“Any team can win” -Terry Bradshaw
In the previous three alt.Blend posts, we covered:
- Living longer coupled with a low-rate environment poses serious challenges to investors; however, similar to positively affecting life expectancy, there are things we can do to increase portfolio longevity.
- For a portfolio to be sustainable, ideal attributes include a growing income stream, asset-price appreciation, and reasonable volatility.
- There is no direct replacement for the value that US Treasuries (“the A-team”) has added to portfolios of the past, and other standard bond holdings – such as the Barclays Aggregate or High-Yield corporate bond indices – likely won’t provide the risk/return/income characteristics they have previously.
- => We have to a) rethink fixed-income allocations and solutions, and b) reframe our expectations for the role fixed income will play in a given portfolio.
With that as our backdrop, this current edition will start to focus on strategies that can play a more substantial role in the fixed income portfolio of the future, aka “the B-squad.” It’s also worth a quick reminder that:
- “Treasuries” refer to bonds explicitly backed by the US Government, arguably involving no credit risk for the bondholder, while
- “Credit” implies bonds issued by corporations, asset-backed loans, securitized structures, or unsecured debt; in this case, the value of the bond not only hinges upon interest rates but also the ability of the underlying borrowers to pay their debts (aka credit risk), market liquidity, and other factors.
Treasuries
I’m including this section to clarify that I don’t expect or believe that Treasuries should or will be eliminated from all portfolios. But, since return expectations are so low, they may provide little value beyond relative stability and a source of funds to rebalance into other asset classes during downturns. In the COVID onset (March 2020), we saw some of the most high-quality credit holdings suffer, while Treasuries benefitted.
Core Fixed Income
In order to target reasonable returns (by today’s standards), the new approach involves taking on more credit risk than was needed in the past. At the same time, investors are now being compensated much less for the risks they’re taking. According to a 1/15/21 update from Strategas, “thanks to record-low rates and spreads, the amount of yield bond investors are earning for each unit of duration has fallen to the lowest level in the last three decades…it would not take much of a move in yields to wipe-out the income return on the index or a fund tracking it.”
Our goal is to find strategies that provide acceptable risk/return/income potential while also differing enough from one another to result in some diversification benefit. First, a few ideas on the liquid side can replace or complement traditional fixed income. The overarching theme involves reducing duration while seeking diversification across credit risks and the liquidity spectrum.
Less Sensitivity and Extra Credit
Reducing the effective duration of a fund – either through owning bonds that are short-term or hedging interest-rates using derivatives – can help mitigate interest-rate sensitivity. Instead of just corporate bonds, many managers are now incorporating asset-backed securities (ABS), residential mortgage-backed securities (RMBS), and commercial mortgage-backed securities (CMBS) to help enhance yield and income expectations.
Within the credit space, analysts can also uncover lower credits or unrated bonds with relatively good risk/reward opportunities. As one example, municipal bond markets are particularly well-suited for deep credit work. The universe of muni bonds is large and diverse (think of every small town and its municipal projects, schools, etc., that may be funded by bonds), and this means that many will fly under the radar of analysts and bond-rating agencies.
Shorter-Duration Funds
There are many mutual funds and ETFs with an ultrashort- or short-duration focus (both taxable and municipal versions) that include many of the segments mentioned above. Also, “absolute return” bond strategies often maintain a relatively short duration because their goal is to generate positive-return in any environment, so they need to limit interest-rate sensitivity. All of these funds will vary significantly across several areas, including:
- Credit quality: investment grade (IG) vs. high yield (generally, an S&P rating of BBB or above, or Moody’s Baa or above is considered IG)
- Effective duration: this will help you understand the interest-rate sensitivity of the fund, expressed in years
- Management: active (most mutual funds) or passive (most ETFs)
- Experience: track-record of the fund and its portfolio managers (“PMs”)
- Flexibility: can the fund “go anywhere” and “do anything” (global, long or short credit, etc.), or is it more limited in its mandate?
- Composition:
- Number of holdings
- Does it hold bonds that mature in the near-term or instead hold longer-duration bonds that are hedged with derivatives to shorten effective-duration
Given the wide range of options, it‘s essential to understand what you own and believe in the strategy in various market environments. If a given fund has performed differently from its peers, it is likely due to a difference in holdings and related risks. Even if the names are similar – e.g., “short duration fund A” vs. “short duration fund B” – the two could be significantly different.
Even though high-quality strategies in this space are typically very stable, during March of 2020, we saw many of these funds decline between 5 and 8%, and they now have returned between 1 and 3% over the past 12 months, with a couple of outliers that have done better (Source: Factset, 2/19/21). The decline was due to a more subdued version of the pricing dislocation we covered in the last alt.Blend (Marky Market & the Unfree Lunch).
