A 3-Fund Approach To Income In 2016

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Includes: ETV, HYI, WEA
by: Michael Foster Financial Services

Summary

Combining a buy-write fund, a high quality bond fund, and an unlevered high yield fund creates a diversified high income-yielding portfolio of relatively low-correlated asset classes.

This approach hedges against a bear or flat market in stocks, rising default rates, and rising Treasury interest rates.

A portfolio of three funds of each type can yield 9.5% in income, thanks to an oversold derisking that has made each of these funds cheap and attractive.

There seem to be three possible scenarios that are top of investors' minds as we get into 2016:

  1. We enter a bear market as a result of a recession or low economic growth.
  2. We see volatility but a flat to slightly down market as a result of low economic growth and/or weak earnings growth (or continued earnings declines) in the S&P 500.
  3. Higher borrowing costs caused by the Fed's continued rate hikes result in higher default rates in the corporate bond market, lowering corporate bond values elsewhere and possibly causing stock prices to fall or see low growth.

A recession is extremely unlikely, but the (somewhat healthy) fear about macro conditions that has persisted since 2008 makes the "r" word a popular one both on Seeking Alpha and elsewhere, although CEOs and executives don't see it (nor, for that matter, do economists at investment banks, in universities, or at the Fed).

Looking at recent stock declines, the feeling that the economy is struggling becomes more convincing, even if hotel occupancy rates are strong, auto sales are strong, home values continue to grow at a moderate rate, unemployment falls and wages rise, and consumer confidence remains strong.

This persistent pessimism can overhang stocks for a long time, making buying and holding an index fund less appealing than it was in 2013. The appeal of indexing declines even more when we see the dividend cuts, earnings declines, and oil tax proposals that the energy sector is currently facing.

Get Paid to Hedge

With all this negativity around, investors might want to consider a way to hedge their holdings while still remaining in the market. Fortunately, the combination of historically low corporate default rates, weak sentiment, and fundamental economic strength in the U.S. makes a high income producing hedged portfolio one way to stay in the market and receive a strong portfolio yield.

To do this, we need to construct a portfolio with three components:

  1. A high quality corporate bond fund, like the Western Asset Premier Bond Fund (NYSE:WEA), gives investors exposure to investment grade bonds, as half of the fund is dedicated to investment grade issues, with the rest going to high yield corporates (22%), mortgage-backed securities (13%), emerging market debt (7%), asset-backed securities (4.3%), and some government debt (1%). Another appeal of this fund is that it has a share repurchase program in place to ensure that, if the fund's discount gets too large, managers can unlock value by buying back stock. This is rare for a CEF, and is appealing on top of the 7% current discount and 8.6% current dividend yield.
  2. A buy-write fund, like the Eaton Vance Managed Buy Write Opportunity Fund (NYSE:ETV), will give investors common stock exposure while also hedging against a market decline thanks to its covered call strategy. Buying ETV will hedge against scenario 2 above, as covered-call strategies outperform in flat to modestly down markets (ETV outperformed the market in 2015, for instance). The fund also pays a 9.7% dividend yield, funded by its covered calls, and trades at a modest 3.3% premium.
  3. A non-levered high yield bond fund, like the Western Asset High Yield Fund (NYSE:HYI), will not face the risk of being forced to sell holdings to reduce leverage in case of a crash in bond markets. It also will not be negatively affected by the Fed's interest rate hikes, since it doesn't borrow money (for more on non-levered funds and HYI, see this article). The fund has over a 116% distribution coverage, a 10.2% dividend yield, and is trading at a 10% discount to NAV.

How to Make the Portfolio

A $10,000 portfolio with equal allocations to each of these three funds will produce $79.28 in monthly income, or a 9.5% yield:

Sources: MFFS, Google Finance, CEFconnect Click to enlarge

This high income stream comes from a diversified portfolio that crosses asset classes. If common stocks fall, the investment grade and high yield debts may not necessarily follow suit. If the high yield debts fall, the investor may have refuge in the common stocks and investment grade bonds.

This diversification is far from perfect, however. High yield bonds and common stocks are closely correlated, as Notre Dame's Frank K. Reilly reminds us:

Studies that examined the correlations of HY bonds with other assets found significant differences in the correlations among the three different credit rating classes of HY bonds: Ba, B, and Caa. … For example, whereas the returns on Ba-rated bonds were highly sensitive to changes in Treasury yields, the returns on B and Caa-rated bonds were minimally affected by Treasury interest rate changes, but highly correlated with the returns on common stocks.

The good news about this, though, is that HYI should be minimally affected by Fed interest rate hikes, since high yield bonds are "minimally affected by Treasury interest rate changes," according to this study, even if those rates may impact ETV (if investors flea dividend-yielding stocks in favor of Treasuries, although this is by no means guaranteed) and WEA (since investment grade bonds are sensitive to Treasury yield changes). Likewise, a lack of correlation between investment grade bonds and common stocks may also help limit losses on the investment-grade bonds, as per p.65 of that same study:

The research also shows that, although HY and IG bonds have experienced similar levels of volatility during stable economic periods, HY bond volatility tends to explode during periods of economic uncertainty, with Caa-rated bonds accounting for most of the sharp increases in volatility.

Examining the Correlations in Recent History

Does the academic theory hold true today? Somewhat.

Click to enlargeLooking 2015, we see a clear long-term correlation between HYI and WEA; all three suffered losses in August when a risk-off sell-off hurt all assets except cash, although HYI's decline was much worse than WEA's.

Other than that, ETV remained insulated and ended 2015 up 12% including dividends. In one time of extreme stress-namely, August--it fell a bit, but in December it proved resilient. It also had no correlation to slightly weak periods in July, while HYI and WEA had no correlation in the first half of the year.

More recently, the lack of correlation between these three has broken down entirely:

Click to enlarge

After a brief period of decoupled performance in December, all three are down sharply year-to-date in a tightly correlated bearish trend, with HYI faring much worse than WEA, but a bit better than ETV.

This does not mean it is time to sell these funds, however. To return to Professor Frank K. Reilly's paper on high yield performance discussed above, in periods of economic uncertainty when risky assets (i.e., everything but Treasuries) fall, high yield bonds will underperform and be more volatile, approaching the riskiness of common stocks: "During periods of political or economic uncertainty, the volatility of HY bonds has become two or three times greater than the volatility of investment-grade bonds, approaching the volatility of common stocks."

This is almost a perfect description of the performance of HYI, WEA, and ETY in 2016, which may indicate that the recent selloff of these funds is a willy-nilly broad-based derisking, as investors seek the refuge of cash or, more recently, of long-term Treasuries (NYSEARCA:TLT) and gold (NYSEARCA:GLD).

This selling pressure may continue, but it is divorced from fundamentals. For this reason, I see a good reason to buy these three funds now, and perhaps buy more if they fall further, as the recent selling has become indiscriminate. Buying these three funds provides high current income, diversification away from energy, stocks, and high yield bonds, while also providing a solid and sustainable income stream.

Disclosure: I am/we are long ETV.

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.

Additional disclosure: I may initiate a long position in HYI, WEA over the next 72 hours.