Income Investing in an Uncertain World | Part 2

Author: Nathan Rowader
Date: January 20, 2017
Category: Alternatives, Financial Planning
Tags: , , ,

In the first part of this series, we outlined the risks associated with achieving long-term investment objectives in a low interest rate world. The solution we outlined increased exposure to higher income assets such as high yield or emerging market corporate bonds. As we indicated however, increasing the exposure to these asset types indeed increases the risk of the overall portfolio in terms of volatility and maximum drawdown. This presents a conundrum: Should an investor merely accept more risk or is there a better way to manage the increased level of risk and still increase the overall income from the portfolio?

Active Selection to Manage Risk

The first thing to examine is whether or not it’s possible to actively select certain parts of the bond market in order to improve the yield while reducing the risk of the overall portfolio. We start with a simple analysis and select bonds that currently exhibit the highest level of income. Since the goal is to generate more income for a portfolio, then simply adding higher income bonds could be a solution. Below is a list of a wide range of different bond asset classes that are suitable for this analysis.

Figure 1: Bond Asset Class

Emerging Market Corporates Investment Grade Credit
Emerging Market Sovereigns Mortgages
Foreign Sovereigns Municipal Bonds
High Yield Credit Short Term Treasuries
High Yield Municipal Bonds Treasuries

See asset class key for more details.

Next, let’s examine the results of a portfolio that rebalances each month. We assigned each asset class a letter grade based on the current yield. Each letter represents a quintile, so A comprises the two asset classes with the highest current yield, B is the next two asset classes with the highest yield, etc. Below are the results of that analysis relative to the benchmark, the Barclays Global Aggregate Bond Index.

Figure 2: Yield Analysis

August 1998 to October 2016

A B C D F Benchmark
Annualized Return 7.65% 7.27% 5.53% 3.39% 2.46% 4.83%
Annualized Volatility 9.81% 6.44% 4.92% 5.95% 3.69% 5.71%
Sharpe Ratio 0.46  0.64  0.48  0.04  (0.19)  0.29
Max Drawdown -33.60%  -20.73%  -13.46%  -14.02%  -6.37%  -10.08%
Avg. Annual Yield 9.50%  6.30%  4.33%  3.02%  1.75%  3.30%

Source: Salient Partners, L.P., Bloomberg as of 10/31/2016

Based on this exercise, a pure yield-seeking strategy isn’t all that bad. Asset classes rated A and B deliver a high level of current income relative the benchmark. While volatility is higher, the higher Sharpe ratio signals the potentially higher reward for an investor. However, the steep maximum drawdown could be unsettling for income investors, most of whom are used to a higher level of consistent capital appreciation. So while this is a decent option, it doesn’t necessarily solve our problem of increased risk.

Momentum represents another option to actively select certain asset classes within bonds. Momentum is the rate of acceleration of a security’s price or volume. In this case, by selecting asset classes exhibiting a high level of price appreciation, an investor can capture momentum because those characteristics tend to persist over time. Below, we rated the asset classes based on 12-month total return, excluding the most recent month. The two asset classes with the highest returns are rated as A, the second highest with B, etc.

Figure 3: Momentum Analysis

August 1998 to October 2016

A B C D F Benchmark
Annualized Return 6.29% 6.60% 4.61% 4.48% 5.75% 4.83%
Annualized Volatility 5.10% 4.57% 4.83% 7.98% 7.74% 5.71%
Sharpe Ratio 0.61 0.75 0.30 0.16 0.33  0.29
Max Drawdown -9.60% -9.00% -15.27% -24.87% -26.16%  -10.08%
Avg. Annual Yield 5.65% 4.87% 4.72% 5.32% 4.47%  3.30%

Source: Salient Partners, L.P., Bloomberg as of 10/31/2016

This analysis reveals the power of momentum. High momentum asset classes, as exhibited in A and B, offer a higher risk adjusted return, higher yield and lower drawdown than the benchmark. When compared to the yield based strategy, the yields are lower and they fluctuate more dramatically. For example, in 2015, the yield would have been significantly lower than the benchmark because low yielding asset classes such as foreign sovereign bonds were in favor.

Now it’s time to explore a combination of higher yields and higher momentum. In the final example, we examine a portfolio that is 50% A and B from the yield analysis and 50% A and B from the momentum analysis.

Figure 4: Momentum & Yield Analysis

August 1998 to October 2016

Momentum & Yield Blend Benchmark
Annualized Return 7.05% 4.83%
Annualized Volatility 5.13% 5.71%
Sharpe Ratio 0.76 0.29
Max Drawdown -9.27% -10.08%
Avg. Annual Yield 6.78% 3.30%

Source: Salient Partners, L.P., Bloomberg as of 10/31/2016

Now we have a good-looking strategy! The combined version delivers the best risk adjusted return of any single strategy version while delivering higher income and better capital preservation than the benchmark. The income is generally stable as well, delivering above benchmark income in all market environments. Dare we tempt the fates and see if we can improve? Of course we do, but that will be the subject of a future post.

DISCLOSURES

Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.

This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

Nathan J. Rowader is a registered representative of ALPS Distributors, Inc.

 

ASSET CLASS KEY:

Emerging Market Corporates: CS Emerging Markets Corporate Bond Index Investment Grade Credit: Bloomberg Barclays U.S. Credit
Emerging Market Sovereigns: Bloomberg Barclays EM Sovereign Mortgages: Bloomberg Barclays U.S. MBS
Foreign Sovereigns: Bloomberg Barclays Global Treasury ex USD Municipal Bonds: Bloomberg Barclays Municipal Bond
High Yield Credit: Bloomberg Barclays US Corp High Yield Short Term Treasuries: Bloomberg Barclays US Treasury 1-3 yr
High Yield Municipal Bonds: Bloomberg Barclays Muni High Yield Treasuries: Bloomberg Barclays U.S. Treasury

 

DEFINITIONS

Credit Suisse Emerging Market Corporate Bond Index consists of U.S. dollar-denominated fixed-income issues from Latin America, Eastern Europe and Asia.

Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the USD-denominated, noninvestment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below.

Bloomberg Barclays EM Sovereign is a rules-based market-value weighted index engineered to measure the fixed-rate local currency sovereign bonds issued in emerging markets as identified by Bloomberg.

Bloomberg Barclays Global Treasury ex USD is an unmanaged index composed of those securities included in the Barclays Global Aggregate Bond Index that are Treasury securities, with the US excluded while hedging the currency back to the US dollar.

Bloomberg Barclays Municipal Bond covers the USD-denominated, long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds.

Bloomberg Barclays U.S. Credit is an index composed of corporate and non-corporate debt issues that are rated investment grade (Baa3/BBB) or higher.

Bloomberg Barclays U.S. MBS tracks the mortgage-backed pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC).

Bloomberg Barclays Municipal Bond covers the USD-denominated, long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds.

Bloomberg Barclays US Treasury 1-3 yr is an unmanaged index of public obligations of the U.S. Treasury with a remaining maturity of one year or more.

Emerging market is a country that has some characteristics of a developed market but does not meet all of the standards to be a developed market.

Max drawdown is the percentage of loss that an asset incurs from its peak net asset value to its lowest value.

S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.

Sharpe ratio is a ratio developed by Nobel laureate William F. Sharpe to measure how a fund performs relative to the risk it takes.

Standard deviation measures the degree to which a fund’s return varies from its previous returns or from the average of all similar funds.

U.S. Treasurys are marketable U.S. government debt securities with fixed interest rates and maturities.

Yield is the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost or on the U.S. government’s debt obligations.


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