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Building Income Portfolios By Subtraction

Mar. 09, 2021 3:48 PM ETAMJ, ANGLX, BSJN, BSL, GAB.PR.K, PDI, PRIF.PR.D, WFC.PR.L9 Comments


  • 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

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This article was written by

ADS Analytics profile picture

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.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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Comments (9)

hawkeyec profile picture
Very nice piece. Good reminder of the fact that everything in investment decision making involves tradeoffs. To paraphrase the great philosopher, you can't always get what you want [so prioritize your goals] and get what you need. Your discussion also highlighted the idea that economic tradeoffs generally involve some form of elasticity, the relationship between some variable and value or price. When making choices the level of sensitivity in the value compared to changes in a given characteristic will change and can have a big effect on one's outcomes.
ADS Analytics profile picture
Yea that's a good summary - ultimately, you have to trade off some things for others. We all want a super high-earning fund with no volatility and abundant liquidity but that's not realistic.
mickelsson profile picture
I agree with the other commenters that this is an interesting and potentially valuable approach, but I wonder how you arrived at some of your ratings in the table near the end of the article.
For example, you list PRIF-B has having low liquidity risk. That stock hasn't traded a single share today (3 1/2 hours after the market opened) and has an average volume of about 2K shares per week so far this year. Are you using a different metric to measure liquidity? You also list PRIF-B's credit quality as medium, but how did you determine that, given that the holdings are CLOs, which often contain mystery meat?
Not being critical, just looking to refine my methods.
ADS Analytics profile picture
@mickelsson Hi - "low" for Liquidity actually means "low liquidity" rather than "low liquidity risk". Apologies, that wasn't clear in the terminology (or the color-coding for that matter). In terms of credit-quality being medium - this is really a combination of the stock being preferred (good) and it being a preferred of a CLO equity fund (less good). So, you get a senior position over some dicey assets which nets out in my view as being sort-of medium.
mickelsson profile picture
@ADS Analytics Thanks for the response, ADS, and for one of the more helpful SA articles I've read in the past few weeks.
costreduction profile picture
@ADS Analytics ...

Wow .. thanks for a very valuable idea. I recently was faced with making an investment choice(s) among several considered and for kicks, tried this matrix concept. I was struck by its ability to rapidly influence my decision-making. In fact, it was so powerful that I ended up opting for a choice previously discarded.

Thank you for contribution. This absolutely just found a spot in my toolbox.

The very best of days to you.
ADS Analytics profile picture
Good stuff. Glad it's helping to distill the decision making process.
ADS Analytics profile picture
I've submitted an update for the color-coding as well as making the Risk Factor columns more explicit what they refer to i.e. "Liquidity Risk" from "Liquidity" etc.
Banneker profile picture
Really good concept in this article, thank you for it. I like the idea of separating out the different risks explicitly as a way to make smarter judgments.
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