A tendency of investors in financial markets, including the income investment space, is to focus on the present and extrapolate it forever. The reality is that market and macro environments change. The problem is that we don’t know exactly how they will change. This suggests that income portfolios should be somewhat diversified across a number of likely outcomes to avoid implicit bets on any particular market outcome, be it duration or credit risk or something else.
In this article, we outline how investors can build portfolios that diversify across various potential scenarios. This allows income portfolios to be more resilient over time while allowing investors to reallocate a resilient pool of capital to more attractive opportunities as they arise.
Specifically, we take an all-weather approach to income market investing. This term borrows from Bridgewater Associates, who thought carefully about how to construct portfolios that hold a number of different assets, some of which can perform positively in all reasonable market outcomes. The goal is not to guarantee a positive portfolio return in all scenarios. Rather, it is about having a diverse set of assets in the portfolio, each of which can perform well in a particular market outcome. Where we differ from Bridgewater’s approach is in buying all of our holdings from income securities trading at yields of 5-10%.
It must be said that this type of All-Weather approach is not for tactical investors or for investors who have a very firm view of how the future will unfold. Rather, it is aimed at investors who want to build a portfolio that is not too focused on a market outcome and has relatively resilient assets that can be reallocated to take advantage of emerging opportunities.
Think about possible market outcomes
To construct a relatively resilient portfolio, i.e. one that holds assets that can perform well in different market environments, we can consider the following matrix borrowed from Columbia Threadneedle which shows a number of possible medium-term economic scenarios as a 2×2 matrix.
Obviously, this list is not exhaustive, but it does a reasonable job of highlighting how the next 12 months could develop in the market and the economy in general.
Scenario A – The Fed tightens excessively, causes a recession
In this scenario, the Fed tightens policy far too quickly, leading to a sharp drop in demand, the economy entering recession, and lower inflation. If that happens, we expect treasury yields to return to 1-2% levels and credit spreads to widen.
In this scenario, it may make sense to hold low-priced, high-quality, long-duration fixed-coupon preferred stocks, such as high-quality bank and insurance preferred stocks.
These stocks would benefit from falling Treasury yields due to their very long duration profile. They would also remain less impacted by rising credit spreads due to their higher quality profile. Securities that trade at tighter credit spreads tend to see less credit spread widening than those that trade at wider credit spreads. For example, credit spreads for BBB-rated corporate bonds increased by 2.3% from end-February to end-March 2020, while B-rated credit spreads increased by 4.7% over the same period.
Some of the titles that look appealing here are:
- Capital One Financial Corp 4.375% Series L (COF.PL), trading at a yield of 6.5%
- JPMorgan Chase 4.55% Series JJ (JPM.PK), trading at a yield of 6%
- Huntington Bancshares 4.5% Series H (HBANP), is trading at a yield of 6.2%
Scenario B – Stagflation
In this scenario, inflation remains persistent, causing interest rates to remain high as the economy enters a recession, which also widens credit spreads.
In this scenario, we like higher-quality floating-rate securities such as agency mREITs and bank-preferred stocks. The coupons on these securities will increase over time as the Fed will be forced to raise the policy rate and keep it relatively high to contain inflation. And, as in the example above, the higher quality profile of these securities should mean that they will outperform if credit spreads widen significantly.
- mREIT AGNC Investment Corp 7% Series C (AGNCN), trading at a yield of 7.5% and a revised yield of 8.76% (i.e. the expected stripped yield on the first trading date call in October 2022 based on Libor futures).
- mREIT Annaly Capital Management 6.95% Series F (NLY.PF), trading at a yield of 7.6% and a revised yield of 8.4% from its first redemption date in September 2022.
- Bank PNC Financial Services 6.125% (PNC.PP) – 3 month Libor + 4.07% floating rate preferred, trading at a yield of 5.8% at today’s Libor of 1.7%, which should rise (based on today’s price) as the Libor rises towards 3% if the market consensus is correct. The return on the stock at that time will be around 7%.
- Valley National Bancorp 5.5% (VLYPO) – set to switch this month to a 3-month Libor + 3.578% floating rate coupon, which would equate to a yield of 5.9% and exceed 7% at a Libor of 3%.
We also like good quality, shorter duration bonds that can protect against both rising interest rates and credit spreads due to their relatively short maturity.
- mREIT Arlington Asset Investment Corp 6.75% 2025 Bond (AIC), trading at a yield to maturity of 6.95%
- BDC Oxford Square Capital Corp 6.5% 2024 Bond (OXSQL), trading at a yield to maturity of 7%
- B. Riley Financial 5% 2026 Financial Services Company Bond (RILYG), trading at a yield to maturity of 7.45%
Scenario C – Soft landing
In this scenario, inflation continues to fall, which allows the Fed to ease off, leaving financial conditions quite favorable. Economic growth is slowing but not tipping into a contraction. Interest rates fall and credit spreads vary.
In this scenario, we prefer to hold medium duration fixed coupon securities ranging from high yield corporate bonds to municipal bonds, depending on investors’ risk appetite. And since short-term rates are likely to peak below the consensus level, it may make sense to hold bond exposure through CEFs, as leverage costs won’t reach excessive levels.
- Nuveen Municipal Credit Income Fund (NZF), trading at a current yield of 5.63%
- Credit Suisse Asset Management Income Fund (CIK), is trading at a current yield of 10%
- Western Asset Diversified Income Fund (WDI), trades at a current yield of 10.4
Scenario D – High Inflation/High Growth
In this scenario, inflation remains a persistent feature of the economy without causing a slowdown in growth.
In this scenario, we expect interest rates to rise, but credit spreads to remain relatively resilient. In this market result, we like BDC’s exposure.
- Golub Capital BDC (GBDC), trades at a dividend yield of 9.2%
- Carlyle Secured Lending (CGBD), trades at a 12% dividend yield
- Oaktree Specialty Lending Corp (OCSL), trading at a dividend yield of 10.1%
Take away food
The medium-term investment landscape looks particularly uncertain. The global economy is still in the process of post-pandemic recovery, rocked by ongoing supply chain issues, localized lockdowns and European conflict. To add to this, many central banks are raising their key rates to deal with fairly persistent inflation. It is impossible to predict what the market will look like a year from now.
Therefore, for some investors, it may make sense to take an all-weather approach and hold assets that are likely to benefit from varying market outcomes. Obviously, the weightings of these outcomes don’t all have to be exactly 25% – it may make sense to lean more towards a “base case” outcome which may be different for each investor.
The other reason an All-Weather approach can benefit investors is by applying a measure of risk factor diversification to portfolios that are typically built bottom-up, with investors individually acquiring assets that appeal to them, disregarding the probable tendency of these assets to behave. very similarly in some market outcomes.
Our own income portfolios hold securities in all of these tranches with some variation due to yield constraints. This is something that has allowed us to reallocate resilient capital to more attractive securities over the past few months as markets struggled.