At quarter end, RLJ has $882 million in cash on hand, plus $600 million available on their revolver. Additionally, they have no debt maturities until 2022.
Since they have cut their common dividend, and much of their expenses are traffic dependent, RLJ is in a solid position to weather the storm, however long it takes. The preferred equity is the level to be in for hotels and RLJ is the best positioned REIT in the sector.
In the oil sector, Crestwood Equity Partners LP, 9.25% Preferred Partnership Units (CEQP.PR) are yielding about 24%. Like RLJ-A, these preferred shares are not callable.
CEQP.PR has very shareholder-friendly features, like:
If we fail to pay the Preferred Distribution in full in cash for any quarter after the Initial Distribution Period, then until such time as all accrued and unpaid Preferred Distributions are paid in full in cash I) the Distribution Amount will increase to $0.2567 per quarter, II) we will not be permitted to declare or make A) any distributions in respect of any Junior Securities (including the common units) and B) subject to certain exceptions, any distributions in respect of any Parity Securities, and III) certain preferred unitholders shall receive the board designation rights described below.
If we fail to pay in full any Preferred Distribution, the amount of such unpaid distribution will accrue and accumulate from the last day of the quarter for which such distribution is due until paid in full. Any accrued and unpaid distributions will increase at a rate of 2.8125% per quarter.
This punitive measure provides Crestwood Equity (NYSE:CEQP) a lot of incentive for them to pay the preferred dividend if possible and decreases the risk of suspension.
CEQP has fallen ~60% recently before recovering some, which is rare for a preferred issue. Historically, CEQP has survived several downturns in the industry and has continued to pay a common distribution throughout. Investors are treating it as a much riskier name than it actually is after how it performed in the 2014 crash. CEQP will likely be able to continue paying a common distribution, which means they will maintain the preferred distribution as well.
Note that CEQP.PR issues a K-1 tax form.
There are some sectors that are clearly going to have a tough period. For our holdings, we remain confident that the shares will recover. This is not the first time that oil, hotels or malls have seen their share prices dive. They will recover, and their dividends will recover as well.
Yet with all the pain, panic brings opportunity. Agency MBS is a sector that has underperformed since the last recession. It’s a sector that thrives from a steeper yield curve and cheap borrowing costs. Conditions we have not seen in a long time. Now that the conditions are here, the market remains bearish, providing us an opportunity to invest at double-digit yields in a sector that will almost certainly be increasing dividends by year-end. For those looking to protect their income, the agency mREIT sector should be a top focus.
We have been huge fans of preferred shares as a source to provide stable income, even in troubled sectors. While prices have proven volatile in panic selling, the distributions continue, even in these troubled sectors where the common dividends have been cut. We have numerous preferred shares in sectors that are not troubled which also sold off and provide compelling investment opportunities.
In capital gains upside, the common shares will have a higher potential total return when the recovery happens. However, for those who prioritize income, the preferred shares in these sectors have yields of 15%-30%-plus. In the case of RLJ-A and CEQP-, neither one can be called, meaning that you can collect those yields as long as the companies remain in business.
Investors who focus on their income will find that opportunities are plentiful. We are still in a bear market, and that means wild moves to the downside are likely to continue happening. Old lows will be retested, and we might even see steeper lows. With that said, we encourage investors to retain some cash, and buy in small bites, keeping a reserve for future investment.
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Disclosure: I am/we are long RLJ.PA, CEQP.PR, RQI, MAC, RFI, NLY, JPC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.