We Now Have An Idea Of Portfolios Hedged To Higher Rates
Summary
- The first part of this year has been dreadful for some rate-sensitive stocks and sectors.
- We can assess the funds that have been positioned correctly during the period.
- Identifying the funds that performed poorly during rising rates and those that have performed well can help us create more durable portfolios.
We now have a perfect illustration as to how funds are positioned for the current rate environment. Our Core Portfolio is exposed to two primary risks: credit and interest rate. Credit risk is the risk that the underlying bond will default and not pay back principal nor interest. Interest rate risk is when rates rise reducing the relative attractiveness of your lower coupon bonds, sending the price lower.
In August of 2016, we implemented a Three Legged Stool strategy in order to combat rising rates. The strategy depended on investing in closed-end funds that hedge their rates (hedged fixed income), shortening durations in Core funds with a focus on short-duration/limited duration funds, as well as floating rate funds which invest in loans that adjust their coupons quarterly. The first two are still in the portfolio while we did advocate removing the floaters early last year as the sector was getting hit from repricings (refinancing) that more than offset the interest rate hedge.
Repricings may be close to running their course. We continue to monitor the space and are seeing some encouraging signs. Look for some more in-depth sector analysis in the near-term.
This is a selection of funds in each category that we follow that have performed well, on a NAV basis, since the start of the year. During that period, interest rates have risen from 2.41% to 2.86%. Additionally, credit spreads, a barometer for credit risk, have widened (meaning more risk) with the high yield spread going from ~350 bps to ~382 bps. If a fund has increased in value since the start of the year, it means that they have an active strategy today that combats both higher rates and wider spreads.
The floating rate sector has performed the best for obvious reasons- they have the least duration of any bond sub-sector.
As a group, all NAV returns were positive YTD through the start of the week. The 'diff' column shows the movement of price relative to the NAV. For the top fund, XFLT, the +3.9% diff means that the discount became 3.9% more expensive.
The space houses a lot of lower-quality funds so beware. And not all floaters are created alike. For example, Ares Dynamic Credit Allocation- (ARDC) is a mix of high yield bonds and floating rate, which skews the results a bit of the table.
Many of the funds are also lower yielding, which when you factor in the risk of their holdings, makes them unattractive. A 6% yield for a levered widget holding very low quality holdings when a treasury nets you 3% and investment grade, unlevered funds get high 4% shows the comparative trade- off.
We did recently issue a buy-alert to our members for a new allocation into the space. Stay tuned for that in a few weeks time.
Another fund that is relatively new is XAI Octagon Floating Rate Income Term- (XFLT), a term trust fund launched in September of last year. It's a very small fund with very light volume so caution is warranted with this fund. The fund is levered to 32%, pays a monthly distribution, and liquidates in 2029. They do have a lot of junkier credits including CLOs. Here is the asset allocation:
This fund is too illiquid for us but the 8.6% yield and solid performance may entice a lot of new investors. It remains to be seen if the fund has seen the discount widen out to the apex yet post-IPO. In addition, the fund's price has run up significantly in recent weeks.
In the preferred space, a sub-sector that is characterized by long durations, this exercise can be extremely helpful in identifying the lowest interest rate sensitive funds.
Cohen and Steers Limited Duration Preferred- (LDP) is living up to its name performing at the top of the heap. We highlighted that fact in our late January report on the fund, "Two Strong Buys To Capture 7%+ Yields and Upside Optionality". The other fund highlighted on that report was the First Trust Intermediate Duration Pref and Income- (NYSE:FPF). That fund was fourth on the list about 40 bps below LDP. Both funds have fairly low durations aided by interest rate swaps and floating rate positions.
But as you can see, the market realized this on LDP with the discount widening by only 1.80%. That compares to moves of 3% to 5% or more on the other funds. While LDP performed the best, the market identified that and traded it accordingly. The opportunity may be in the other funds that have seen significant discount widening.
