KIO: Invest With The Pros

KIO: Investing With The KKR Professionals

Inside the Income Factory® members know that I like investing with experienced, professional money managers who invest millions of dollars for a living. But even the pros sometimes lose money, and us along with them. KKR Income Opportunities (NYSE:KIO) is a good example of a fund that is run by a highly regarded and experienced credit and investment shop, but has also had its ups and downs in terms of market pricing over the years, along with the high-yield credit market generally.

Being a big believer in high yield credit (loans, bonds, CLOs, BDCs, etc.) as a way to earn "equity-level returns" through steady cash yields, rather than with equity-level volatility, I have been attracted to credit funds run by the likes of KKR, Ares, Apollo, Barings/Mass Mutual, Prudential, Carlyle, Blackstone, Credit Suisse and others. So I hold a major position in KIO in my personal account, as well as in our Inside the Income Factory® model portfolio.

While I don't practice market timing in a technical sense, I do look at premiums, discounts and yields, as well as total return records, in deciding what to put new money into, and when. I have been a fan of KIO for some time, but my record on timing my purchases of the fund has been spotty.

In my personal account, I loaded up on KIO back in late 2020 and throughout 2021, which was poor timing. So I'm carrying a "paper loss," although I have no intention of selling and turning it into a real one, since the steady accumulation and compounding of KIO's 12% cash distribution continues to outdistance my initial paper loss on the investment.

Taking A Closer Look At KIO

KIO describes itself as an "income opportunities" fund, which suggests that it considers a range of corporate debt instruments to be potentially on its radar scope. In its words: "The Fund seeks to achieve its investment objectives by employing a dynamic strategy of investing in a targeted portfolio of loans and fixed-income instruments of U.S. and foreign issuers, and implementing hedging strategies in order to achieve attractive risk-adjusted returns."

What that means, in KIO's case, is essentially corporate loans and high-yield bonds, of which it recently held 51% high-yield bonds and 43% corporate loans. It also dabbles in CLO's (collateralized loan obligations) for 5% of its portfolio. That's not nearly as much CLO investment as some other funds do that describe themselves as being opportunistic, like Ares Dynamic Credit Allocation (ARDC) or XAI Octagon Floating Rate & Alternative Income (XFLT). This is not a criticism of KIO, but merely a distinction from other funds that are sometimes compared to it.

How well has KIO done?

KIO's record(per CEF Data)over the past ten years is pretty good, considering how low - i.e. close to zero - base interest rates were during much of that period. So earning a 6% total return during the past decade for a fixed income fund is not bad, especially with the more recent Covid and post-Covid market drops weighing it down. KIO's 10-year performance and prospects are not dissimilar from that of Apollo Tactical Income (AIF), which wehighlightedrecently, although KIO is more evenly split between senior secured loans and high-yield bonds, whereas AIF is primarily a loan fund, with a smaller allocation to bonds.

What's important to me is:

• How did KIO do versus its peers? Since that helps us determine whether the fund's managers are real pros within their industry, since I want to be investing with the very best. I want to know that even during down-market periods, I have managers that have "been there and done that" before, and if anyone is likely to find value and avoid trouble in all kinds of markets, they will be the ones.
• So from that perspective, I am pleased to see that KIO was #5 out of 26 other funds in the high yield bond category over the past 10 years.
• Even better, I am heartened to see KIO #4 out of 30 in total return over the past 1 year period, and #1 out of 30 for 2023 year-to-date (on both market price total return as well as NAV total return!).
• Not only is the year-to-date ranking (#1) excellent, but the absolute total return percentages, 21% year-to-date on market price, and 16% on NAV, are impressive as well, which we will return to in a second as we examine distribution coverage.

How does KIO earn its total return?

Credit funds make their money the way most banks do, by collecting interest on their portfolios of loans, bonds or other credit instruments. I have often called this income - the cash that flows in day after day from their loan and bond portfolios, regardless of whether the market value of those portfolios has gone up or down - the funds' "business as usual" income.

Accountants and analysts call it, more formally, "net investment income" or "NII." It is defined as the net cash flow, minus fund expenses, from the interest and/or dividends that flow in routinely from a fund's investment portfolio. It does not include capital gains or losses. For credit and other high-yielding fixed income funds, the "river of cash" provided by the NII in today's current higher interest-rate environment can be 9-10% or more. So any capital gains the funds may achieve over and above their NII are essentially "icing on the cake."

