We are now four and a half months into 2019, and so far it has been a strong one despite the recent renewed bout of volatility. Of course, this compares to what we experienced in the fourth quarter of last year when high yield sold off and CEFs saw discounts widen out, creating a double-edged sword headwind.
The Core Income Portfolio has been around for over 3 years now, and the objectives have always been the same. The strategy is to generate a high current income, while maintaining principal to a degree that is significantly below that of equities. In other words, get very close to equity-like returns with far lower risk.
When we started the marketplace service, we did so because discounts at the time were extraordinarily cheap. In fact, in late 2015, discounts were in the top 5% of the widest observations of the last twenty years! At the time, Seeking Alpha had a relatively small presence of expert analysis on closed-end funds.
We saw a similar dynamic occur in the fourth quarter, where discounts blew out due to the bear equity market compounded by tax-loss harvesting. When coaching our members, we want to make sure that they limit their allocation (as a % of total liquid assets) into closed-end funds. Remember, CEFs are a security type, not an asset class. This security type can have more risk, as the price can trade around the true value of the fund (the NAV) by a large amount. We wrote several years ago on this very topic discussing CEF price risk as opportunity, while NAV movement was the true measure of risk.
The Core Income Portfolio primarily focuses on taxable and tax-free bond CEFs rather than a complete asset class diversification portfolio. This is done on purpose, as most investors either A) already own equities either through ETFs, individual dividend stocks, or mutual funds, and B) often want very little to no exposure in equities due to the systematic beta risk. Instead, we often look at these opportunities in our Peripheral bucket for those members who want and need those positions in their portfolio.
Key Objectives Of The Portfolio
- Current Income
- Risk Controls
The yield on the portfolio today is just over 8%, down about 74 bps since the start of the year. Much of that decline is simply price appreciation, pushing up the current value of the position while the distribution payment stays the same. The Core Income Portfolio yield tends to stay in a fairly tight range between 7.25% on the low end to just over 9% on the higher end. That is because we do not make large tactical bets in certain areas of the CEF marketplace.
One thing we do not do is simply select the highest-yielding funds. The goal is to make the portfolio as close to buy-and-hold as possible, which means eliminating the more volatile and speculative bets. We consider funds like Eagle Point Credit Company (ECC) and Oxford Lane Capital (OXLC), which are effectively high-beta equity plays in the guise of fixed-income funds that would likely never be placed in the portfolio. While those funds yield in the low teens, the risk levels, we believe, are too high to be considered for entry into the Core Income Portfolio.
From an income standpoint, the highest-yielding funds we own are the PIMCO Dynamic Income Fund (PDI) and the PIMCO Dynamic Credit Income Fund (PCI), which pay around 10% per year when including the year-end special distributions. From a risk standpoint, these are about as risky as we get - which is to say, not extremely risky. These are leveraged beasts with loads of lower-quality bonds that reside in a sub-sector (non-agency MBS) that we feel is favorable. As opposed to equity-tranche CLOs, which we think are fine during market booms but will crater during market busts.
Steady income is the main priority, but we achieve it through a diverse set of sub-sector exposures in the fixed income space. Approximately 10% of the 8% yield is derived from tax-free munis, with another 5% coming from taxable munis. These are spaces we are high on today and will continue to have a place in the portfolio. The rest of the portfolio is a blend of corporate bonds, floating rate loans, and mortgages. We also have a small allocation to a real estate fund that is a mix of eREITs, preferreds, and bonds.
Our proprietary research process blends our macro outlook with quantitative research of CEFs, with a final step of doing fundamental research on the fund itself. This last step is one we see missing from many investment strategies that focus on the CEF space. But it is a must-do part of the process in order to avoid catastrophic distribution cuts and horrific surprises like dilutive rights offerings.
As opposed to being tactical and buying the "cheapest" funds on a frequent basis, we look for "steady eddies" that will earn us at least the distribution yield of the fund when we purchased it. While we do not occupy the lowest-risk sections of the bond CEF market, we do not tend to operate within the highest-risk sectors either. That middle market, to us, is the key to building a sustainable income stream portfolio that rivals equities in return but with substantially lower risk.
More important than buying at a discount is buying at the right times in the right sectors. We like areas of the market that are just entering being "in favor" and likely to experience a prolonged period of a rising NAV. What we have found is that retail investors in the CEF space tend to sell off CEFs that see a tighter-than-normal discount, even though the NAV is rising nicely. The discount, to us, is secondary.
