BXSL - Income Opportunities For A Heightened Volatility Environment

Summary

• Market volatility has risen significantly over the first half of the year from its more subdued level over 2021.
• We highlight a number of investment strategies that address this elevated level of market volatility.
• These strategies range from higher-quality longer-duration bonds to floating-rate assets as well as to MBS and CLO Equity.
• Allocating to the income space with an eye to the current market regime is less likely to lead to negative surprises for investors.

This article was first released to Systematic Income subscribers and free trials on Aug. 24.

After a steady uptrend since the end of Q1 2020, markets turned significantly more volatile this year. For instance, stocks, as measured by the S&P 500 index, saw a 24% drawdown peak-to-trough in the first half of the year which was followed by a 17% rally which is now in the process of reversing.

We don't know whether this more volatile market is here to stay or whether it's a passing phase. Whatever it is, this higher volatility environment is something that income investors should take into account in their allocation. In this article we highlight a few income investing strategies that take this more volatile market environment into account, ranging from more defensive to more aggressive. What these strategies have in common is that they recognize the nature of the current market environment without giving up on yield.

One of the most unnerving things that income investors saw over the first half of the year is that just about all income assets sold off in unison. This runs counter to the typical dynamic between bonds and stocks where high-quality bonds typically rise when stocks fall and vice-versa.

However, it's important to keep in mind that bond/stock correlation is not always positive or constant. Specifically, investors need to understand that the source of the shock often determines whether bonds and stock returns can offset each other.

If the shock comes from the equity market e.g. from corporate earnings, margins etc. then bonds do tend to offset moves in stocks. However, if the shock comes from the fixed-income market e.g. inflation, monetary policy mistakes etc. then bonds tend not to offset drops in stocks and, instead, fall alongside stocks.

The good news recently is two-fold. First, bond yields have risen sharply - 10Y Treasury yields stand 2.2% above their early-2022 levels. And, perhaps more importantly, the negative correlation between bonds and stocks has reemerged. In other words, bonds have started to behave more like they do historically and are starting to offset the drops in stocks.

The chart below shows that in the period of 2015 - 2019 Treasury and stock returns have tended to exhibit a negative correlation. However, this changed in 2020 and, more so, in 2022 when bonds and stocks have tended to move together. The focus on inflation by the Fed and their willingness to push the economy into recession to rein in inflation means that what's bad for bonds is also now bad for stocks.

If this behavior continues, as we expect, it, once again, makes higher-quality longer-duration bonds more attractive. This includes municipal bonds which could outperform in a "typical" recession when Treasury yields fall and credit spreads rise.

In this sector we like the mutual fund Invesco Rochester Municipal Opportunities Fund ( ORNAX ) with a 4.61% yield. ORNAX has a 5Y total return of 4% which is 2-3x the average Muni fund and that includes CEFs. We also like the CEF Nuveen Municipal Credit Income Fund ( NZF ), trading at a 5.3% yield and a 5.9% discount. The fund has an above-sector yield, wider than average discount and it has outperformed the average muni CEF by over 1% per annum over the last 5 years in total NAV terms.

Judging by Fed Funds futures the market consensus is that the Fed will start to reverse its previous hikes before the second half of 2023. The Fed itself, via the dot plot, as well as governor commentary, has been quite clear that they don't intend to unwind hikes this quickly and, in fact, expect to keep raising the policy rate over 2023, if not at the same rate as now.

This divergence in views between the Fed and the consensus presents an asymmetric risk profile for markets in two ways. First, short-term rates could keep rising higher than markets expect. And two, greater tightening in financial conditions than the market expects could result in another bout of market weakness.

This is why we continue to favor floating-rate preferreds and BDCs with significant income beta to higher short-term rates. On the higher-quality side we like floating-rate bank preferreds such as ( PNC.PP ) and ( VLYPO ). Banks are in very strong shape this time around with large capital buffers. Investors may recall that the banking sector was one of the few rocks during the last brief recession.

On the higher-yielding side we also like a number of BDCs such as ( GBDC ) and ( BXSL ) which are still trading at attractive valuations and which boast strong income upside to rising short-term rates. Clearly, a hawkish Fed surprise can push markets, including higher-beta assets like BDCs lower. However, unless we see a significant deterioration in corporate credit fundamentals, BDC NAVs are likely to stay much more resilient than prices. For instance, despite credit spreads rising 2.5% over Q2, BXSL and GBDC NAVs fell only 0.9% and 1.4% (total NAV returns were positive in Q2), with no increase in non-accruals and no realized losses.

Finally, investors can also take advantage of the rise in volatility by monetizing it. For example, mortgage assets such as agency and non-agency MBS can be thought of as callable bonds i.e. bonds with an embedded short option from the perspective of the investor - short, because the borrower can exercise the option and refinance the mortgage. Because interest-rate volatility has increased significantly, it makes sense, from this view, that mortgage valuations (e.g. mortgage option-adjusted spreads) have cheapened.

This can allow investors to, indirectly, sell volatility via a position in mortgage securities. More aggressive investors can choose to express this view via a position in mortgage REIT common shares. Our own approach is to allocate to mortgage REIT preferreds which add a layer of safety for investors while delivering very attractive yields. For example we continue to like the ( NLY.PF ) and ( DX.PC ). NLY.PF will float with a coupon of 3-month Libor + 4.993% which will equate to a yield of around 8.4% at the current level of Libor which will almost certainly keep rising as the Fed continues to hike.

Finally, the CLO Equity sector can also benefit from an elevated level of volatility. This is because CLO Equity securities have a debt profile with fixed credit spreads but can reinvest portfolio loan repayments into loans priced below par. This can result in not only an increase in net income to the strategy but also generate capital gains as loans repay at par. At the moment we view CLO Equity funds such as OXLC and ECC as very expensive, however, investors can take advantage of baby bonds issued by the funds which have significant protections and very high levels of asset coverage. Specifically, we like the OXLC 6.75% 2031 bond ( OXLCL ) trading at a 7.2% yield.

Takeaways

We don't know whether this higher-volatility regime is here to stay. However, what is clear is that investors shouldn't ignore this feature of the current income market. Investors can allocate to income securities that can perform well and deliver an attractive level of yield if volatility continues to be elevated over the medium term. Taking into account the current market regime as well as diversifying across a number of strategies that are mindful of it is more likely to allow investors to reach their goals.

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