In this post, we highlight how investors can build portfolios that diversify across various potential scenarios. Doing so allows income portfolios to be more resilient over time while also allowing investors to reallocate a pool of resilient capital to more attractive opportunities as they come up.
Specifically, we take an All-Weather approach to income market investing. This term borrows from Bridgewater Associates, which thought carefully of how to build portfolios that hold a number of different assets, some of which can deliver positive performance in all reasonable market outcomes. The point isn’t to guarantee a positive portfolio return in all scenarios. Rather, it is to have a diverse set of assets in the portfolio each of which can perform well in a particular market outcome. Where we differ from the Bridgewater approach is by sourcing all of our holdings from income securities trading at 5-10% yields.
To build a relatively resilient portfolio, i.e., one that holds some assets which can perform well in different market environments, we can consider the following matrix borrowed from Columbia Threadneedle which shows a number of possible economic scenarios over the medium term as a 2×2 matrix.
Scenario A – Fed Overtightens, Causes Recession
In this scenario, the Fed tightens policy too much too fast which causes demand to drop sharply, economy to move into recession and inflation to fall. If this happens, we expect Treasury yields to move back lower to a level of 1-2% and credit spreads to rise.
Some of the securities that look attractive here are:
- Capital One Financial Corp 4.375% Series L (COF.PL), trading at a 6.5% yield
- JPMorgan Chase 4.55% Series JJ (JPM.PK), trading at a 6% yield
Scenario B – Stagflation
In this scenario, inflation remains persistent, causing interest rates to remain high while the economy enters a recession which pushes credit spreads wider as well.
We like higher-quality floating-rate securities such as agency mREIT and bank preferreds as well as short-term bonds.
- mREIT AGNC Investment Corp 7% Series C (AGNCN), trading at a 7.5% yield and a 8.76% reset yield (i.e. expected stripped yield on the first call date in October 2022 based on Libor forwards).
- mREIT Arlington Asset Investment Corp 6.75% 2025 bond (AIC), trading at a 6.95% yield-to-maturity
Scenario C – Soft Landing
In this scenario, inflation keeps grinding lower, which allows the Fed to take their foot off the pedal, leaving financial conditions fairly supportive. Economic growth slows down but is not tipped into a contraction. Interest rates move lower and credit spreads range trade.
- Nuveen Municipal Credit Income Fund (NZF), trading at 5.63% current yield
- Credit Suisse Asset Management Income Fund (CIK), trading at a 10% current yield
Scenario D – High Inflation/High Growth
In this scenario, inflation remains a persistent feature of the economy without causing growth to stall.
In this scenario, we expect interest rates to move higher but credit spreads to remain relatively resilient. In this market outcome, we like BDC exposure.
- Golub Capital BDC (GBDC), trading at a 9.2% dividend yield
- Carlyle Secured Lending (CGBD), trading at a 12% dividend yield
The investment landscape over the medium term looks to be particularly uncertain. The global economy is still in the process of post-pandemic recovery, buffeted by continuing supply chain issues, localized lockdowns and a European conflict. To add to this, many central banks are in the process of hiking policy rates to deal with fairly persistent inflation. What the market will look like in a year’s time is impossible to predict.
This is why for some investors it can make sense to take an All-Weather approach and hold some assets that can benefit in various market outcomes. Obviously, the weightings of these outcomes don’t all have to be exactly 25% – it can make sense to tilt more to a “base case” outcome which can be different for each investor.
Check out more in-depth and timely commentary as well as Income Portfolios and interactive Investor Tools at our Premium service.
ADS Analytics LLC / Systematic Income provides opinions regarding securities and other related topics on an impersonal basis; therefore no consideration is made towards your individual financial circumstances.
All content presented here is not to be regarded as investment advice or constitute a client / advisor relationship. It is for general informational purpose only.
Trading securities involves risk, so you must always use your own best judgment when trading securities. You assume the entire cost and risk of any trading you choose to undertake. You are completely responsible for making any investment decisions.