JPI - 6-8% Yielding Baby Bonds - Heroes Of The 2022 Income Market

• The drop across the income investment space has been both broad and deep, hitting just about every type of asset.
• We take a look at which features have enabled some securities to weather the storm more successfully than others - we find these features more prevalent in shorter-maturity baby bonds.
• We also discuss the mechanics by which investors can utilize more resilient securities to sustainably grow the income level of their income portfolios over time.
• And highlight examples of baby bonds that have remained resilient as well as a number of securities that have fallen harder which we are rotating into.

This article was first released to Systematic Income subscribers and free trials on June 22.

The broad and deep drawdown we have seen this year across the income space has been disorienting and painful for many investors. If there is a plus side, it's in the fact that along with capital losses it provided a number of important takeaways. These takeaways are not particularly unique to the current market drawdown but tend to show up again and again. This suggests that they are valuable not only to understand the current drawdown but also to use in thinking about portfolio allocation for the next inevitable drawdown as well.

In this article, we focus on the particular features of income securities that have allowed some to weather the storm more successfully than others and highlight examples of these securities, many of which we have held in our Income Portfolios since 2021. We also discuss how investors can use more resilient securities to grow the income level of the portfolios over time by rotating into assets that have fallen harder.

Some Key Income Takeaways (so far) of 2022

To set the stage and provide some context let's take a look at the lay of the land in the income space. The following chart shows how different sectors have performed so far this year.

Many investors tilt primarily to CEFs so this is how the various CEF sectors look in total price return terms year-to-date.

Many income investors are not only interested in the level of income they derive from their portfolios but also want a measure of resilience or stability in their portfolios. Seeing a portfolio cut in half is not particularly pleasant. More importantly, it can trigger negative behavioral tendencies such as selling out at the lows only to buy back higher. Steep portfolio drawdowns can also make it difficult for investors to reallocate to emerging opportunities as there is simply less capital to go around. Finally, as many CEF investors are well aware, steep CEF drawdowns often lead to distribution cuts on the back of deleveraging - we have already seen a number of forced deleveraging in the space such as in the PIMCO taxable, Nuveen preferred and BlackRock Taxable Muni funds. Most importantly, however, holding resilient securities can grow portfolio wealth and income over time - we show an example in the next section.

If we look across the broader income space, what we see is that there are four main features that have allowed some securities to remain resilient this year. They are decent quality, short / medium maturities / lack of embedded leverage and lack of discount mechanics. Let's go through these in turn.

By decent quality we just mean that a given security doesn't have to be AAA or even investment-grade - it just can't be very low quality i.e. an equivalent of B / CCC in rating agency parlance. This is for the simple reason that a very low quality security is much more vulnerable to a downturn in the macro picture.

Turning to maturity, we explicitly focus on short / medium term maturities rather than, say, duration because a medium-term maturity limits both interest rate as well as credit spread sensitivity. This is also why we like to make a distinction between interest rate duration (what people mean when they speak of duration) and credit duration.

For example, a 5-year bond will roughly have an interest rate and credit duration of 4.5. This means that a 1% rise in interest rates will cause the bond to fall in price by roughly 4.5% and a 1% rise in credit spreads will also cause the bond to fall in price by 4.5%. A 5-year loan by contrast will roughly have a duration of zero and credit duration of 4.5, meaning its price will be broadly insensitive to changes in interest rates but it will be as sensitive to changes in credit spreads as a 5-year bond. The key point here is that a loan can still be very sensitive to the overall market even if it is not sensitive to changes in interest rates.

Another key point is that a 3-year bond, for example, will be about half as sensitive as the 5-year bond to changes in interest rates and credit spreads and also half as sensitive as the loan to changes in credit spreads.

By lack of embedded leverage what we mean is leverage undertaken by the security itself, i.e. a leveraged CEF for instance. The point here is simple - the higher the leverage the more it magnifies the losses in the underlying asset. A typical CEF with 30% leverage holds 50% more assets than its net assets, i.e. for each $1 of NAV there is around $1.50 of assets. This means that a 10% drop in asset prices translates into a 15% drop in the NAV. This makes it difficult for funds carrying explicit leverage to maintain resilience.

By lack of discount dynamic we mean securities that don't trade at a discount to NAV such as bonds or preferreds in contrast to securities that can trade at a discount to NAV such as CEFs and BDCs.

Many investors loaded up on loan CEFs coming into the year with the view that interest rates were obviously going to rise and loans would be a great place to be because their prices would be insensitive to rising rates and their coupons would increase.

Loan CEFs are down about 18% so far this year - this is clearly not as large as the 24% drop in High-Yield Corporate Bond CEFs, but it's a long way from zero. More than half of this drop is attributed to the widening of the discount. This is because discounts tend to be procyclical - they widen during risk-off periods and vice-versa. This makes it difficult for CEFs, even those allocated to higher-quality assets, to remain very resilient.

