How We, As Income Investors, Are Navigating Recession Risks

That the economy will soon enter a recession is quickly becoming the consensus view. Few investors believe that the Fed will be able to engineer a soft landing. Rather, many view that the Fed will, unusually, be forced to keep tightening financial conditions even in the scenario of a sharp macro slowdown to ensure that inflation is wrung out of the system. 

A common heuristic for a recession is two consecutive quarters of negative GDP growth. Although this is not the technical definition of a recession (NBER makes the determination in its sole capacity) it’s useful enough. By this metric we may already be in a recession. GDP fell 1.4% in Q1 and some quantitative GDP forecasts, such as the Atlanta Fed GDPNow, are forecasting another drop for Q2. 

Similarly, various leading indicators are moving lower while recession probability models are moving higher. 

Borrowing from the All-Weather matrix below, a recessionary environment could see a moderate level of the Fed Funds rate, say below 3%, if recession moderates or it could see a a rise above the current consensus of around 3.5% if inflation remains high. The key takeaway here is that investors ought to be prepared for either outcome, as neither one is preordained.

In terms of allocations that make sense to us in the following environment, in the Muni space we like the BNY Mellon Strategic Municipals (LEO) and Nuveen Municipal Credit Income Fund (NZF), trading at 5.3% and 5.4% yields respectively. 

In preferreds we like the Tax-Advantaged Preferred Securities and Income Fund (PTA) and the Nuveen Preferred and Income Term Fund (JPI), trading at 7.9% and 8.0% yields respectively. 

In the BB-rated corporate bond space we like the iShares Fallen Angels USD Bond ETF (FALN) with a 6.95% portfolio yield (7.2% weighted-average yield-to-worst less a 0.25% management fee) which allocates primarily to fallen angels i.e. BB-rated high-yield corporate bonds that used to be rated investment-grade but were dinged and are now mostly rated with the highest sub-investment-grade rating. The fund’s 4.2% trailing-twelve month yield is well below its underlying yield capacity as it ignores the strong pull-to-par element of the high-yield corporate bond market with the average bond trading around $90. BB-rated bonds tend to be pretty resilient over default cycles, certainly much more than the broader “junk” space.

Having lower-beta securities in the portfolio can also make sense to mitigate the impact of market fluctuations on investor wealth. This can help investors maintain conviction in their holdings and mitigate the often disastrous sell high / buyback low cycle of trading. For example, shorter-maturity corporate bonds deliver a very similar yield as longer-maturity bonds in the current market environment due to the flatness of the yield curve. However, they are less sensitive to changes in interest rates and credit spreads. Here we like the SPDR Bloomberg Short Term High Yield Bond ETF (SJNK), featuring a 8.7% weighted-average yield and trading at a 4.85% distribution yield. The fund’s duration at 2.4 is about half of the typical high-yield corporate bond fund.

Finally, we like having some exposure to rising short-term rates, particularly in the scenario where the Fed keeps hiking past the current consensus of 3.5%. One higher-quality option is the Janus Henderson B-BBB CLO ETF (JBBB) which primarily holds investment-grade CLO tranches. The fund’s income profile has been growing over the recent months as short-term rates have risen. The fund’s SEC yield is 4.3% as of June and will continue to increase in the coming months. 

The obvious question is if, as it seems increasingly likely, recession really does come to pass, why not just stay on the sidelines and allocate only when the worst is over. This approach certainly sounds good, however, in practice it doesn’t always work as neatly as it seems. Timing the entry point is hard given the uncertainty around both the macro and market picture at any one time. For instance, investors who have stayed on the sidelines so far can pat themselves on the back with the view that they have not incurred much damage so far this year. However, this success can breed failure since investors may remain on the sidelines just as the market starts to recover. This recovery may lead to regret of having failed to allocate at the trough, leading some investors to remain on the sidelines and waiting for the double dip which may never come, as it didn’t come after March of 2020. For this reason we like to allocate through the drawdown to make sure that we have a peak risk allocation at the tough. 

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