- Subtractive or negative knowledge has been a useful approach to decision making across different disciplines.
- We take a look at how investors can use this approach in building income portfolios, by disaggregating securities into individual risk factors and reducing exposure to unfavorable ones.
- We highlight a number of fixed-income funds and preferreds that provide exposure to some risk factors and limit exposure to others.
- Looking for a helping hand in the market? Members of Systematic Income get exclusive ideas and guidance to navigate any climate. Learn More »
This article was first published on 22-Feb.
In his book Antifragile, Nassim Nicholas Taleb discusses the usefulness of subtractive or negative knowledge which he views as being more robust to error than positive knowledge. Charlie Munger points to the same approach when he says that "It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent".
In this article we take a look at how this approach can be used in the income investing space. The main takeaway is that because different assets and investment vehicles are bundles of risk factors, investors can build more robust portfolios by limiting exposure to individual risk factors that don't suit their style or risk profiles, rather than aiming to hit home runs in their investing.
A Quick Summary Of Key Risk Factors
The broader population of risk factors underlying various types of income securities is huge. In this article we only focus on a few key ones below.
Interest rate duration is the familiar metric of sensitivity to changes in risk-free interest rates. Most fixed-income oriented funds disclose this metric, however, investors can also position across individual sectors to dial up or down the exposure to changes in interest rates. For example, the taxable municipal sector features, probably, the highest duration of the income space, followed by investment-grade, tax-exempt munis, emerging-market and high-yield bonds on the lower side of the spectrum. Floating-rate sectors such as loans and some RMBS and ABS assets have, in effect, no duration.
Credit duration is not as familiar a metric to income investors but it's worth discussing because it is another risk factor that users can dial up or down. Like its interest-rate analogue, credit duration (or technically-speaking, "spread DV01" or "credit DV01") is a measure of the price sensitivity to changes in credit spreads (aka discount margin for loans). For fixed-coupon instruments like corporate bonds, the credit duration is pretty much the same as interest rate duration so investors who want to decrease duration risk in bonds are forced to also cut down on credit duration. This may not always be desirable for two reasons. First, investors may have a constructive view on credit but bearish on duration. And secondly, because the credit spread curve is upward sloping (credit spreads of longer-maturity securities tend to be higher than those of shorter-maturity securities), investors earn a higher yield for taking longer credit duration risk. Floating-rate assets like bank loans or ABS can have no interest rate duration but sizable credit duration due to their longer maturities.
Credit quality is largely self-explanatory and has to do with the likelihood of permanent economic loss such as default.
Discounts are a feature of the investment vehicle rather than a given asset. Discounts are a feature of closed-end funds, though during periods of stress they can show up in ETFs as well. Discounts have procyclical dynamics - they tend to tighten when assets rally and widen when assets drop. This exacerbates the volatility of CEFs, driving larger price moves to the upside as well as downside. For example, the chart below shows that the preferreds CEFs saw a 10% larger drawdown in price terms than in NAV terms due to the widening of discounts.
Source: Systematic Income
Investors, who want a more stable portfolio or want to be able to draw on portfolio capital to allocate to attractive opportunities during drawdowns should have a pocket allocated to securities other than CEFs.
Liquidity has to do with how quickly investors can move a given position and at what (bid/offer) cost. Liquidity varies greatly across different securities so it's hard to generalize here. An investment vehicle that is superior in this regard are mutual funds where the management company provides liquidity at no (explicit) cost. Investors who want to be able to move a lot of risk should look either to mutual funds or to exchange-trade securities with high daily volumes.
Leverage can be defined in various ways. In this article we are more interested in the leverage embedded in the investment vehicle itself i.e. a leveraged CEF vs. an unleveraged ETF or a preferred stock, for example. The reason is that leverage can have knock-on consequences for both total return as well as sustainable income generation levels for funds. A useful example here is to compare the NAV performance of the MLP CEF sector to an unleveraged index-tracker such as the JPMorgan Alerian MLP ETN (AMJ). The chart below shows how the MLP CEF sector was forced to deleverage on the way down which has locked in permanent capital losses for investors and created a sizable performance gap between it and the unleveraged fund. This gap has obvious negative consequences for the amount of income that the CEF sector can produce going forward.