A quick word about the Energy sector before we move on. It is true that Energy has done OK so far this year - MLP funds are up in the mid to high-single digits. However, it's important to point out that the sector has just deflated by around 20% in the last two weeks. The reason is simply that Energy is a cyclical sector and recession estimates have risen sharply recently on the back of the evident willingness by the Fed to drive the economy into a tree in order to get inflation down to a more reasonable level. If the macro picture continues to worsen, we would expect the Energy sector to move into the red. Overall, its high volatility and cyclicality makes Energy a poor candidate in the resilient bucket of income portfolios in our view.

A Look At Baby Bonds

What all of this comes down to is that shorter-maturity bonds are a type of security that can boast all of the above features. On the service we maintain a watchlist of about 20 baby bonds that can fit the bill - an extract is shown below. The average bond in this list is down just 2.9% so far this year.

Even though bonds are pretty vanilla financial instruments they can sound exotic to investors more used to ETFs and CEFs. However, baby bonds are traded as easily as CEFs. Many of the baby bonds we follow are issued by household income investment vehicles such as mortgage CEFs, REITs and BDCs though traditional companies also issue baby bonds. Not all baby bonds have moderate maturities - some have very long maturities so investors need to be choosy.

To illustrate how holding some resilient securities can increase a portfolio income level over time, let's consider two situations at the start of 2022.

Portfolio Position A holds $10,000 worth of Credit Suisse Asset Management Income Fund (CIK) - a high yield corporate bond CEF. The distribution rate of CIK was around 7.7% at the start of the year, generating $770 a year.

Portfolio Position B holds $10,000 worth of MMB (a made-up moderate maturity bond). MMBs had yields of around 5-7% or so at the start of the year - let's go with 6% - which generates $600 a year. If we use the average drop of around 3% in our Watchlist, that means the value of this position is now $9,700. If the investor decides to take advantage of the dislocation in the market and rotates this amount of capital into CIK which now has a distribution rate of 10.3%, the annual income level now becomes $999.10 or 30% higher than a position that was fully allocated to CIK in the first place at the start of the year.

Of course, an investor could have just held cash to begin with, however, cash has a high opportunity cost given its low yield. In our view, investors can usually afford to take a bit more risk to earn a respectable yield by holding some of the baby bonds we have in mind here. This also makes them less twitchy to put the cash to work at the slightest wobble in markets.

It should also be said that an extended multi-year period without serious drawdowns can allow a higher-yielding / higher-beta portfolio to generate enough income to offset the eventual drawdown. However, sharp drawdowns appear to come around every couple of years like clockwork (2012, 2015, 2018, 2020, 2022) which suggests that a more resilient bucket can deliver a real boost to portfolio incomes over time with the kind of rotation we discussed above.

It should also be said that a portfolio can look like it generates a higher level of income but that is often a kind of optical illusion particularly in the context of fixed-income securities whose negative pull-to-par is not obvious from current yields. In short, the 7.7% CIK distribution rate at the start of the year was well above the fund's actual portfolio yield which was actually closer to 6%. In short, when valuations are high as they were in 2021 the opportunity cost of being in lower-yielding / more resilient assets was actually less than many investors may have thought. This is because in a period of expensive valuations, many higher-yielding CEFs have significantly lower underlying portfolio yields than their distribution rates would imply.

Our Outlook

At this point in the market cycle, we are not adding to our pocket of more resilient securities - rather we are reducing it. That may seem like madness given the price action, but that was their actual role in our Income Portfolios.

For investors looking to keep a few securities in mind to rotate into when valuations move back up, we would highlight the mREIT Arlington Asset Investment 6.75% 2025 bond ( AIC ) now trading at a 7.7% yield (AIC is up 1% year-to-date in total return terms), the XAI Octagon Floating Rate Series A 2026 ( XFLT.PA ) now trading at a 6.7% yield (XFLT-A is down 1% year-to-date) and the BDC OXSQ 6.5% 2024 bonds ( OXSQL ), trading at a 6.7% yield (OXSQL is up 2% year-to-date).

The securities that we are rotating into are higher-yielding assets that have suffered significant drawdowns. As highlighted above, we like corporate credit exposure - yields are not far from the upper level of their range this decade while interest coverage is near a 40-year high and defaults are still exceptionally low. Corporate interest coverage will invariably move lower while defaults will rise but this combination is a good place to start. Refinancing requirements are also very low - only 6% of the high-yield sector is maturing in the next two years.

Our favorite remains the Credit Suisse Asset Management Income Fund ( CIK ), trading at an 8.4% discount and a 10.3% current yield remains our pick in the sector. It features an unusually low fee structure and strong historic outperformance.

We also like household-facing assets such as non-agency RMBS given strong household balance sheets, low level of debt service and a tight labor market.

Here we would again highlight the Western Asset Mortgage Defined Opportunity Fund ( DMO ), trading at a 13% discount and a 10.3% current yield.

We also like higher-quality preferred moderate duration CEFs such as the Nuveen Preferred and Income Term Fund ( JPI ), trading at a 6.5% discount and a 8.25% current yield. Being a Nuveen term fund, JPI is likely to offer investors an exit at the NAV in 2024 which would result in the discount compressing to zero - providing both a nice performance tailwind as well as an anchor in case we see more volatility ahead.

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