This is in marked contrast to equity funds, where capital gains have to be the main part of "the cake" itself, rather than icing on the cake, if the funds want to earn a 9-10% equity return. Equities (like the S&P 500) generally only pay dividend yields of 1-2% (SPY, for example, yields 1.5%). For equity funds to earn and pay a 9-10% distribution, they have no choice but to achieve and harvest capital gains of another 7-8% on top of their 1.5 to 2% yields. They may not achieve that consistently every year, but they need to average that over time if they expect to match the average equity return over the long term.

In comparing equity investing to credit investing, I often refer to the capital gains that equity funds need to achieve as "heroic" income, since it requires fund managers to actually achieve gains and sell assets at a profit, in order to earn their target returns and pay their distributions. Credit funds merely have to "clip their coupons and cash their dividend checks" to generate their "business as usual" net investment income.

Fortunately, KIO has the best of both worlds in that it has a steady stream of "business as usual" net investment income from its loan and bond portfolio, which most recently (4/30/2023 semi-annual report, page 16) covered its distribution by 107%. But it had additional capital gains from its loan and bond portfolio that were the approximate equivalent of its NII, bringing its total return for the first six months of the year up to twice the amount of its NII. Since June 30, its total return has increased further and is currently 21% for slightly over 8 months.

The capital gains most likely reflect the steep discounts over the past year in the credit markets, as prices have tended to overestimate the likelihood of recession and default increases. So KIO and other credit investors could buy discounted but healthy loans and bonds in the secondary market, hold them to maturity while (1) collecting their stated coupons (which represented a higher yield than the stated coupon because so many of their loans and bonds had been purchased at a discount) and (2) then later collect the full par value at maturity, booking a capital gain for the difference between par and what they originally paid to buy the instrument. This is why credit markets (senior loans, HY bonds, CLOs, etc.) have so often done better for investors during volatile economic periods, because markets, encouraged by a media that loves to carry inflated "the sky is falling" types of stories, typically overcompensates investors for perceived credit risks (Link for more details).

This is good news for KIO investors, since we know our current distribution is fully covered by NII, but realize there may be extra income (i.e. realized capital gains) that will have to be paid out by the fund in order to meet its "90% of taxable income" distribution requirement; at least as long as KIO has loans and bonds on the books that it bought at discounts and will generate capital gains upon maturity.

Pricing, Yields and Risk

KIO currently pays a 12% distribution yield which, as we just explained, is fully covered by its NII. But the fund sells at a -6.8% discount to its net asset value, so KIO investors can buy each share for just 93.2% of its full value. KIO has actually sold at bigger discounts over the past year, with an average discount of about -10% and a low of as much as -14% early in the year. But the current discount is very close to what the average discount (-7%) has been for the past 5 years. I suspect the bigger discounts of the past year or so have reflected the pessimism in the credit markets when a recession seemed to be constantly just around the corner. Now considering that markets and the economy seem less pessimistic, as well as KIO's performance over the past year, I think a discount more in line with the fund's historical norms seems appropriate.

KIO's distribution yield on its NAV (i.e. its fully valued shares) is currently 11.2%. That's the yield shareholders would receive if they paid the full NAV per share. But since we can buy at the 6.8% discount, the actual yield on our investment is 12%, rather than the 11.2% it would be if we had to pay full price.

This may seem like a minor point to some investors, but in credit markets, just like other financial markets, generally the riskier the asset, the higher the yield (and vice versa). So to be able to hold a portfolio of "11% assets," in terms of risk, and get paid for holding "12% assets" because we bought in at a discount, represents a shift in the risk/reward balance in our favor as investors.

Who else is investing along with me?

Besides having successful professionals managing my funds, I have also emphasized ("From Slide Rules to Spreadsheets...") how I like to invest alongside professional institutional investors who manage tens of millions of dollars for a living. KIO definitely attracts that sort of investor, with 46% of its stock held by institutions, including: Morgan Stanley, Clough Investments, SIT Investments, Guggenheim, Vivaldi Capital, UBS, Advisors Asset Management, Invesco, Bank of America.

Obviously, investing with professionals doesn't guarantee success, but I think it lessens some of the downside risk of major surprises coming out of nowhere, since it means there are a lot of sharp eyes besides mine, keeping an eye on the investment.

I look forward to your questions and comments.

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Thanks,

Steven Bavaria