YH Core Income Portfolio Update: Focusing On Risk

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We introduced the Yield Hunting Core Income Portfolio on Seeking Alpha in the latter half of 2016. At the time the US 10-year yield hit a record low of just 1.37%. While there was still some room left for it to fall further we were nearing the end of the full cycle of interest rates. The cycle today is essentially complete as the 10-year hit an all-time low of just 32 bps back in March of this year. It’s possible that it could reach a lower level, but essentially, the bottom is in.

The Core Portfolio is an answer to the question: What can I do to improve my future returns while reducing my equity risk exposure? So many investors have been burned by two decades of significant market volatility. During that time, we have had two S&P 500 drawdowns of 50% or more plus two smaller draw downs of 20% or more.

And over those two decades, the average baby boomer went from being mid-forties to mid-sixties. They are now prepared to retire (or have already retired). Their mindset is very different. They can no longer weather, nor do they want to weather, another significant downturn.

Their goals are different. Their objectives are different. And most likely, their portfolio ideas are very different. As they approach the de-cumulation phase the complexity and strategies surrounding their portfolios are going to shift. The accumulation phase is far easier to manage. Most of Wall Street and most financial advisors are geared toward the accumulation phase. You can buy a target date fund or some kind of balanced fund or ETF and you’re all set. Over time, you dollar-cost average in and reinvest distributions and build your wealth.

But the de-cumulation phase is far harder. This is why so few financial advisors do it “right.” By right we are talking about true retirement income distribution planning where there is a conscientious effort to produce tax-efficient income from the portfolio. And not simply build a 60/40 portfolio of funds and ETFs and selling some shares each month to send to the client for spending. That is NOT a plan nor a solution to the problem.

Core Portfolio Results Through July

Our goal when constructing the Core is to create a high-yielding portfolio with the least amount of risk possible. In other words, we want to produce a ~7%+ yield with the least risk we can. We do that by being diversified across sectors and positioning in the best funds possible in those sectors.

The portfolio is down 3.13% so far this year, trailing the S&P 500 slightly but besting more appropriate benchmarks. We often get asked why the “safer” portfolio is trailing the broader equity index like the S&P 500. The main reason for trailing them is the lack of overweight to the mega-cap tech stocks. We can see that perfectly illustrated in the chart below (which is actually data through Aug. 7). Without those five mega names, the index would be down 5% YTD (and down just over 6.5% through the end of July).

But the fact remains that those five names are in the index and do affect the returns.

Our flagship Core Income Portfolio continues to recover from a poor March and April. During July, the portfolio model returned almost 3% on both price and NAV.

All funds in the portfolio were up on a NAV basis in the month of June. We just had three funds that were down in price, which means it was all discount widening.

The detractors from the portfolio were:

  • Western Asset Mortgage Opp (DMO): -2.3% on price but up 0.9% on NAV
  • Apollo Tactical Income (AIF): +0.6% on price but up 2.8% on NAV.
  • Putnam Premier Income (PPT): +0.1% on price and up 0.7% on NAV.

The positive contributors to performance were:

  • Blackrock Taxable Muni (NYSE:BBN): +7.0% on price, +4.5% on NAV
  • Blackrock Credit Allocation (BTZ): +6.5% on price, +5.6% on NAV
  • PIMCO Dynamic Credit and Mortgage (PCI): +5.6% on price, +2.3% on NAV

The Core was up 3.76% in the month of July essentially even with the primary benchmark, Amplify High Income (YYY) which rose 3.77% in the month. Year-to-date, however, the Core is still besting YYY by 700 bps (-3.13% vs. -10.62%).

The main reason for the difference – and what accounts for a lot of the outperformance of the Core vs. YYY – is that amount of risk taken in the latter part of the cycle. By reducing risk like we did for several months leading up to the COVID-19 crisis – helped mitigate a lot of the downside realized in the passive benchmark.

