Low yields and tight credit spreads have created a tough environment for income investors.
One way that investors can enhance their income levels is by freeing up more capital to allocate to fixed-income assets via leveraged ETFs, PIMCO StocksPLUS funds or equity futures.
The StocksPLUS funds is the most risk-averse, hands-off strategy, while holding equity futures requires the most operational know-how but provides the most control to investors.
Low yields and tight credit spreads have made life hard for income investors. The traditional strategies of boosting yield by increasing duration and taking more credit risk are unappealing, given the flat yield curve and rich credit valuations. In this article, we discuss three alternative strategies that allow those investors with equity holdings to replicate these holdings with a lower capital outlay which then allows more capital to be allocated to income-generating fixed-income assets.
A Yield Desert
Income investors are facing a difficult market landscape. Both nominal and real interest rates stand at the lower end of their historic range.
At the same time, the yield curve is flat, which provides little to no additional yield pickup for increasing duration.
While there are pockets of value such as EM external debt and junior CLO debt, most fixed-income asset classes boast yields boasting distinctly unappealing yields.
Within the CEF space, we can see this by plotting the median trailing-twelve month yields of income-focused funds. Rich underlying asset valuations, high prices, tight discounts, and ongoing distribution cuts have left CEFs with historically low yields.
Source: Systematic Income CEF Tool
The majority of fixed-income CEF sectors are trading at yields at the lower end of their historic range. Sectors that do not share this statistic are ones that have disappointed investors such as loans or MLPs.
Strategies To Boost Income
In light of low historic yields, what strategies can investors use to increase their income?
The most obvious strategy has historically been to increase duration. This strategy still works although it doesn't work nearly as well. For example, by going from 10-year to 20-year Treasuries, you are picking up 0.3% in yield while almost doubling your duration exposure. The better alternative, in our view, is to do the opposite and to decrease duration.
You can pick up a little bit of yield by going from 10-year to 3-Month Libor while avoiding sizable duration risk. Not only that, but you also have additional investment options at the shorter end of the curve such as loans, junior CLO debt, RMBS, floating-rate investment-grade bonds, floating-rate Treasuries and others which can diversify your existing fixed-income exposure. The LIBOR point on the curve has usually been understood to be around AA/A rating, given its presumed role in unsecured bank financing, so there is a little bit of a credit drift baked in here as well.
Another investment strategy to increase yield is to add credit risk. For example, investors can move from government bonds to investment-grade corporates or from investment-grade to high-yield. The trouble with this is that credit spreads are on the tight side, meaning that the compensation for the additional risk is not overly compelling save for a limited number of opportunities which require a lot of conviction such as EM high-yield credit.
A final strategy which we explore in more detail below is to move a larger proportion of investment capital into income-producing securities without sacrificing equity exposure. What do we mean by this?
Investors will typically hold some equity and some fixed-income exposure, among other types of assets, in their portfolios. Whatever the allocation amount set aside for equities, investors may be able to replicate that exposure with less capital.
The downside of this approach is that this strategy only works for major equity passive indices like the S&P 500, Russell 2000, MSCI EAFE, and a few others. While this seems like a major downside, the reality is that active equity investing does not appear to sustainably outperform passive management.
By the end of 2018, some 92.09% of active large-cap core stock fund managers over the past 15 years had underperformed the S&P 500. In addition, this was the ninth straight year that a majority of actively run funds in such a congested U.S. funds marketplace had lost to their respective blue-chip index, according to the latest SPIVA research. (Large-cap growth managers did even worse over that period -- 94.59% trailed their respective S&P index through Dec. 31, 2018.)
Because all of the alternatives we discuss below use leverage, the cost of leverage is an important factor in their performance. There is some good news on this front, however. The cost of leverage is tied to short-term rates which have been falling as the Fed has pivoted in a dovish direction and cut rates. It remains to be seen whether this is indeed a "mid-cycle adjustment" or whether short rates have peaked for good. For the time being, however, the cost of leverage has fallen by nearly 1% which goes straight to the bottom line of these strategies.
Many investors think they can increase their income by using closed-end funds for their equity allocations. The reality is different. The combination of high management fees, non-trivial leverage costs of CEFs, and low dividend yields of stocks means that equity CEFs typically do not offer higher earning yields than unleveraged passive investment vehicles like equity ETFs.
Another benefit of reallocating more capital to fixed income is that a greater allocation to high-quality bonds may decrease the overall volatility and drawdowns of the portfolio. This is because high-quality bonds typically boast negative beta to stocks.
In the sections below, we present three different flavors of this strategy.
1. Leveraged ETFs for Equity Exposure
Various fund houses offer leveraged versions of popular equity indices with both 2x and 3x leveraged alternatives available. A 2x leveraged equity fund allows an investor with a $100k allocation to equities to replicate the beta exposure with a $50k allocation, leaving the other $50k to invest in other income-generating assets.
As many commentators point out, leveraged funds technically only replicate the leveraged exposure on a daily basis. This is true, however, if we look over 1-year period, the beta of a 2x leveraged fund like the ProShares Ultra S&P 500 (NYSEARCA:SSO) is still fairly close to 2x, if not 2x exactly.
Source: ADS Analytics LLC, Tiingo
A more important point about leveraged funds is that their performance is path-dependent. For example, because SSO deleveraged after the financial crisis, it took the fund much longer to get back to even than it did for the unleveraged version. There is nothing particularly nefarious here as it is simply the magic of compound returns which holds for both leveraged and unleveraged assets.
