LBRDP - Managing Risk In Income Portfolios

2023-05-31 12:52:42 ET

Summary

• Many income investors tend to build their portfolios bottom-up by allocating to whatever attractive opportunities they come across.
• While this can work to an extent, it creates the risk for unpleasant surprises if there is no broader risk management context.
• In this article, we highlight a number of risk management techniques that we find helpful in our own income allocation.
• And highlight some income ideas that fit well into our broader risk management framework.

This article was first released to Systematic Income subscribers and free trials on May 23.

Many investors approach income allocation in a bottom-up way that has some parallels to being a "kid in a candy store." If they see a security that looks appealing, whether due to its attractive yield or potential upside or both, they add it to their portfolio.

This can work well to a point, however, the risk with this approach is that investors can lose control of the broader portfolio risk profile which can lead to unpleasant surprises in case markets lurch one way or another.

In this article, we highlight a number of techniques we like to use which can ensure investors maintain a firm group on the overall portfolio while being able to take advantage of individual opportunities as they come along.

We also highlight a number of securities that can diversify overall portfolio risk exposure and ensure that the portfolio continues to perform in various market scenarios.

A Brief Overview Of Income Risk Management

In this section, we highlight a number of risk management techniques that we have found useful in our own allocation.

An important key lesson of the last year-and-a-half is that risk is not one-dimensional . Many investors view securities on the more-safe / less-safe spectrum, however, this view does not provide an adequate sense of how they might perform in different market environments.

Investors with this one-dimensional view of risk were likely surprised when very high credit-quality securities fell by a third or more during 2022 due to the sharp back-up in interest rates, whereas the typically higher-beta assets like junk bonds and stocks fell by 20-25%.

Many high-credit-quality investment-grade securities have a very long duration, and this caused them to drop sharply last year. At the very least, investors need to consider both credit quality and duration risk factors when allocating to individual income securities.

The second way we like to manage risk is to consider a number of different scenarios which could transpire over the medium term and ensure we hold securities that could benefit in various scenarios. This lowers the potential volatility of the portfolio, makes it easier to remain invested and opens up opportunities for rebalancing (i.e., the only "free lunch" in income investing).

The reality is that even the best investors are surprised by the various twists and turns in the economy and markets, so allocating based on a single outcome is unlikely to achieve investors goals. Ensuring that a portfolio can perform well whatever happens is a better recipe for income allocation.

A third technique is to be wary of securities boasting some of the highest yields , however tempting they may be. While some high-yielding securities are unquestionably attractive, many expose investors to permanent capital and income loss.

What we tend to find is that very high-yielding securities typically fall into one of three buckets. One, they take on an excessive amount of risk, creating the high risk of permanent capital and income loss (particularly when it comes to leveraged vehicles such as closed-end funds, or CEFs, that are prone to frequent forced deleveraging).

Two, they often carry very high valuations, particularly in a CEF format, which not only leaves a lot of yield on the table but also exposes investors to premium collapses.

And three, they often wildly over distribute, either returning investors their own capital or being forced to cut the distribution which also tends to push the premium lower, leading to sharp losses.

A fourth and one of our favorite techniques is to always maintain some exposure to, what we call, drier-powder securities . These securities have modest credit and duration risk and have tended to sail through various market meltdowns with aplomb. These securities include shorter-maturity baby bonds from business development companies, or BDCs, and CEFs, among others.

A fifth technique is to keep calm during drawdowns and take advantage of opportunities at a measured pace . While "backing up the truck" can make a compelling copy, it's typically not a good investment strategy.

Markets can easily overshoot to the downside, so putting all cash to work on the first dip is usually a bad idea. It's important for investors to have a sense of historic market ranges to make sure they can still take advantage of lower prices, even if they end up lower than they expected at first.

A sixth technique is to keep the margin of safety in mind. This includes keeping valuations of assets like CEFs and BDCs in mind. It also refers to the price of various assets like corporate bonds. For example, at the end of 2021, the average high-yield bond traded at a price of around $105 while in October it traded closer to $85. Obviously, a $20 lower price creates an additional margin of safety not only with respect to potential changes in interest rates but also from worst-case scenarios like defaults.

Many investors take the view that "it's better to pay $105 in an environment when the recession is unlikely than to pay $85 when a recession is likely". Our allocation approach is to always anticipate a potential recession in a year's time and make sure that the overall portfolio can remain fairly resilient. This means we dial down risk exposure in the "good times" and dial it up when things look fairly bleak and valuations are much more attractive.

A final seventh technique is to have a sense of opportunity cost at any one time. In income investing, opportunity cost is a measure of what the investor misses out when not taking much risk. This means that when compensation for taking additional risk is small (such as it was in 2021) it can make sense to reduce risk exposure.

For example, as we discussed at the time, CEFs generated very little in additional yield in 2021 through leverage. This may seem counterintuitive because leverage costs were low in 2021, but it's because overall yields were low as well, which means that management costs and leverage costs ate up much of the additional yield provided through leverage. Discounts were very tight also, which further limited the amount of additional yield CEFs could generate. This is the primary reason why we reduced our CEF exposure over 2021 in favor of unleveraged open-end funds and bonds.

Some Ideas

In the context of the current market environment, we find a number of securities attractive.

For example, we continue to like higher-quality Business Development Companies. These securities can continue to perform in the scenario that short-term rates remain elevated for some time while the economy slows down but doesn't crash. In this sector, we like Sixth Street Specialty Lending ( TSLX ) and Carlyle Secured Lending ( CGBD ), trading at 13% and 11.1% yields.

We also maintain exposure to drier-powder securities such as the mortgage real estate investment trust ("REIT") Arlington Asset Investment Corp 6.75% 2025 bond ( AIC ) and the BDC Oxford Square Capital 6.5% 2024 bond ( OXSQL ). These shorter-maturity bonds boast near double-digit yields and have also been very resilient over the last few years.

Finally, we like a number of longer-duration, higher-quality assets such as the REIT Public Storage Series H and Liberty Broadband ( LBRDP ) trading at yields of 5.6% and 8.3%, respectively. These securities should outperform if we see a significant slowdown in macro activity. They are particularly attractive now that longer-term Treasury yields have backed up from their recent lows.

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