Rising Rate Implications For Income Portfolios
Summary
- Rising rates have been top of mind for income investors since the start of the year.
- The usual approach to rising rates has two problems. It fails to distinguish between two different rising rate environments and their different impact on assets.
- And it uses the textbook definition of duration which is, at best, misleading as it ignores other important drivers of asset prices besides rates.
- We discuss the two different types of rising rate scenarios, their impact on various assets and the role of empirical duration in security analysis.
- We also highlight a number of different sectors and securities which can potentially remain resilient under one or both rising rate scenarios which we continue to hold in our Portfolios.
- This idea was discussed in more depth with members of my private investing community, Systematic Income. Learn More »
Rising rates have been top of mind for income investors who are worried about the knock-on impact of higher rates on their holdings. The traditional advice investors receive on dealing with rising rates make two errors. First, it conflates two different types of rising rate environments and it focuses on duration, ignoring the much more relevant real-world metrics that capture how securities behave in the real world. We discuss both of these errors in the article and what investors can do to avoid them.
In this article we take a look at a number of investment options that have been relatively resilient in the face of rising rates. Our key takeaway is that investors who want to protect against higher rates have to decide which rising rate scenario is most likely and most damaging for their portfolios. This is because not all rising rate scenarios are created equal, so to speak, as they can have different consequences for various assets.
Breaking Down The Rising Rate Scenarios
Experienced investors know full well that there are different types of market dynamics and environments that cause interest rates to move higher. The reason this is important is that different market environments have different consequences for various assets. This is why positioning for higher rates can be a challenging proposition. One asset that responds favorably to a certain type of rising rate environment can do poorly in a different rising rate environment. What this means for investors is that they should think through which rising rate scenario is the one they are more worried about.
The first kind of rising rate scenario is one we call a messy surprise that happens on the back if either a hawkish monetary policy surprise or due to a surprisingly high inflation reading. A policy surprise could take the form of the Fed coming out this year and declaring that they are planning to hike rates sharply by the end of the year. This would, no doubt, shock the market which has been operating under the assumption that policy rates would remain around zero through 2023. This would also likely result in a spike in interest rates across the curve. An example of this kind type of scenario was the 2013 taper tantrum when the market was surprised by the expected tapering of the bond purchase program. As investors may recall, the taper tantrum was not particularly friendly for either income or growth assets. The S&P 500 sold off about 6% on the news with higher-dividend sectors like Real Estate and Utilities falling by around double that. Fixed-income sectors also took it on the chin with some dropping by low double-digit amounts.
An inflationary surprise with a data reading coming in much higher than expectations can fuel concerns about near-term hikes and can be as damaging as a policy surprise for both income and growth assets. The recent rise in rates has been fueled largely by growing inflation expectations with money-market instruments indicating rising expectations of pre-2023 Fed hikes. Days when rates have risen sharply have tended to be risk-off for growth assets and damaging for income assets as well. The upshot of the messy surprise scenario is that there are fewer options for positioning as both pro-growth, higher-beta assets as well as more defensive income assets will both likely take a hit. And because this environment is risk-off, CEFs are likely to underperform as their discounts should widen in a period of broadbased market weakness.
The second type of rising rate scenario is what we call a reflationary recovery scenario of decent, if not gangbusters, growth, moderate, but not runaway, inflation and gradually rising interest rates amid muted market and macro volatility.
This market environment, unlike the messy surprise, is much more pro-growth and pro-risk. Small-caps and cyclical sectors like banks and energy should do well and lower-quality fixed-income sectors should outperform as their credit spreads and high yields can soak up the gradual rise in interest rates, allowing such assets to generate positive returns. In this scenario, CEFs are likely to perform well as discounts should be well-contained, particularly, if the Fed continues to stay on the sidelines in line with their current guidance.
Dumbing Things Down Usually Fails
The typical piece of advice investors regularly come across in market commentary is to focus on the duration metric in order to position appropriately in the face of rising rates. The trouble with this advice is that it not only conflates the different types of market environments that drive rates higher but it also ignores other key drivers of asset performance.
To illustrate why a focus on duration can lead investors astray consider the following example. In the chart below we compare the NAV performance of the PIMCO High Income Fund (PHK) which shows a duration of 7.0 on its website against the performance of the Vanguard Intermediate-Term Corporate Bond ETF (VCIT) which is an investment-grade corporate bond ETF with a duration of 6.5. What the proponents of the duration metric suggest is that not only should VCIT have outperformed PHK since the start of the year but that both funds should be in the red given the sharp rise in risk-free rates (0.7% rise in 10-year Treasury yields along).
Source: Systematic Income
Unfortunately, the real-world is more complex as the nearly double-digit return differential between these two funds shows. Readers who follow our commentary know very well that we've been banging on this point for much of 2021 which is that duration, alone, doesn't tell you a whole lot. Specifically, it doesn't really tell you how a given asset will actually respond to a rising rate environment.
In order to have a better handle on that we need to understand both the market environment that we are in as well as the impact of other fund drivers. As we've discussed multiple times in our articles, in the current market environment which has, so far, behaved akin to a reflationary recovery scenario, lower-quality portfolios such as those of PIMCO taxable CEFs will tend to fare better relative to their higher-quality counterparts. This means that, at the very least, investors should consider other features of portfolios like credit quality in order to be able to position appropriately.
Positioning For A Messy Surprise
A messy surprise scenario, as we touched on above, entails a risk-off period across financial markets. This scenario makes it difficult for investors as there are fewer assets that should generate positive returns.
The chart below shows how various CEF sectors performed a month after the start of the taper tantrum in May 2013. It shows that not only was there no place to hide in terms of underlying asset performance but that prices strongly underperformed NAVs, or, in other words, CEF discounts widened sharply.