Source: ADS Analytics LLC, Tiingo
Taking a look at annual returns, SSO has typically delivered on its double-return mandate.
Source: ADS Analytics LLC, Tiingo
One way to potentially mitigate this path-dependence dynamic of compound returns is by using monthly reset funds like the Direxion Monthly S&P 500 Bull 2X Fund (DXSLX) rather than the daily reset ETFs.
2. PIMCO StocksPLUS Funds
These PIMCO funds are some of the most complex funds available to investors. However, conceptually they are quite straightforward. PIMCO have a unique value proposition in equities which is that the way to add alpha to an equities portfolio is not by doing a better job at stockpicking. It is by adding bonds to a cheap equity beta portfolio.
This means that the StocksPLUS funds source equity beta with equity index swaps and futures, typically S&P 500 but also Russell 2000 and MSCI EAFE and then overlay this equity position with a low-duration bond portfolio (the one exception being the long duration PIMCO StocksPLUS Long Duration Fund (PSLDX)). This means that, for the same capital outlay, the StocksPLUS funds provide both equity as well as fixed-income exposure, effectively doubling up the use of the capital.
This means that these funds are more efficient in utilizing capital than the leveraged ETF strategy. For example, while a 2x leveraged ETF allowed an investor to reallocate half of the capital previously allocated to unleveraged equity beta exposure, the StocksPLUS funds allow the investor to allocate the same capital to both equity as well as fixed income. So, in our 2x leveraged ETF example, an investor with a $100k original allocation to equities can now allocate roughly the full $100k to fixed income via a StocksPLUS fund rather than the $50k in the case of a 2x leveraged equity ETF.
In terms of mechanics, these funds behave as follows. They arrange equity swaps with dealer banks where the fund receives the performance of the equity index in exchange for paying a fee of around Libor + 20-50bps. It's not completely clear how the fund collateralizes this transaction. If it posts cash (most likely on the order of 5-15%), then it loses the benefit of being able to invest this cash. On the other hand, if it pledges high-quality assets like Treasuries or agencies via a tri-party account, it continues to benefit and accrue returns from those assets without suffering a cash drag.
The bulk of the paid-in capital is then invested in fixed-income securities and derivatives. The majority of the portfolio is typically allocated to high-quality assets like Treasuries, agencies, and cash equivalents. The fund also typically in some proportion hedges its duration exposure via interest rate swaps. All of this means that the volatility profile of the funds is fairly similar to the equity benchmark itself.
Source: ADS Analytics LLC, Tiingo
In terms of yield, we can break the StocksPLUS performance into the following major components:
- Fund pays equity index fee of Libor + 0.2-0.5%
- Fund subtracts fee of around 1% from NAV
- Fund earns bond yields on fixed-income portion of portfolio
- Fund pays swap rates on the fixed leg/earns Libor on the floating leg
Simplifying further, we get to: -0.35% (averaging the assumed equity index fee above Libor) - 1% fund fee + portfolio credit spread + bond/swap basis. This means that, all in all, the fund fixed-income portfolio needs to trade at around a 150bps credit spread in order to generate returns in excess of the equity benchmark. However, the high quality of the fixed-income portfolio makes us question whether the fund can achieve this objective.
If we look at the returns of these funds in excess of their equity benchmark over various periods, this is indeed what we find. Over the last 5-7 years, the duration-hedged funds have not delivered excess returns. What drives the funds' long-term excess performs appears to be the illiquidity premium of various types of assets like TIPS and non-agency RMBS that provided a one-off boost shortly after the end of the financial crisis.
Source: ADS Analytics LLC, Tiingo
While the concept behind the StocksPLUS funds is a good one, it does appear that PIMCO is either not taking sufficient credit risk in order to generate excess returns, or its tactical positioning within the fixed income space has not been working out.
3. A DIY Futures Solution
A third way that investors can use to increase their allocation to fixed income, while keeping their original equity exposure, is a DIY alternative to the StocksPLUS funds. This approach requires the investor to open a futures account and access equity beta via products like E-Mini or micro E-Mini equity index futures.
Although this approach requires somewhat more active management of the trading account, the benefit is greater flexibility of fixed-income investment options. And although the investor loses access to PIMCO's fixed-income know-how, they also forego the fairly steep fee of around 1%, which is double that of many fixed-income ETFs.
Another important benefit of this approach is that, arguably, the interests of PIMCO and investors are not fully aligned. PIMCO is interested in showing historic outperformance of its funds versus their equity benchmarks, which it has already achieved. Investors, however, are more interested in delivering superior future outperformance. A DIY approach addresses this agency gap between the interests of investors and fund managers.
Lower interest rates and tight credit spreads have driven income levels of fixed-income instruments to near historically low levels. Previous standard ways to enhance yield such as extending duration or moving out the credit spectrum are no longer working as well due to a flat yield curve and rich credit valuations. One alternative that investors have at their disposal, however, is to replicate their desired equity exposure via passive indices. This can take the form of leveraged ETFs, PIMCO StocksPLUS funds or self-managed futures. Although this requires a passive equity allocation, the main benefit of this strategy is that it frees up more capital to allocate to income-generating fixed-income assets which can make up for a low level of yields.
Out of the three alternative strategies we discuss in the article, the DIY futures option gives investors the most control over their fixed-income allocation at the lowest possible cost, although it does require greater account management. The PIMCO StocksPLUS option is a low-risk alternative that is unlikely to sharply outperform or underperform the equity benchmark. The leveraged ETF option is somewhere in between these alternatives.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.