Thoughts on Portfolio Construction and Diversification (Part 2)

Fixed income plays an important role in any portfolio that's retirement oriented. Aside from providing an income stream, it has the potential of providing diversification to help ensure capital preservation.

Of course, fixed income, or debt comes in a variety of flavors, which means there is a wide variation both in terms of yield, as well as the potential for a low or negative correlation to equities.

Among the options available to investors are:

• US Fixed Income
• High-Yield Fixed Income
• Non-US Fixed Income
• Emerging Markets Fixed Income
• Convertibles

Within each of these categories are numerous sub-categories, but for the purposes of this article. I think the list suffices.

It should be apparent to the reader that each of these classes will vary sharply in terms of yield, based on risk (real or perceived) and duration. Additionally, the classes vary considerably in terms of correlation to equities.

For example, high yield (aka "junk") debt will more closely track equities, since a healthy economy which would favor stocks will also mean there's less likelihood of default on lower rated bonds.

Likewise, convertibles will also track equities fairly closely, since a part of their value stems from the ability to convert it to common stock.

Any investor who held positions in either or both classes during the last downturn, thinking they were "protected", got a rude awakening.

Given the difficulty in achieving diversification within fixed income for the average retail investor, the easiest way to employ debt in one's portfolio is via ETFs or CEFs.

My personal preference is to use CEFs, realizing that I'm making a "bet" on the manager's skills, as well as on the asset class. As a rule, I prefer to invest in funds that have at least a 10 year track record, or barring that I'll check management's track record at another similar fund.

Additionally, I only buy the fund at a discount to NAV to gain an additional margin of safety. An excellent resource for evaluating both ETFs and CEFs is etfconnect.com. It provides a wealth of information on both share price and NAV history, top holdings, distributions, management fees, etc.

I've found it possible to achieve multiple goals within my portfolio through the use of CEFs. As an example, the core holding in my fixed income segment is GIM, a global sovereign debt fund. One of my "macro" themes is a long term bearish outlook for the USD, and my position in GIM gives me my exposure to fixed income, as well as taking advantage of dollar weakness in the longer term

Full disclosure: Long GIM, AVK, HTR

Comments

[TucsonSpike:]

Thanks for a good article. Fixed income CEFs seemed to have changed over the past year and a half. For many years they were pretty steady compared to the overall market and provided good yields. However lately the are among the most volatile of investments, and I no longer hold them, as the only way to make and preserve money is to trade them fairly frequently. And I just find that there are a lot of ETFs to trade that are more reliably profitable. In addition, the ETF universe now includes a lot of inverse funds which have been very good to me.

Your point about having diversification within the fixed income sector is right on.

Jun 22 02:52 PM

[Old Trader:]

Tucson,

Thanks for the kind words. You're definitely correct in noting the changes within the world of CEFs, but I think there's still merit to the sector...it just takes more digging to unearth.

I'm planning a final "installment" on this series on portfolio construction which will get into hedging, and rest assured, the inverse ETFs will be mentioned.


On Jun 22 02:52 PM TucsonSpike wrote:

> Thanks for a good article. Fixed income CEFs seemed to have changed
> over the past year and a half. For many years they were pretty steady
> compared to the overall market and provided good yields. However
> lately the are among the most volatile of investments, and I no longer
> hold them, as the only way to make and preserve money is to trade
> them fairly frequently. And I just find that there are a lot of ETFs
> to trade that are more reliably profitable. In addition, the ETF
> universe now includes a lot of inverse funds which have been very
> good to me.
>
> Your point about having diversification within the fixed income sector
> is right on.

Jun 22 03:15 PM

[odin:]

While I do believe that yield is going to be valuable in the future, not all income funds are born equal (on a risk-adjusted basis). It is important to realize that with fixed income investing that you are selling a put on the assets. GIM for e.g. has a high yield because its invested heavily in the sovereign debt of emerging markets (Russia, South Korea, Australia etc). Unsurprisingly, they are heavily correlated to those markets. I'm not sure that they will provide the safety that people expect out of fixed income investments. Similarly, HTR is a leveraged fund and that point bears attention.

As a guide, it is likely that the historical default rates on HY instruments will understate the future defaults by a wide margin.

Valuation is simply one aspect of convertible bond trading. Because the market is not extremely deep (comparatively speaking), technicals play a huge role. That is what took down converts last year and I dont believe looking at charts can give a sense of how institutions are looking at convert funds (or when a big fund winds down). Convert arb is still dead and a lot of funds are way under their high water marks.

While buying CEFs at a discount may psychologically feel better (good value), there are many reasons why CEFs trade at discount/premiums. Those discounts are not realizable unless a fund liquidates and if it does liquidate, its likely doing so under distressed conditions. The middle-single or even teen digit discounts will be little consolation. What is more important to see them in the context of historical discounts.

I think CEF/ETF investing for individuals has many positives, but the above points need attention.

Jun 22 03:27 PM

[searcher:]

Those CEF's that exhibit a loose periodocity in their discounts yet have 'decent' managerial/structural characteristics points do exist and are good value for the patient. One very large fly in the ointment is dodgy liquidity, thus, patience ...

Jun 22 04:02 PM

[Old Trader:]

Odin,

Your point on GIM is well taken. My position in it is also based on an excellent long term track record by the management. My position in HTR is less than one percent of the portfolio, so whether it triples tomorrow, or goes to 0, it would little to no effect on overall portfolio returns. I'd agree there's probably some pain to come in the high yield sector.

