Adding Some Spice to Your Income Portfolio

Welcome back to Dividend Dynamo, where we're building a portfolio that works as hard as you do (but hopefully with better hours and no mandatory team-building exercises).

Quick Recap: Our Core Holdings So Far

We've been constructing our income-focused portfolio piece by piece:

• PFFA: Our preferred stock ETF foundation

• PBDC: Business development company exposure

• GPIX & SPYI: Covered call strategies on the S&P 500

Today, we're venturing into what I like to call the "misunderstood middle children" of the income world: term preferred stocks and baby bonds from closed-end funds (CEFs).

Why Term Preferreds and Baby Bonds? (Hint: It's Not Your Father's Perpetual Preferred)

While most preferred stocks are perpetual, meaning they're as sensitive to interest rate movements as a teenager's mood swings, term preferreds and baby bonds come with something beautiful: a maturity date.

Let me paint you a picture of why this matters so much. Remember 2022? When the Fed embarked on its rate-hiking spree, perpetual preferred stocks suffered significant losses. Take a typical $25 perpetual preferred paying 5%; when rates jump, that sucker could drop to $16 or $18. That's a 28-36% loss that you might NEVER recover because there's no maturity date forcing it back to $25.

The Maturity Date Magic: Here's where the term preferreds become beautiful. That maturity date acts like a financial magnet, pulling the price back toward $25 as time passes. It's called "pull to par" and it works like clockwork:

• Year 1 (2025): EICC trades at $23 because rates are high

• Year 2 (2026): Price creeps to $23.50 as maturity approaches

• Year 3 (2027): Now at $24 … the magnet gets stronger

• Year 4 (2028): Trading at $24.75 … almost home

• Maturity (April 2029): You get exactly $25.00

This happens regardless of where interest rates go! Why? Because as maturity approaches, the market stops caring about current rates and starts caring about one thing only: "This fund has to pay me $25 in X months."

The Time Decay of Discounts: Think of it like this: Would you pay $23 for something you KNOW you'll get $25 for in 6 months? Of course! That's a guaranteed 8.7% return. As time shrinks, any discount to par becomes an increasingly obvious free lunch, and the market gobbles it up.

Meanwhile, that poor perpetual preferred investor is still sitting there at $18, hoping and praying that someday, maybe, if rates fall enough, they might see $25 again. Spoiler alert: they might be waiting forever.

Or consider Compass Diversified (CODI); they have run into problems lately, when they revealed challenges with their largest subsidiary (Paywalled), and their perpetual preferred stocks have been hammered. Look at this:

Here's the Term Preferred Difference:

• Buy EICC today at $25 with its 8% coupon.

• Rates spike to 10%? Sure, the price might temporarily drop to $23.

• However, here's the kicker: On April 30, 2029, you'll receive $25 back. Period.

• Plus, you collected 8% annually while you waited.

The Math That Matters: With a perpetual preferred, you're making two bets:

1. The company stays solvent (good bet with CEFs)

2. Interest rates cooperate (a terrible bet … who knows where rates will go?)

With term preferreds and baby bonds, you're making just ONE bet:

1. The company stays solvent until maturity (with those 200-300% coverage ratios, this is a very good bet)

Real Money Example: Say you have $10,000 to invest:

• Perpetual Preferred Route: Buy 400 shares at $25. Rates rise, dropping the value to $18. You're down $2,800 and praying rates eventually fall.

• Term Preferred Route: Buy 400 shares of EICC at $25. Rates rise, maybe it drops to $23 temporarily. However, you can be certain that by 2029, you will have received your $10,000 back, plus you will have collected $800 per year in income.

This certainty of principal return transforms these from rate-sensitive securities into true fixed-income investments. You can mark your calendar for when your money comes home … try doing that with a perpetual preferred!

The Safety Net Nobody Talks About

CEFs possess a unique characteristic that makes them remarkably safe for bondholders and preferred stockholders. Thanks to the Investment Company Act of 1940, CEFs must maintain:

• 200% asset coverage for preferred stocks

• 300% asset coverage for debt

Translation: These funds must have at least $2 in assets for every $1 they owe preferred holders, and $3 for every $1 of debt. It's like having a financial fortress with multiple layers of protection.

But here's where it gets really interesting, and why these securities are so safe. When a CEF's leverage creeps toward these limits (say, their assets drop in value during a market downturn), they can't just cross their fingers and hope for the best. The law forces their hand …

What Happens When Trouble Brews:

1. Immediate Dividend Freeze: The CEF must stop ALL common stock dividends. No ifs, ands, or buts. Those yield-chasing common shareholders? They get zilch until the coverage ratios are restored.

2. No Share Buybacks: The fund can't buy back any common shares. Every penny stays in the fund.

3. Forced Deleveraging: If the freeze is unsuccessful, the fund must issue new common shares to raise cash. Yes, this dilutes existing common shareholders, but it adds fresh capital to protect the preferred and bondholders.