What to expect: relative stability; dividend yields ranging between about 1 and 3%; durations ranging between 0 and 3 years.
Credit Opportunities: RMBS, ABS, CMBS
While you may find some exposure to these areas in the aforementioned short-duration funds, there are also standalone strategies that primarily hold ABS, RMBS, and/or CMBS, and they’re worth spending a couple of paragraphs on because the risk/reward experience can vary so significantly.
Many readers are familiar with RMBS since these were a central focal point of the 2008 Financial Crisis. They are securities comprised of many underlying residential mortgages (those many mortgages are “securitized” by banks into neat packages or bonds/notes that can be easily traded). All is well if the homeowners (borrowers) pay their mortgage and interest, as these payments flow through to the RMBS bondholders; if they don’t pay, however, then bondholders have a problem.
Some risks can be mitigated via strong underwriting: borrowers with strong credit ratings, home equity (people don’t like to walk away from equity), and – in instances where payments are missed – recovery mechanisms. Going into the Crisis, borrowers had bad/no credit in the first place (“subprime loans”). They then walked away from homes in which they had no equity (what’s the downside?), leaving RMBS holders to try and recover value from properties where prices had utterly collapsed.
As of 2/17/21, two RMBS mutual funds on my “dashboard” have returned -9% and -27% over the past 12 months, after enduring drawdowns of about -43% and -67%, respectively, in the COVID onset of 2020; i.e., these experienced an even more severe drawdown than equity markets, along with a far slower recovery (Source: Factset, 2/19/21).
RMBS is a subset of Asset-Backed Securities (ABS), but the concept is similar. Instead of mortgages, the underlying holdings of ABS are often credit card receivables, home equity loans, or auto loans; i.e., these are the assets that back the securities.
CMBS is another subset of ABS where the underlying assets are commercial mortgages rather than residential mortgages. The return, yield, and volatility profile will vary significantly across commercial property types and associated risks.
What to expect: attractive yield and performance in most market environments, but potential for very substantial volatility during severe market selloffs because of pricing dislocation in credit markets (caused by limited liquidity, leverage, and forced selling).
Credit Arbitrage
Credit arbitrage (aka “credit arb”) is partially a subset of merger arbitrage ( “merger arb”), which is a well-known alternative strategy that tends to exhibit low correlation to traditional markets in various environments. Simply put, merger arb attempts to take advantage of two companies that are planning to merge through taking long or short positions in equity, debt, or options of those companies.
Typically, when one company acquires another company, it benefits the target company’s stock price and hurts the acquiring company’s stock price. Thus, a fundamental merger arb strategy is to be short the stock of the acquirer and long the stock of the acquiree. If implemented correctly, this can minimize the impact of stock-price movements (hence the low correlation to markets) while making money from the convergence of the two stocks IF the deal goes through.
Credit arb focuses on the companies’ debt instruments to accomplish a similar goal: take advantage of M&A and other corporate events. Essentially that means greater stability and more limited return potential vs. merger arb, but those may be good attributes because we want this to be a fixed income replacement. Importantly, it can also perform well during periods of rising rates, giving it an advantage over many traditional fixed income strategies. As long as there are normal levels of M&A and market volatility, then the opportunity set tends to be decent for this space.
Unlike the other areas we’ve covered, liquid solutions in this space are pretty limited. One example of a credit arb mutual fund pays close to a 3% yield. The same fund dropped almost 9% during March of 2020, but has now returned nearly 7% over the past 12 months (Source: Factset, 2/19/21). Rather than standard duration measures, these funds may instead use “duration to event,” since the event (merger, spinoff, etc.) is the timeframe of interest.
What to expect: more risk/return than most short-duration funds; opportunity for diversification vs. both equity and other fixed-income holdings.
[Aside: Merger arb is a subset of “event driven” strategies, which include other corporate events, like spinoffs (the opposite of a merger), tender offers, activism, and there are many complexities come into play when considering all of the senior and junior equity, debt, and deriviatives that can be used to try and capitalize on these situations. Many of those other events can often be included in a merger arb or credit arb strategy, so they are more accurately event-driven funds. If you want to learn more, this Special Situation Investments piece is surprisingly in-depth.]
As this current writing is already getting lengthy, we’ll continue with alternatives and less-than-daily-liquid strategies, like credit hedge funds, private credit, and even private real estate, in the next edition.
Until then, this is the end of alt.Blend.
Thanks for reading,
Steve