Our risk management analysis of the portfolio tends to go back to the "1/3 2/3" rule: the portfolio sees one-third the movement of the S&P on NAV and two-thirds the movement on price. By keeping our exposure to the higher-risk sectors low, we can significantly increase our Sharpe ratio (risk-adjusted returns). Over longer time frames, the "1/3 - 2/3" rule tends to hold much more closely.
At other times, we notice that the flight to safety can significantly help our strategy. For instance, on Monday, May 13th, 2019, the Dow Jones fell 617 points, or about 234 bps. The Core Income Portfolio lost about 94 bps on price and 46 on NAV. That 94 bps is about 40% of the movement of the S&P 500 (a beta of 0.40), while the 46 bps on NAV was about 19.5% of the movement. These are the types of days where we earn our relatively small subscription fee.
Today, we have a blend of sub-sectors but are overweight non-agency MBS, high-yield bonds, and leveraged loans. While these have been in the Core for quite some time given our view of the macro picture, we have gone heavier into them since the fourth quarter. That may change if we think the macro picture is likely to change or we see NAVs reverse course and roll over.
Most investors think of fixed income as one monolithic and homogeneous market. But they, then think of equities as a highly diverse universe, including numerous factors like large vs. small caps, growth vs. value, quality vs. junk, international vs. domestic, etc. The fixed-income market is many times the size of the equity market and much more diverse. It is also, from a knowledge base, substantially more difficult to understand. Thus, the most common thing we see investors do is significant due diligence in equity positions, and then simply round out their asset allocations with a "core" bond fund.
That core bond fund will likely have an allocation to all the sub-sectors of the fixed-income space with little deviations compared to the primary benchmark, the Barclay's U.S. Aggregate. That is despite the fact that it will not be very favorable in the near-term environment. The primary reason for that is that most core bond mutual funds aren't very nimble and have strict mandates not to deviate from the benchmark too much in order to qualify to be in Morningstar's Intermediate Duration category. That allows them to maximize the amount of cash flows into the fund.
This gives us a distinct advantage to "cherry-pick" what we think are the best sub-sectors. For example, in a rising rate environment, we wanted to reduce our muni exposure and increase our short-duration high-yield and floating-rate exposure. Does this mean we sell out of munis entirely and allocate 100% to these spaces? No. It just means we shift our focus and find the best opportunities in those sectors that we think will continue to benefit from the current environment.
A good example was in November and December of last year, when rates "peaked" and started to head lower, especially on the short end. In mid-December, the Fed "pivoted," allowing us to make a shift to be more aggressive in munis. Discounts were extraordinarily wide (the widest since the Taper Tantrum) and yields very attractive from a risk-reward standpoint.
Conversely, floaters also became extremely cheap as the retail market abandoned what was one of the hottest spaces in fixed-income. The thinking was that if the Fed wasn't going to raise rates, why be in floating-rate any longer? But in the CEF space, we saw a highly compelling double-discount that is still closing today. Not only were the underlying bonds nearly 6 points below par, implying very high default rate scenarios that were extremely unlikely to materialize, but the CEFs themselves were trading at large double-digit discounts as well. So when others were selling, we were buying hoping to capture a rising NAV, as those loans repriced higher but also with optionality that the CEFs' discounts would tighten as well.
We think the CEF market remains slightly out of favor after many "newbies" to the space were burned in the fourth quarter of last year. This is not surprising, as the retail investor continues to hunt for yield in a low-yielding world. We still believe that the CEF market will continue to see renewed interest over the coming years, thanks to a mass of new retirees needing higher-yielding products to make their financial plans work. Couple that increasing demand with the fact that supply only continues to shrink (in 2018, there were again more CEF deaths than births), and you have a favorable environment for discounts to tighten.
Twenty years ago, a high-quality bond portfolio yielded well over 6%, while your stocks made over 8%. That meant a 60/40 portfolio earned over 7% annually on average. Today, yields for high-quality bonds are below 4% and treasuries are below 3%. In addition, it is highly likely that the equity portion of the portfolio will be lucky to earn 6% per year and could be well below that, depending on the time line used.
Today, we only have a few "Buy-rated" funds in the Core Income Portfolio, including:
- Ares Dynamic Credit Allocation Fund (ARDC), yield 8.55%
- Blackstone/GSO Strategic Credit Fund (BGB), yield 9.11%
- Nuveen Real Asset Income & Growth Fund (JRI), yield 7.87%
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Disclosure: I am/we are long ARDC, BGB. 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.