Financial markets over this past year have been pretty nerve-wracking for even the most experienced investors. One clear benefit, however, of the fast and furious roundtrip we saw this year in asset prices is that it provided a kind of stress test for various income assets, securities and allocation strategies. And although we shouldn’t expect future drawdowns to behave exactly like what we saw in March, the lessons offered by the market are very valuable for guiding investors in their portfolio construction efforts going forward.
In this article we highlight a handful of lessons offered up by the markets this year. These lessons include avoiding high premium CEFs, betting the portfolio on a single market outcome, chasing yields during a period of expensive valuations and others.
Positioning the Portfolio for a Single Outcome
The low level of interest rates has been a constant topic of market pundits, most of whom have been warning about rising inflation and higher interest rates for many years. This has pushed many income investors out of longer-duration assets and into floating-rate assets like loans.
This approach has a number of problems. First, and most obviously, interest rates did fall quite a bit lower over the past year. Secondly, fixed-rate assets provided more of a cushion than floating-rate assets due to their duration exposure. Thirdly, fixed-rate assets did not see their coupons fall due to the drop in short-term rates while floating-rate assets suffered significant drops.
The chart below shows that the loan CEF sector saw the biggest amount of distribution cuts relative to the number of funds in the sector. In fact there were more cuts this year than there are funds in the sector as many funds had several cuts.
The high-yield bond CEF sector, on the other hand, saw much steadier distributions.
This not only supported portfolio income levels but also allowed the high-yield sector discount to remain tighter, supporting portfolio wealth.
With interest rates even lower than they were at the start of the year it’s tempting to finally get rid of any duration exposure . In our view, this would be a mistake. Duration exposure is worth holding given the tendency of interest rates to fall during periods of market weakness. Secondly, interest rates are certainly lower but they are still well off any kind of hard lower bound. And thirdly, the yield curve is relatively steep which further boosts duration assets via rolldown.
Keeping Dry Powder Handy
Different income securities will tend to have different levels of drawdowns. This, along with the fact that markets tend to be both mean-reverting and volatile, means that investors can grow both total wealth and portfolio income levels through opportunistic rebalancing.
For example, historically, CEFs have had price drawdowns at least twice that of open-end funds. And although the market volatility we saw this year feels very unique and, let’s hope, not to be repeated anytime soon, the fact is that market drawdowns happen on a regular basis, though the precise catalyst may be different each time.
What this means is that investors can reallocate from more resilient to less resilient securities during drawdowns to lock in attractive yields as well as grow total portfolio wealth which is what ultimately drives sustainable income generation.
In our view, dry powder allocation should not be in CEFs regardless of portfolio quality. Mutual funds and target-maturity ETFs are much better options due to their tendency to either have no discounts (mutual funds) or relatively contained discount widening during market shocks.
Watch Out For CEF Premiums
This lesson won’t surprise any experienced investors, however, given the recent run-up in CEF premiums it bears highlighting once again.
There are two main reasons why it’s worth avoiding CEFs with high premiums. First, it substantially reduces the price yield of the fund relative to its NAV yield. For example, a fund with an NAV yield of 8% only provides a distribution-rate of 6.4% at a 25% premium.
The second reason why it’s worth avoiding CEFs with high premiums is that it makes them fragile, in the sense, that there is asymmetric risk of greater downside than upside returns, particularly in case of a distribution cut.
On an individual basis we saw multiple cases of funds deflate their premiums due to distribution cuts. For example, the three distribution cuts in the PIMCO taxable suite caused a 15-25% loss in price return – on the order of 2-3 years worth of distributions. These losses are extremely unlikely to be made up anytime soon.
On an aggregate basis, funds with higher premiums / tighter discounts within sectors saw greater drawdowns this year. For example, the chart below shows that multi-sector CEFs with higher premiums in the third week of February saw larger peak-to-trough price drops than funds with lower premiums / wider discounts.
The loan sectors looks pretty similar.
As does the preferreds sector, plus a number of others.
Some investors have a cavalier attitude about drawdowns. In our view, avoiding drawdowns are important for three reasons. First, bigger price drops make it more difficult to maintain conviction in the portfolio which could cause investors to sell holdings and lock in capital losses by failing to benefit from a recovery in asset prices. Secondly, larger drawdowns leave less capital to allocate to other attractive opportunities. And thirdly, greater NAV drawdowns are more likely to cause a fund to deleverage which locks in capital losses on the fund level.
With yields moving lower it may be tempting to juice portfolio returns or income levels by moving into higher-beta and/or higher-yielding CEF sectors or moving into common shares of mREITs or BDCs. And, of course, this could work out well over the medium-term since the market and macro consensus appears to be that we are just at the start of the recovery.
However, for investors who want to maintain relative stability in the portfolio wealth levels this may not be the right call. This is for two reasons. First, valuations have largely retraced – for instance, high yield credit spreads have recovered more than 90% of their widening. And, secondly, higher-yield sectors tend to be more fragile in the sense that they don’t recover as well through periods of market volatility. The chart below shows that those sectors that had the highest yields at the end of 2019 are significantly lagging other sectors in performance.
Another point worth considering is whether to allocate to common shares or senior securities of higher-yielding sectors like mREITs and BDCs. Historically, BDC baby bonds have performed comparably to BDC common shares with much lower volatility. What this means is that the yield pickup of BDC common shares has been largely illusory, at least over the last 5-7 years.
The picture is similar for mREITs where preferreds have done a better job of preserving value than common shares.
Looking at these two charts it’s tempting to conclude that the common shares are hugely undervalued relative to the preferreds and the right trade is to rotate out of senior securities and into common and wait for them to “close the gap”.
There is a little bit of truth in this view as price-to-book ratios of common shares have come down. However, this is a mostly wrong message to take away from the charts. The key point is that after periods of volatility we shouldn’t expect all leveraged vehicles like mREITs, BDCs and CEFs to swiftly trade back to their original prices if they underwent deleveraging. We go through some of the math in the chart below where the blue line is the path of asset prices, starting at $100 and retracing back to $100 over a period of a month of 21 business days. In the scenario below where a leveraged vehicle is forced to deleverage after its leverage level hits 50% will continue to trade well below its starting NAV – in this scenario it will lose a quarter of its original NAV despite asset prices recovering fully. To be fair, this is quite a tough scenario but it’s not completely unrealistic. Many leveraged vehicles such as MLP and CLO equity funds, BDCs and mREITs remain more than a quarter off their pre-drawdown peaks.
The corollary of this dynamic is that for investors who allocate entirely to funds may want to broaden their exposure to individual preferreds as well as baby bonds which can allow them to not only tailor their exposure but also overweight more attractive securities.
A related lesson here has to do with yield vs. total return. Income investors will typically focus on the yield of a given security rather than its total return prospects, which makes a lot of sense. However, it can also blind investors to the importance of the link between returns and income. This is particularly the case for CEFs which will often adjust their distributions in line with major changes in income.
For example, earlier this year we saw a large wave of distribution cuts by the MLP sector which was caused by a double-whammy of significant deleveraging as well as falls in portfolio constituent dividends. The deleveraging of the CEF sector was itself a response to the sharp drop in underlying NAVs which caused the funds to bump up against their asset coverage and credit facility covenant limits. The CLO equity sector was another case in point where the two larger funds significantly cut their distributions due to significant deleveraging.
It’s important to point out that the previous distribution levels of these funds are very unlikely to come back in the medium term because the funds don’t have sufficient capital to earn the same amounts. This is because significant amounts of capital were lost during the deleveraging phase and organic capital building by the funds will take much longer.
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