There’s always lots of things happening in markets – new securities are issued or redeemed, new funds set up, fund mergers announced, distributions move up or down, prices shift – that it can be easy to lose track of the big picture. It’s easy to be pushed around by the market itself, allowing the tail of the market to wag the dog of the overall investment strategy, so to speak. Re-focusing on what the investment strategy actually is helps to keep things on an even keel.
An important question to always keep in mind is “what am I trying to achieve?”. Sometimes the answer is not always obvious. For example, if you listen to Howard Marks he will be laser-focused on “superior returns” by which he means outperformance (of the average manager, presumably, in his space which is credit). That makes a lot of sense – for Howard Marks. As co-Chairman of an asset management firm, his job is to be better than other asset managers. That allows him to attract more money to the firm and drive the firm’s returns. There is nothing sinister or cynical about this and I love Marks’ broader investment approach of “you can’t predict, but you can prepare” but what he does for a living is central to his approach to markets.
Most income investors don’t run asset management firms and so don’t necessarily share outperformance of an average manager as their primary investment goal. And in any case retail investors tend to hold assets across a wide range – much wider than an average manager or firm that would tend to specialize in particular sectors anyway.
So, what other types of investment goals are there? For income investors there are a few.
There are risk-focused investors who focus on principal preservation and achieving strong risk-adjusted returns. Often, these investors either have a large capital base which means they don’t need to generate high yields on their capital or they also hold a separate equities portfolio which takes care of the growth / high return part of the equation. This allows them to maintain a reserve which can be used to rotate in and out of equities depending on valuations. These investors are not going to use CEFs for their income given their much higher volatilities (due to leverage and the additional discount volatility) and stick to open-end funds. In individual senior securities they might look at high-quality illiquids (Ameren, Conn. Light & Power etc) or CEF Preferreds like OPP-A, GLU-A that don’t get pummeled as much due to lack of passive fund sponsorship.
There are also investors who aim to maximize the distributions they get on their holdings. These investors will tend to hold CEFs with double-digit or near double-digit distribution rates. I have discussed how it’s basically impossible for CEFs, outside of CLO Equity CEFs, to organically generate high single-digit portfolio yields in the current environment. Tilting to high distribution funds also means that investors will often hold CEFs with high premiums as the these funds tend to attract significant demand. One strategy here is to hold funds that have high distributions but also higher quality holdings like FAM, OPP or MIN. These funds don’t have a prayer of covering their distributions but neither do lower-quality funds if they distribute anywhere north of 7%. Some individual preferreds, particularly, in the non-agency focused space like CIM-D or NYMTN have yields north of 8% and continue to look ok.
There are other investors who wish to fix distribution levels, in order to generate a stable cashflow stream. Most CEFs are less attractive here due to their tendency to make distribution changes. CEFs with managed distribution policies are worth a look, particularly those with level policies, but nothing prevents funds from changing their policies. CEFs with managed distribution policies are marked in the CEF Tool (Sector View tab) plus there have been recent articles on the topic. Non-callable fixed-rate preferreds or long-duration preferreds discussed in the yield winter article might foot the bill here.
Other investors are absolute return / tactical. Here, CEF relative value (RV Ideas tab in CEF Tool) or flipping preferreds might work.
Value-focused investors will tend to rotate their holdings based on what the market gives them. This means moving from CEFs to open-end funds / preferreds and from lower-quality to higher-quality securities as valuations richen and vice-versa.
Obviously, this taxonomy is artificial and many investors move through these types over an investment cycle and many others share multiple types. However, it does serve a purpose in clarifying what it is we are all doing as the market ebbs and flows.
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