For example, YYY has a larger allocation to equities. The portfolio asset allocation is effectively 20/80 meaning 20% in stocks and 80% in bonds. Additionally, some of their bond positions are of the higher-risk variety like Nexpoint Strategic Opp (NHF), PIMCO Energy Tactical Cr Opp (NRGX), and Western Asset Emerging Markets (EMD). By actively managing and avoiding some of these riskier names we can greatly increase the return profile of our portfolio.

We are proud of the Core performance since inception as it easily trounces some of the publicly traded ETFs and mutual funds that are “fund-of-funds” in the CEF space.

How We Stack Up

We’ve looked at some of the performance numbers of some key competitors that are publicly-traded vehicles. Most of the time what we see is even these “professionally made” securities focus far too much on yield or discounts. Too little is then focused on risk. For example, we’ve made a big deal about avoiding some of the areas of the CEF market that were “too good to be true.”

Those areas of the market include collateralized loan obligation funds (“CLOs”), MLPs, and some other more esoteric areas of the market that were very high risk. To be sure, we weren’t immune from the downturn either. Definitely not. In fact, PIMCO Dynamic Income (PDI) and PIMCO Dynamic Credit and Mortgage (PCI) proved far less resilient than most would have been thought. They got caught in an illiquid sector (non-agency MBS) which saw a lot of selling effecting even closed fund structures. And these types of areas of the market often take the elevator down and the stairs back up. It will take time to heal. The COVID-19 thing is not helping as so many lost their jobs and it remains to be seen whether borrowers will be able to make mortgage payments.

One fund that does this is Matisse Discounted CEF Strategy (MDCEX) which specifically states in their investment objective to purchasing the most discounted CEFs in the market. Year-to-date, the fund is down 22.6% with a one-year number -16.4% return. A lot of that had to do with overweighting riskier pieces of the market like MLPs:

Right now, both our short-term and long-term performance track record is negatively skewed from the sharp and sudden decline we experienced in March. During the March volatility, our strategy declined more than our comparable benchmarks due to an overweighting to energy and MLP Closed-End Funds (and this all during a time when oil futures went negative).

And I don’t write that to poke fun or promote our service but to show the risks of investing by certain factors without a keen eye towards risk.

Thoughts On The Portfolio

The portfolio remains heavily invested in three areas of the bond market:

  • Mortgages
  • Municipals
  • Preferreds

We believe these areas of the market still offer the best risk reward though that’s skewing. These are higher-quality areas of the fixed income market as opposed to loans, high yield (junk bond), CLOs, and emerging market income. When constructing the Core, our goal isn’t to simply find the highest yielding funds or sectors but to balance the risk versus the reward.

From a micro level, when constructing the portfolio one must look closely at correlations and exposures. What we see too often is the overweighting of some of the riskier sectors but investors think they are diversified because they own six different funds. But the correlation of NAVs of those funds are all above 90%.

One thing we wish we had done differently early this year was to adjust faster away from CEF structures into NAV-traded funds. What that means is when discounts are tight risk is elevated.

The discount to the NAV of a CEF creates some downside cushion. When a fund is trading at a -10% discount and typically trades at a -5% discount, there is some downside protection there. Conversely, if a fund is trading at par when it typically trades at a -5% discount, there’s some added risk there.

This is where we were in February. When discounts are tight you have added a significant amount of new risk to your portfolio. And moving to more deeply discounted funds may not be the savior as there’s likely a reason that those funds are trading wide.

Our goal in the Core is to pair higher risk funds – which are often the smallest weights in the portfolio – with base funds. Base funds are more stable funds, more well-managed funds, and provide less volatility helping to dampen returns. These more defensive assets help to create a better full cycle income portfolio.

One thing we want to do in the future is to introduce and add NAV-traded funds into the Core when discounts are tight. The objective being that with an ETF for example, the price is tethered to the NAV preventing most discount risk – or the risk that the fund’s share price will fall much more than its NAV during a downturn.

The objective being to capture the tailwind of closing discounts but to rotate out of at least some of them so as to not experience the re-widening. However, this can be a game of chicken. The tight discount environment can exist for a number of months or even years. By swapping out too early you can be giving up significant higher yields and returns. Swapping too late and you can experience what occurred in late February and March – a fast declining share price.