In regards to converts, its my understanding that, as you pointed out, a lot of hedge funds were in the convert arb strategy, and the ban on short selling effectively blew that strategy up, resulting in wide scale "dumping" of convertible bonds, killing the NAVs of convert funds. Still, the sector HAS recovered, somewhat, this year.

A final point in regards to steep discounts to NAV, something I've noticed is that there's a growing tendency by CEFs to periodically (like once a year) announce a tender for a certain percentage of shares outstanding, typically, at a price somewhere around 3-5% under NAV. Since quite a few funds trade at discounts north of 10%, that can result in a pleasant "surprise" for fund holders.

On Jun 22 03:27 PM odin wrote:

> While I do believe that yield is going to be valuable in the future,
> not all income funds are born equal (on a risk-adjusted basis). It
> is important to realize that with fixed income investing that you
> are selling a put on the assets. GIM for e.g. has a high yield because
> its invested heavily in the sovereign debt of emerging markets (Russia,
> South Korea, Australia etc). Unsurprisingly, they are heavily correlated
> to those markets. I'm not sure that they will provide the safety
> that people expect out of fixed income investments. Similarly, HTR
> is a leveraged fund and that point bears attention.
>
> As a guide, it is likely that the historical default rates on HY
> instruments will understate the future defaults by a wide margin.
>
>
> Valuation is simply one aspect of convertible bond trading. Because
> the market is not extremely deep (comparatively speaking), technicals
> play a huge role. That is what took down converts last year and I
> dont believe looking at charts can give a sense of how institutions
> are looking at convert funds (or when a big fund winds down). Convert
> arb is still dead and a lot of funds are way under their high water
> marks.
>
> While buying CEFs at a discount may psychologically feel better (good
> value), there are many reasons why CEFs trade at discount/premiums.
> Those discounts are not realizable unless a fund liquidates and if
> it does liquidate, its likely doing so under distressed conditions.
> The middle-single or even teen digit discounts will be little consolation.
> What is more important to see them in the context of historical discounts.
>
>
> I think CEF/ETF investing for individuals has many positives, but
> the above points need attention.

Jun 22 04:41 PM

[Old Trader:]

searcher,

True enough (your point about exercising patience and waiting for the stock to "come to you", rather than "chasing" it).

Jun 22 04:43 PM

[odin:]

>
> In regards to converts, its my understanding that, as you pointed
> out, a lot of hedge funds were in the convert arb strategy, and the
> ban on short selling effectively blew that strategy up, resulting
> in wide scale "dumping" of convertible bonds, killing the NAVs of
> convert funds. Still, the sector HAS recovered, somewhat, this year.
>

Agreed. The asset class has rallied along with/due to credit. However, it bears noting that returns here are driven by technicals just as much as fundamentals. And a lot of funds that are underwater massively are less incentivized to keep going. I shudder to think of the impact if one of the big billion+ funds decided there just wasnt enough opportunity left to keep going. For what its worth, I do like the asset class (the hybrid nature allows you to stay in the sweet spot of changing sentiments much longer) but for profitable convert investing, timing is very much key.


> A final point in regards to steep discounts to NAV, something I've
> noticed is that there's a growing tendency by CEFs to periodically
> (like once a year) announce a tender for a certain percentage of
> shares outstanding, typically, at a price somewhere around 3-5% under
> NAV. Since quite a few funds trade at discounts north of 10%, that
> can result in a pleasant "surprise" for fund holders.

True, but that would not be the basis for my trade. There are faster guns trading on that kind of information.

Jun 22 09:41 PM

[anarchist:]

On Jun 22 04:41 PM Old Trader wrote:

>So if it's <1% of your portfolio why bother?
>
> Your point on GIM is well taken. My position in it is also based
> on an excellent long term track record by the management. My position
> in HTR is less than one percent of the portfolio, so whether it triples
> tomorrow, or goes to 0, it would little to no effect on overall portfolio
> returns. I'd agree there's probably some pain to come in the high
> yield sector.
>
> In regards to converts, its my understanding that, as you pointed
> out, a lot of hedge funds were in the convert arb strategy, and the
> ban on short selling effectively blew that strategy up, resulting
> in wide scale "dumping" of convertible bonds, killing the NAVs of
> convert funds. Still, the sector HAS recovered, somewhat, this year.
>
>
> A final point in regards to steep discounts to NAV, something I've
> noticed is that there's a growing tendency by CEFs to periodically
> (like once a year) announce a tender for a certain percentage of
> shares outstanding, typically, at a price somewhere around 3-5% under
> NAV. Since quite a few funds trade at discounts north of 10%, that
> can result in a pleasant "surprise" for fund holders.
>
> On Jun 22 03:27 PM odin wrote:

Jun 23 04:28 PM

[Fund Insider:]

Refreshing to see people writing about CEFs still.
ETFs are getting so much attention, but CEFs give the asset manager so much more flexibility to make long term investments (no shareholder redemptions). They also reduce taxable gains being realized due to shareholder activity and the tendancy of open end fund investors to buy high and sell low.
Also the best FI managers in the world all have CEF's trading, so no compromise on the asset management skills. Main downside is that fees tend to be high, which is a major factor in FI investing.
I'd only use CEF for lower credit quality (high yield, or even investment grade corporates - and these days munis). A fund buying TSY and GNMA would be overpriced in the CEF vehicle.

Jun 26 08:50 AM