Attractive Income Opportunities In Niche And Resilient Sectors

This is an extract from an earlier article at Systematic Income Premium

It’s fair to say that one takeaway for income investors this year is that a lot of the bread-and-butter income sectors took significant losses. This even includes many of the higher-quality assets such as investment-grade bonds which normally outperform during market downturns.

In this article, we take a bird’s eye view of the income space to see how various sectors have performed year-to-date and what yields they are currently offering. We then focus specifically on sectors that have remained relatively resilient and offer attractive yields.

A Bird’s Eye View Of The Income Space

Most income investors are interested in not just the yield they can achieve on their holdings but also the relative resilience of their holdings. It’s no good earning a 10% yield if the portfolio’s longer-term return ends up being 3% through-the-cycle.

Let’s have a look at how the various credit sectors look with respect to their current estimated yield (y-axis) and their total return over the first half of the year (x-axis). Credit yields have fallen since June (the date the table above references) primarily as credit spreads have compressed so we adjust spreads lower by about 20% (roughly the amount of compression since 30-June we see in HY corporate bonds).

The more appealing quadrant of higher yields and better return is highlighted in green and the less appealing quadrant is highlighted in red.

Systematic Income

Obviously, investors need to be careful here with extrapolating performance. Just because a sector fell very hard doesn’t necessarily make it unattractive. It’s also important to point out that just because a sector was resilient this time around may not mean it will be resilient in the next market shock since market shocks are not all alike. That said, there is still a lot of utility in looking at this proof-is-in-the-pudding kind of numbers.

What we see is that a number of CLO and CRT sectors look quite attractive with ABS sectors being even more resilient though lower-yielding. These sectors boast decent yields with outperformance to boot. On the other hand, some of the traditionally “safer” sectors like investment-grade bonds and agency MBS don’t look very attractive in the chart.

Stance and Takeaways

The purpose of the article is to provide some allocation ideas for investors managing income portfolios. Specifically, it is to highlight that some of the more niche sectors can look much more attractive than the bread-and-butter or even “safer” sectors that traditionally make up investor portfolios.

The other takeaway is to think in terms of sector allocation rather than “best funds” since even the “best fund” in whichever sector will find it difficult to swim against the current of an unfavorable market environment that drags its entire sector lower.

Finally, investors should think in terms of multiple scenarios rather than a single axis of yield or quality. For instance, investors should be prepared for various potential outcomes such as higher or lower interest rates and higher or lower credit spreads. Investors who allocate in a bottom-up manner by building portfolios from individual securities that they like the look of may end up with undiversified portfolios whose performance can disappoint.

Here we also highlight a number of funds that tap into each of the three attractive and resilient sectors discussed above: CLO Debt, ABS and non-agency MBS.

In the CLO Debt space, we like the Janus Henderson B-BBB CLO ETF (JBBB) which allocates primarily to investment-grade CLO Debt securities. The fund has a 3.1% distribution rate and a 5.1% SEC yield. The fund’s income will continue to increase in line with further rises in the Fed policy rate. The fund is down around 6% year-to-date including dividends.

A CEF which allocates to both ABS and CRT sectors is the Nuveen Mortgage and Income Fund (JLS), trading at a 6.2% yield and a 17% discount. About 40% of the portfolio is in investment-grade rated securities and about half the fund is in floating-rate securities which will help to drive fund income higher. The fund has a modest duration of 2.4 and carries 29% of leverage. JLS has delivered a -7.6% total NAV return this year which has outperformed the multi-sector CEF space by about 5%. The discount is trading cheap to the sector average.

Systematic Income CEF Tool

Finally, we continue to like a fund that is focused mostly on the non-agency RMBS sector – the Western Asset Mortgage Opportunity Fund (DMO). DMO is trading at a 11% current yield and a 15% discount. Its total return this year of -10% is about 4% better than the broader Multi-sector CEF space and about 5% better than the average taxable PIMCO CEF. The fund holds around 80% in floating-rate securities so its income will continue to benefit from higher short-term rates.

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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.

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