This is why we call it a game of chicken.

But without a crystal ball there’s no way of knowing when the end of the tightening cycle is here and discounts are about to widen back out. So what we typically do is gradually reduce and reposition. What does that look like?

  • Reducing overall exposure to CEFs in favor of open-end funds (ETFs, OEFs)
  • Shifting from higher-valuation funds (tighter discounts) to wider discount funds
  • Shifting from higher leverage to lower leverage funds within the same category
  • Swap from higher risk categories and funds to lower risk categories and funds.

It was this latter point that we were doing for most of the last several months prior to the COVID-19 crisis hitting. By shifting away from high yield which was trading tight to treasuries as well as having relatively tight discounts to NAV, we reduced the downside risk. For example, we bought heavily into both tax-free and taxable munis including:

  • Blackrock Municipal Bond (BBK)
  • Guggenheim Taxable Muni (GBAB)
  • Blackrock Taxable Muni (BBN)
  • Nuveen AMT-Free Quality (NEA)

As well as adding new mortgage exposure including from DoubleLine Opportunistic Credit (DBL) and Putnam Premier Trust (PPT). The former fund is more a “high yield” exposure through non-agency MBS. The latter is more investment grade with agency MBS. The difference being that agency MBS is purchased by the Fed and backed by the government. Non-agency are third-party labeled originations of the mostly subprime variety.

Risk assumption in the portfolio is extremely important and should be considered all above else. But again, most investors are too busy being swindled by fake unearned yields and wide discounts that are usually there for a reason.

Lastly, on performance. While the portfolio has struggled to recoup the market value levels of February, they are slowly recovering. This is indicative of the bond market and the lower liquidity compared to equities. What we often see are the underlying bond take the elevator down as liquidity dries up and price fall fast. Eventually, bargain hunters enter and the bonds stabilize and start to recover. But they take the stairs back up. That’s what we are seeing today.

I’m cautiously optimistic about NAVs in certain areas of the fixed income CEF space. They continue to climb back albeit much slower than other areas of the markets. But remember, in the meantime we can reinvest coupons at higher coupon rates. For example, with PIMCO Dynamic Income (PDI), the current yield is 10.60%. However, in mid February, the yield was 7.98%. By reinvesting that $0.2205 per share per month back in you are increasing your overall yield. This is especially the case if you are using their DRIP.

Concluding Thoughts

We continue to hold in our “Portfolio Upgrade” positioning favoring those higher quality positions. While we have some exposure to some higher risk assets we believe we are not adequately being compensated for those risks and the lack of visibility.

So here we sit, hunkered down in those categories in funds that we think, while slightly on the expensive side, provide better protection. This is a very fear-driven market. First the fear of an unknown pandemic driving people out. Then FOMO, a fear of missing out.

Even accounting for some of the “rebound laggards” like value stocks, returns on multi-asset portfolios since the bottom in late March have been the strongest ever. And since price momentum tends to track growth momentum, we believe there are reasons to remain positive but realistic about future gains.

With both equity and credit valuations appearing to be fair-to-expensive rather than cheap, whether you judge them based on short-term technical measures or long-term fundamental, there’s little to no risk premium for new shocks to the market.

This is why we have created these Better Income Models to help do-it-yourself investors AND financial advisors navigate the current environment without being so defensive that their portfolios earn nothing. This is going to be a big problem for investors going forward.

Our Yield Hunting marketplace service is currently offering, for a limited time only, free trials and 20% off the introductory rate. 

Our member community is fairly unique focused primarily on constructing portfolios geared towards income. The Core Income Portfolio currently yields over 8% comprised of closed-end funds. If you are interested in learning about closed-end funds and want guidance on generating income, check out our service today.  We also have expert guidance on individual preferred stocks, ETFs, and mutual funds.

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Disclosure: I am/we are long CORE PORTFOLIO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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