Increase income portfolio returns with drier assets
This article was first published to Systematic Income subscribers and free trials on March 2.
Recent years have shown that market shocks are both frequent and unexpected. This dynamic suggests that being able to take advantage of the inevitable downside can both boost long-term income portfolio returns and reduce portfolio volatility. In this article, we discuss these drying powder assets, why allocating them might make sense, and where we see some interesting options.
Why dry powder actives
There are many ways to build and manage income portfolios. One is to be fully invested at one’s maximum risk appetite at all times. It’s a common way for income investors to manage their portfolios because it’s the way to maximize return – doing anything else is like leaving money on the table. And as the refrain says – it’s hard to beat “cash” in your pocket.
The problem with this view, however, is that focusing strictly on yield often comes at the cost of ignoring the capital base. And, we would say, what ultimately builds wealth is a sustainable base of capital rather than “cold hard cash”. The world of income is littered with high yield stocks that have left investors with a hole in their portfolios that will take time to heal.
That’s why we prefer to build income portfolios that also feature potentially resilient holdings alongside other higher-yielding ones. We call these potentially resilient assets – drying powder assets. The reason we use the word “drier” rather than “dry” is simple. In our view, truly dry assets are rare and those that exist offer little or no yield – a good example are Treasuries, very high quality short term munis or high quality short term corporate bonds superior. Holding securities with yields close to zero can be very difficult for most investors, especially since there are many higher yielding options. Therefore, a more realistic choice for most investors, in our view, is to balance the return with the risk, ie to get a little more return while controlling the risk. This means drier assets won’t retain 100% of their value on a market downturn, but they will also offer a decent return without burning a hole in investors’ pockets.
An important characteristic of income markets is the simple fact that they tend to be highly inverted. We can see this in metrics like corporate credit spreads below.
We can also see this by looking at the CEF discounts below.
What this suggests is that as income markets move towards a more expensive valuation, it makes sense to increase the amount of drier assets to take advantage of an inevitable sell-off.
Four other points are worth emphasizing. First, the markets greatly simplify this countercyclical allocation approach for income-oriented investors because, typically, different parts of the market move together, i.e. credit spreads, haircuts and stock prices, tend to be strongly correlated. This means that, more often than not, credit spreads, stocks, and discounts are all expensive or cheap at the same time.
Second, for investors to follow this approach, it is important to have a hunch of the upside potential. For example, an investor who holds 5-6% dry powder assets instead of holding an 8-9% yielding asset is missing out on about 3% every year. However, if large drawdowns occur every two years and drier powder assets can outperform by 10-15%, this can add a significant boost to investors’ long-term wealth and which, of course, can then lead to a higher level. of income.
Third, using drier assets as a strategic part of income portfolios can also reduce volatility. Some investors handle portfolio volatility poorly, however, the reality is that it is much easier to lose faith in a portfolio and hit the sell button on a draw when losses are magnified. Dryer assets can help control portfolio declines, which, in turn, can help investors stay invested during declines rather than repeating the usual cycle of selling low and buying back high.
Fourth, the returns of many ultra-high yield securities can be illusory. This could be due to something like over-distribution which is very common in high yield CEFs or the obvious fact that high yield securities also carry additional risk so investors shouldn’t just bank the returns higher assuming all is good for the money.
Dry Powder Ideas
In this section, we highlight some of the driest stocks that we like and hold in our income portfolios. Some of them have already been rolled out in recent weeks during times of market stress, taking advantage of the strong sell-off in some pockets of the income investing space.
First of all, we like some shorter duration open-end funds. For example, the Nuveen Short Duration Municipal High Yield Bond Fund (NVHAX) allocates to higher-yielding/unrated municipal bonds with shorter maturities and has provided historical returns comparable to many tax-exempt CEFs. Year-to-date, the fund has generated a return of around -2%, a duration of around 4% and a current yield of just over 3%. We also like the Angel Oak Multi-Strategy Income Fund (ANGLX) – a non-agency RMBS-focused fund that has returned 4.5% and is down 1.4% year-to-date.
Second, we continue to love Term CEF as the Invesco 2023 Target Maturity High Income Fund (IHIT) which allocates to CMBS securities. The fund is down about 5% year-to-date in terms of price, or about half of credit CEFs on average, with the net asset value down just 1.5%, or about a third credit CEFs. The fund’s floating rate assets, duration hedging, maturity structure, relatively high quality profile and modest leverage can help it hold up well during downturns. It trades at a current yield of 6% and a discount of 3.4%.
We also like the Nuveen Mid-Duration Municipal Term Fund (NID) which is down 3.4% year-to-date or less than half of the tax-exempt CEF sector. We have recently used the fund to rotate into attractively priced muni funds and would look to reverse if the munis reverse their recent decline over the next few months. NID is trading at a yield of 3.9% and a discount of 0.4%.
Third, we like a number of top tier titles with shorter deadlines. These include the BDC OXSQ 6.5% 2024 bonds (OXSQL), trading at a yield to maturity of 6.5%. We also like the CEF RSF 5.875% Series A (RMPL.P) trading at a yield to maturity of 5.43%. Both have been roughly stable since the start of the year.
Fourth, we like a number of pinned preferred securities such as the mREIT Chimera Investment Corp. 8.00% Series A (CIM.PA) is trading at a yield of 8.09% and is currently redeemable. The company’s portfolio operates with a relatively low leverage of 1.0x with a fairly high equity/preferred hedge of 4x. The stock is down 1.2% year-to-date, about a quarter of the preferred average value.
Take away food
Allocating a portion of the revenue portfolio to dry powder assets has a number of benefits. Ultimately, due to their relative resilience, they allow investors to take advantage of market declines in higher yielding assets. At the same time, they don’t burn a hole in investors’ pockets as they often trade at respectable yields as well. The past few years have shown that market shocks can come from very unexpected sources. Investors who are well positioned to take advantage of this are more likely to achieve their investment goals and derive a high level of sustainable income from their portfolios.