BBDC - Key Income Lessons Of 2023

2023-12-29 07:27:09 ET

Summary

• In this article, we highlight the key lessons of 2023 for income investors.
• These include keeping an eye on the Fed cycle, investment vehicle diversification, relative value and tactical opportunities as well as using valuation as the key allocation principle.
• These lessons are not unique to 2023 and are likely to keep delivering for income investors who take them into account in their allocation.

This past year had a large number of pivots, ranging from monetary policy to interest rates to various sectors such as banks and commodities. With so many twists and turns it can be hard for investors to find their footing in the income market landscape. In this article we take a look at a number of lessons that this year has delivered. These lessons will also likely come in handy over the following years as well.

Many income investors stick primarily with CEFs with the view that the sector provides enough diversification to perform well across various market environments. However, this year, it really paid to look beyond this traditional income structure and diversify across income investment vehicles . Specifically, it made sense to overweight BDCs in income portfolios. The chart below shows the total return of ETF proxies for both CEFs (via YYY) and BDCs (via BIZD). BDCs finished the year miles ahead of the broader CEF space.

This may not seem like a fair comparison as BDCs hold primarily floating-rate instruments and short-term rates zoomed higher this year. However, this comparison actually favors CEFs because corporate bond yields are now lower than when they were at the start of the year (credit spreads are tighter and Treasury yields are roughly flat) which have supported CEFs more than BDCs from an NAV perspective as the average credit CEF has a longer duration than BDCs. And as far as equity CEFs go, stocks, as gauged by the S&P 500, have outperformed BDCs this year. In other words, even with the stock and bond market tailwind behind them, CEFs underperformed hugely.

There are several reasons for this. One, BDCs are much less prone to deleveraging than CEFs. Market volatility was pretty high this year which has whipsawed CEF NAVs, leading to occasional deleveraging which, in turn, led to a locking in of economic losses.

Two, BDC valuations have held up much better than those of CEFs. The average BDC is trading at a small premium while the average CEF is trading at a high single-digit discount. BDC discounts have held up well due to dividend increases over the past couple of years.

One might think that loan CEF discounts should have held up well however they haven't - the average loan CEF is trading at a 7% discount, better than the average CEF but hardly anything to write home about. This is likely for the simple reason that BDCs have been able to deliver significantly higher net income gains than loan CEFs as roughly half of their leverage cost is fixed and has not increased with short-term rates whereas loan CEFs have almost entirely floating-rate leverage instruments.

Although BDC outperformance may seem like a lucky break, the reality is that investors don't have to be geniuses to know that the sector would benefit from a rise in short-term rates. At the start of 2022, short-term rates could only go up and when the policy rate moves, it tends to move quite a bit, as the Fed tightens or eases policy.

When BDC prices started to fall in 2022 as a result of broadbased risk-off sentiment, it offered a very good opportunity to lean into the sector as we did in our Income Portfolios.

What about now?

Clearly, the combination of somewhat elevated valuations (much higher than CEFs and slightly above the historic average) as well as a likely step-down in income due to lower short-term rates over the medium term means BDCs are less attractive at the moment than they have been for most of the post-2022 market environment. So while we have reduced our BDC allocation we continue to hold BDCs with a greater margin of safety as well as those with higher-quality portfolios.

We continue to like companies like OBDC, ARCC and GBDC in the BDC space.

This past year has also been rich in tactical opportunities which have delivered high levels of alpha, many of them at double-digit levels over a relatively short amount of time.

These included the Carlyle Credit Income Fund ( CCIF ) which offered investors a tender offer while trading at a significant discount, something we discussed at length on the service and summarized in a separate article . A total return of around 10% for several weeks of work was a good result for investors.

Another was the FS Credit Opportunities Fund ( FSCO ) which we discussed first in April as a potential tactical opportunity when it was trading at a 35% discount which has since tightened to sub-20% and should continue to tighten from here. The total return was 45% from publication.

Finally, we highlighted the Barings BDC ( BBDC ) in June when its valuation was trading at a 26% discount to the sector average valuation. The total return was 20% from publication.

Apart from the potential to generate excess returns over relatively short periods, tactical opportunities also allow investors to learn about various features of the market and how they tend to play out. This knowledge can then be compounded and put to use at later dates.

At the moment we continue to like the PIMCO Dynamic Income Strategy Fund ( PDX ) which trades at a significantly wider discount than its PIMCO counterparts. Some of this is deserved given its relatively high fee and Energy focus, however, we expect the valuation to outperform over the medium term as its distribution rate is hiked in line with its higher level of net income.

The past year, once again, showed the value of drier-powder securities , or assets that deliver attractive yields despite their lower-beta profile. These securities are useful because they typically outperform the broader income market in a sell-off, without incurring a large yield opportunity cost.

This year has seen a number of market hiccups due to various factors, some expected, such as fairly hawkish Fed communication and others not, such as the Bank mini-panic. What drier-powder securities have in common is that they tend to hold their value during these risk-off episodes. For instance, while many income securities had double-digit drawdowns this year, drier-powder securities tended to see drops of low-single digits.

It is during these episodes that they come in especially handy as they allow investors to rotate to higher-yield alternatives on their watchlist from this more stable source of capital. We continue to like shorter-maturity baby bonds such as OXSQZ and OXLCZ with yields well north of 8%, particularly as credit valuations are quite rich at the moment.

Something else that generated a lot of value this year has been our relative value approach . Specifically, over the last couple of years we have identified a number of relative value pairs whose valuation divergences offer attractive rotation opportunities. These candidates are typically highly correlated either because they tend to hold very similar portfolios (e.g. intra-sector CEFs of the same manager) or by being preferreds or bonds of the same issuer.

For instance, the chart below shows our relative value rotation strategy between two Cohen preferred CEFs. The blue line, which highlights the strategy, shows that it has significantly outpeformed the individual CEFs.

The strategy has, in fact, delivered enough alpha to be the best-performing "CEF" in the sector.

Other pairs where we have successfully applied this approach have been the corporate bond CEF pair of CIK and DHY, mortgage REIT Annaly preferred suite, various high-quality BDCs, baby bonds of the same issuer such as Saratoga Investment and others.

Finally, we continue to use valuation as the key allocation guide rather than macro or market forecasts. This is not only because many forecasts at the start of the year, such as a recession or a cascading wave of bank failures never came to pass, but that valuation gives you a higher margin of safety regardless of what actually happens.

We use a countercyclical approach alongside valuation measures. That is, we tilt to higher-yielding / higher-risk assets when yields rise and vice-versa. Many income investors tend to do the opposite - when yields fall they tend to stretch on the risk spectrum for higher-yielding assets because it feels safe to do so as "the times are good". However, this strategy is typically punished with severe drawdowns that limit the opportunity to add these assets at much lower prices.

Recently, we reduced some of our high-yielding assets as yields have fallen significantly and credit spreads are historically very tight. We plan to use our drier-powder allocation, as highlighted above, to pick up higher-beta assets during the next drawdown.

Takeaways

Overall, 2023 was not particularly unique and many of this year's lessons are the same ones we have seen in prior years. Keeping an eye on the Fed cycle, investment vehicle diversification, relative value and tactical opportunities as well as using valuation as the key allocation principle are strategies that continue to deliver for investors. Amid market volatility and macro twists and turns, it can be easy to lose sight of these reliable drivers of performance. However, just as in 2023, they are likely to keep delivering for investors next year and beyond.

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