4. Asset Sales: In extreme cases, they'll sell portfolio holdings to reduce leverage.

Think of it like this: If you're a preferred stockholder or bondholder, you have an entire army of common shareholders standing between you and any losses.

Real-World Example: During the COVID crash of 2020, several CLO CEFs saw their asset values plummet. What happened? They quickly issued new common shares at distressed prices, bringing in fresh capital. The result? Not a single missed payment to preferred stockholders or bondholders, even as common shareholders got crushed.

This isn't some theoretical protection … it's battle-tested. In the entire history of CEFs, finding one that defaulted on preferred stock or bonds is like finding a unicorn riding a dinosaur. The structure simply doesn't allow it to happen under normal circumstances.

The Current Opportunity: Term Preferreds in the Spotlight

The market is currently offering us what I call a "confusion discount." Here are the standout term preferreds from our CLO-focused CEFs:

Eagle Point Income (EIC) Term Preferreds

• EICA: 5% coupon, matures 10/2026

• EICB: 7.75% coupon, matures 7/2028

• EICC: 8% coupon, matures 4/2029

Despite primarily investing in safer BB-rated CLO debt tranches (as opposed to the riskier equity tranches), these are yielding 7-8% to maturity.

Eagle Point Credit (ECC) Term Preferred

• ECCC: 6.5% coupon, matures 6/2031

Oxford Lane Capital (OXLC) Term Preferreds :

• OXLCP: 6.25% coupon, matures Feb 2027

The Baby Bond Bonanza

Even safer than term preferreds (remember that 300% coverage requirement), baby bonds from these same issuers are paradoxically yielding MORE:

Oxford Lane Baby Bonds

• OXLCG: 7.95% coupon, matures 2/2032 (the only 2032 baby bond in the market!)

• OXLCI: 8.75% coupon, matures 6/2030

• OXLCZ: 5% coupon, matures 1/2027

Eagle Point Credit Baby Bond

• ECCU: 7.75% coupon, matures 6/2030

The Upside-Down World We're Living In

Here's where it gets interesting (and by interesting, I mean profitable for those paying attention):

1. Baby bonds are yielding MORE than term preferreds … This is backwards, like paying more for coach than first class. We typically expect a higher return for higher risk, so bonds should yield the lowest return, given they are considered the safest investment in the capital stack.

2. OXLCG has an 8.32% YTM when comparable investment-grade BDC bonds yield 5.5-6%

3. EICC offers nearly 8% YTM despite EIC's conservative focus on BB-rated CLO debt

The market is essentially saying "I don't understand CEFs or CLOs, so here's an extra 2-3% yield for your trouble." Don't mind if we do!

Why This Mispricing Exists

Most investors see "CLO" and think "2008 financial crisis." They don't realize:

• CEFs can't blow up like banks because of leverage limits

• EIC invests in BB-rated CLO debt, not the equity tranches

• These securities are essentially at the top of the capital structure

• Many investors don't even realize these are CEFs, not regular corporations

Implementation Strategy

Start with 5-10% of your income allocation. These aren't your grandmother's Treasury bonds, but with 200-300% asset coverage requirements and defined maturity dates, they're far from speculative.

Priority Order:

1. OXLCG: The only 2032 baby bond available, highest safety tier

2. EICC: Best risk/reward among term preferreds (EIC's conservative portfolio, with less equity and more debt tranches)

3. OXLCI or ECCU: Solid 2030-2031 baby bonds

4. OXLCP: For those wanting near-term maturity with high yield

The Bottom Line

Adding CEF term preferreds and baby bonds to our Dividend Dynamo portfolio is like finding a designer watch at a pawnshop: the seller doesn't know what they have, but you do.

These securities offer:

• 7-8% yields to maturity (2-3% above comparable securities)

• Defined endpoints (no interest rate sensitivity if held to maturity)

• Structural safety via coverage requirements

• Current mispricing … because of market misunderstanding

We're not suggesting you bet the farm on these. But as a complement to our existing holdings, they offer a rare combination: higher yields than similarly safe securities, with the added bonus of knowing exactly when you'll get your principal back.

Want to know more about term preferreds & baby bonds? Check out innovativeincomeinvestor.com today!

What am I doing with my family investments? In the next few weeks, I will be starting and adding to positions in a few of the CEF baby bonds and/or preferreds. Which ones? I have my eye on ECC baby bonds … and will update you all when I make a decision which investments to make in this space.

In our next installment, we'll explore another corner of the income universe. Until then, remember: in the land of the blind, the one-eyed investor is king … and right now, most investors have their eyes firmly shut to these opportunities.

Disclosure: This is educational content only. Always conduct your own research and consider consulting with a financial advisor before making investment decisions. Yields and prices change daily. And remember, sometimes the best opportunities are hiding in plain sight, disguised by three-letter acronyms that scare away the masses.