Source: Systematic Income
It's important to highlight that these risk factors are not entirely distinct. For example, lower quality assets also tend to have lower interest and credit durations due to their larger coupons and shorter maturities.
A Risk Factor Smorgasbord
Below is a sampler of some of the income securities we have discussed on the service and qualitative measures of the risk factors described above.
Obviously, investors don't need to put this together for current and potential holdings but having it as a mental framework makes a lot of sense in our view.
Source: Systematic Income
Given the run-up in Treasury yields, many investors are worried about the impact of rising rates on their holdings. In the table above there are several options with low or medium duration exposure and decent yield levels. Obvious options are shorter-maturity ETFs such as the Invesco BulletShares 2023 High Yield Corporate Bond ETF (BSJN) which holds high-yield bonds maturing around 2023 which limits how much interest rate duration they have. This option may also be appealing for investors who worry about potential credit volatility as its credit duration is also low and it has no leverage.
Investors with a constructive view on credit, may want to increase credit duration exposure by allocating to low interest-rate duration funds like Angel Oak Multi-Strategy Income Fund (ANGLX) which has moderate credit duration. And investors who want to use leverage to drive up yield have a number of CEFs that allocate to floating-rate assets such as the Blackstone Senior Floating Rate Term Fund (BSL).
Investors who don't want to overextend on either interest rate or credit duration but are happy to move towards somewhat riskier underlying assets may want to consider CLO equity CEF preferreds such as Priority Income Fund 6.25% Series B (PRIF.PB) - this relatively small sub-sector of preferreds boasts yields of around 6-7% and because they tend to feature mandatory maturities also cap interest rate and credit duration which makes them very appealing options in our view.
Investors happy to take duration risk in credit and rates but who want to avoid discount volatility and want to remain in decent quality assets may want to consider the Wells-Fargo 7.5% Series L (WFC.PL), rated split investment-grade and featuring a 5.34% yield.
Investors who are ok with moderate duration risk in rates and credit and want to up their yield by taking discount volatility and leverage exposure but also want to be able to get out very quickly can have a look at any number of very liquid high-yield or multi-sector CEFs such as the PIMCO Dynamic Credit and Mortgage Income Fund (PCI).
Investors happy to take sizable duration risk, don't care about liquidity, prefer very high quality exposure and want to maintain no discount or explicit leverage exposure can look at some equity CEF preferreds such as the Gabelli Equity Trust 5% Series K (GAB).
You get the idea - by disaggregating income securities into risk bundles investors can tailor their portfolio to make sure it aligns with their investment utility function. It also ensures that a portfolio of assets contains a number of different risk factor exposures so that an unexpected shift in markets does not leave investors exposed but allows a rebalancing of assets into more attractively valued securities.
There are many approaches to investing and different investors find value in many different methods. One approach that we find appealing and use on the service and which can be used alongside others is to consider income assets and investment vehicles as bundles of different risk factors. This risk factor disaggregation makes it clear how much exposure a given security has to various risk factors. In turn, this allows investors to pick and choose among the different levels of exposure as they go about building up their portfolio. This bottom-up approach can create portfolios that better reflect investor views and goals and perform in a more predictable fashion to changes in markets.
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This article was written by
ADS Analytics is a team of analysts with experience in research and trading departments at several industry-leading global investment banks. They focus on generating income ideas from a range of security types including: CEFs, ETFs and mutual funds, BDCs as well as individual preferred stocks and baby bonds.
ADS Analytics runs the investing group Systematic Income which features 3 different portfolios for a range of yield targets as well interactive tools for investors, daily updates and a vibrant community.
Analyst’s Disclosure: I am/we are long WFC.PL. 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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