Source: Systematic Income
We got a flavor of this dynamic in the last month as well with a few risk-off spikes in interest rates. The average performance across recent three days that saw an average of 0.11% rise in 10y Treasury yields was negative across the board for all sectors with most sectors seeing wider discounts as well.
Source: Systematic Income
Our key takeaway here is that CEFs are going to be a tough place to allocate capital in this scenario.
For investors who care a lot more about CEF NAV performance rather than price (perhaps because they have very little interest in portfolio turnover and are of the extreme buy-and-hold variety) we offer the following chart which shows the top fixed-income CEF performers by NAV over the three dates.
Source: Systematic Income
The chart includes a number of target term CEFs such as the First Trust Senior Floating Rate 2022 Target Term Fund (FIV) and the Nuveen High Income 2021 Target Term Fund (JHB) which tend to be better behaved due to lower leverage and lower-maturity assets.
Alternatively, investors can have a look at senior securities which don't have the discount dynamic, particularly those with maturities, either near-maturity baby bonds or term preferreds. The chart below shows sector performance across the three days proxied by open-end funds or senior securities.
Source: Systematic Income
The top sector performer is the CLO Equity Debt sub-sector, which at the moment contains only two Eagle Point Credit Company (ECC) baby bonds. Although the maturities of these bonds are not particularly short being in 2027 and 2028 the two securities should continue to be "pinned to par" for moderate moves in yields which makes them behave locally as having very low duration.
Investors looking for shorter maturities without giving up a ton of yield should have a look at a number of CLO Equity term preferreds such as the Oxford Lane Capital Corp. 6.75% Series 2024 (OXLCM) with a 2024 maturity trading at a 6.74% stripped yield and a -0.2% YTC as it is currently callable and is slightly above par or the Priority Income Fund 6.375% Series E (PRIF.PE) also with a 2024 maturity and trading at a 6.5% YTW.
Investors who want a higher-quality holding while sticking should have a look at the cash alternatives, primarily open-end funds, discussed here.
Positioning For a Reflation Recovery
Positioning in a reflationary environment is significantly easier as it tends to be risk-on rather than risk-off which allows both pro-growth and lower-quality assets to perform well.
Our main go-to metric for this kind of environment is what we call empirical duration rather than textbook duration. Empirical duration is a measure of how different securities respond to rising rates in the real world and is measured by the slope of the regression of its daily returns to changes in interest rates. Specifically, we use daily NAV returns for CEFs with a 6-month return window.
Assets with negative empirical duration are those that tend to rally on days of rising rates. Because rising rates tend to be indicative of economic expansion and a risk-on environment, these assets are usually pro-growth or lower-quality. This includes stocks and higher-yielding fixed-income sectors such as high-yield bonds and loans.
Source: Systematic Income
Sectors with positive empirical duration are the higher-quality fixed-income sectors such as Treasuries, taxable munis, investment-grade bonds and others.
The big difference between the two rising rate scenarios is that higher-beta assets like stocks which can do poorly in a messy surprise scenario can do just fine in a reflationary recovery scenario.
We can summarize this dynamic by annotating the following chart from GSAM. When rates rise quickly - above a two standard deviation pace over a given month, the environment is likely to be one of a messy surprise and stocks tend to fall. On the other hand, when the rate rise is at a moderate pace, this tends to reflect a growing expansion or the reflationary recovery scenario and stocks will tend to do well.
Source: Systematic Income
Investors who want to remain in the world of CEFs can consider the following chart which shows funds with low empirical duration and sub-25% investment-grade allocation.
Source: Systematic Income
A number of target term CEFs remain attractive options here - the funds mentioned above as well as the Nuveen EM Debt 2022 Target Term Fund (JEMD) with a 4.66% current yield (and a 4.28% covered yield plus 0.9% PTN Yield).
Mixed-credit CEFs that allocate to loans, high yield bonds alongside CLO equity and CLO debt such as the Ares Dynamic Credit Allocation Fund (ARDC) and Apollo Tactical Income Fund (AIF) have negative empirical duration due to their partial floating-rate exposure and sub-investment-grade holdings. They also feature attractive discount valuations, strong historic returns and wide allocation mandates and remain attractive.
Funds with an allocation to equity upside such as the pair of the Virtus AllianzGI funds: Convertible & Income Fund (NCV) and Convertible & Income Fund II (NCZ) are attractive because of their 1/3 convertible bond allocation which is able to partially capture equity upside without foregoing a lot of income in the process. These funds remain attractively valued at a near double-digit discount and a close to 9% current yield.
MBS funds such as the Invesco High Income 2023 Target Term Fund (IHIT) and the Western Asset Mortgage Opportunity Fund (DMO) that allocate to more idiosyncratic assets, some of them floating-rate, are also attractive, though their valuation has grown more expensive of late.
Takeaways
Investors who are concerned about the impact of rising rates and who want to position their portfolios in anticipation of this development have to consider the two different market environments that can lead to higher interest rates. An environment that we call messy surprise is one that is caused by either a monetary policy or an inflation surprise can lead to a risk-off period in markets and make it challenging for stocks and CEFs. Assets that can digest rising rates in this environment are term securities such as short-maturity baby bonds and preferreds as well as higher-quality assets such as target-maturity credit and muni open-end funds.
A reflationary recovery, on the other hand, is much more pro-growth and pro-risk which allows growth assets such as stocks, convertible bonds and higher-yielding assets such as high-yield credit and loans to perform well. Using funds' empirical duration rather than the textbook definition can allow investors to identify funds with additional upside.
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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 NCV, FIV, JEMD, JHB, PRIF.PE, ECCX. 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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