In the multi-sector sub-group:
We've discussed the strength of the PIMCO group in our recent monthly update on the funds. They have interest rate swaps where they 'receive floating' meaning that they expect rates to increase. PIMCO Global StocksPLUS- (NYSE:PGP) is included in the group because that's how it is reflected in CEFConnect.com. However, the fund should really be classified as an equity fund given their 100% exposure to the S&P 500 index through futures contracts and then the margin invested into the core fixed income strategy.
Nearly half of the funds had a positive return YTD though the price performance has been decidedly mixed.
Meanwhile the real estate sector, as one would anticipate, has been decimated by the recent rise in rates.
The disparity of NAV returns really comes down to how the funds are investing in the real estate sector. For example, Invesco High Income 2024 Target Term- (IHTA) and Principal Real Estate Income- (PGZ) both invest in cMBS and unlisted equity positions that have helped protect the NAV performance. Other funds like Neuberger Berman Real Estate- (NRO) and RMR Real Estate Fund- (RIF) invest in primarily equity REITs with the former investing more so in the lower-quality area of the space which has been hit particularly hard.
Investment grade has overall negative returns as one would expect from portfolios invested in mostly corporates.
Putnam Master Intermediate- (PIM) is one we've discussed in Weekly Commentaries and on the chat. It is the sister fund for Putnam Premier Trust- (PPT). Interestingly, CEFConnect puts the funds into different categories (PIM into investment grade taxable while PPT into other-global income).
The funds have performed well in the first couple of months during the year as they carry a negative duration of 1.5 years. Hence the reason they are up nicely since the start of the year.
High yield is a highly disparate category and it really boils down to how much in the way of floaters, if any, the fund has.
The top fund, KKR Income Opportunities- (KIO), for example, is a near 50/50 blend of high yield bonds and loans. The second on the list is Aberdeens Income Credit Strategies Fund- (ACP) which has just over 20% in loans. This clearly has bumped up the NAVs. Generally speaking, high yield bonds tend to be less rate sensitive as their durations are typically lower. Here you are accepting more credit risk over interest rate risks.
Conclusion
It is impossible to know for sure which way long-rates will trend. Are we in for a secular bear market in bonds where the 10-year continues to rise through the 3s? Or is this bout of selling more sentiment driven and hard data will come in below expectations creating demand for our debt. In our recent newsletter, we talked a lot about the financing of the U.S. deficit and the strain that places on the yield.
Combining some of these funds that are benefiting from higher rates (hedged from interest rate risk) and maybe have higher credit risks should be paired with funds that maybe have more duration (higher interest rate risks) but lower credit risks. The diversification should allow NAVs on an aggregate basis to remain more stable while you collect a nice yield from both types of funds.
Going forward, with credit spreads tight they are unlikely to provide the capital gains opportunity in the form of rising NAVs that they have in the past few years. Still, defaults remain low with economic growth improving corporate balance sheets.
We construct portfolios that not only take advantage of opportunities in particular funds but also incorporate a top-down analysis of the markets, sectors, and funds themselves to produce diversification benefits reducing risk-adjusted returns. We just issued our March newsletter where we incorporate some of these ideas into our Core Portfolio.
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This article was written by
Alpha Gen Capital is a former financial advisor and his analysis is meant to provide a relatively safer income stream with CEFs and mutual funds. He has been writing about investing on Seeking Alpha for the past decade and he aims to help investors better understand how to properly construct a portfolio.
Alpha Gen Capital leads the investing group Yield Hunting: Alt Inc Opps, where along with his team of analysts, he focuses on closed-end funds and getting yield from bonds to complement dividend portfolios. The service is dedicated to income investors who are searching for yield without the high risk of the equity market. Additionally, they provide 4 actively managed portfolios. Learn more.Analyst’s Disclosure: I am/we are long FPF, PIM, PGP, ARDC, LDP, PGZ. 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.
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