Income Investing in an Uncertain World | Part 3

Author: Nathan Rowader
Date: March 10, 2017
Category: Alternatives, Financial Planning
Tags: , , , ,

In the second part of this series, we outlined how a simple ranking system, using yield and momentum as ranking data points, can provide current income in excess of Bloomberg Barclays Global Aggregate Bond Index with a level of risk similar to the index. This process solved the problem of excess risk in a simple buy and hold strategy of high current income asset classes. For the most part, an investor could simply stop at the ranking system and likely get what they need to achieve their financial objectives. But can we improve on the simple ranking system? Yes we can!

Combining Active Selection with Risk Targeting

The goal of risk targeting is to establish a quantifiable level of risk, as measured by standard deviation for example, and then rebalance the portfolio periodically to ensure that this level of risk is held constant across all market conditions. In this exercise, we will attempt to create a portfolio that delivers the highest level of current income at a target standard deviation of 5.0%, with a full monthly rebalance. We chose 5.0% because that is similar to the long-term standard deviation of the benchmark, the Bloomberg Barclays Global Aggregate Bond Index. But first, we have to understand the purpose of risk targeting.

Typically an investor constructs a portfolio around some type of risk tolerance, but the threshold of that tolerance is usually based on some type of long-term average. For example, the long-term average annual standard deviation of the benchmark is 5.72%, but as Figure 1 demonstrates, the standard deviation is frequently above or below that average. As a result, an investor with a quantifiable risk tolerance of 5.72% would feel uncomfortable during 2003—2004 or 2008—2009 due to the sharp capital loss, but would get impatient around 2012–2014 due to the low relative returns. Both of these issues are encapsulated in the sharp changes to standard deviation.

Figure 1: Rolling 52-Week Standard Deviation of the Bloomberg Barclays Global Aggregate Bond Index

December 1999—December 2016

Sources: Salient Partners, L.P., Bloomberg, as of 12/31/2016

 

Risk targeting attempts to smooth out the risk of a portfolio by adjusting allocations so that the portfolio adapts to the current market conditions. Typically, this adjustment means increasing exposure to higher-risk assets, like high-yield bonds, in periods of declining market risk and increasing exposure to lower-risk assets, like Treasurys, during periods of rising market risk. Ultimately, these changes should deliver the most attractive combination of risk and return.

For the purpose of this analysis we will use the same assets as the previous parts of the discussion, as shown in Figure 2. This time, however, we will construct a portfolio with a targeted standard deviation of 5.0% using current income and Salient’s proprietary method for forecasting risk. If you want to do this yourself, you can use something like 3-month risk measure, which will come close to our experiment’s results.

Figure 2: Bond Asset Class

Emerging Market Corporate Bonds Investment-Grade Credit
Emerging Market Sovereign Bonds Mortgages
Foreign Sovereign Bonds Municipal Bonds
High-Yield Credit Short-Term Treasurys
High-Yield Municipal Bonds Treasurys

See asset class key for more details.

Figure 3 shows the results of this analysis compared to the yield analysis from Part 2, specifically highest ranked asset classes of the analysis. As you can see, the risk-targeted version is superior to the simple ranking system.

Figure 3: Yield Analysis

August 1998—December 2016

  A B Risk-Targeted Yield Benchmark
Annualized Return 8.08% 7.18% 7.37% 4.65%
Annualized Volatility 9.53% 6.19% 5.09% 5.75%
Sharpe Ratio 0.52 0.65 0.83 0.26
Max Drawdown -33.60% -20.73% -8.85% -10.08%
Sources: Salient Partners, L.P., Bloomberg, as of 12/31/2016

Next, as we did in Part 2, we examine momentum as another method for gaining access to high income. We define momentum as 12-month return minus the last month of the period. Let’s see what happens when we apply risk targeting to momentum.

Figure 4: Momentum Analysis

August 1998—December 2016

A B Risk-Targeted Yield Benchmark
Annualized Return 8.08% 7.18% 7.37% 4.65%
Annualized Volatility 9.53% 6.19% 5.09% 5.75%
Sharpe Ratio 0.52 0.65 0.83 0.26
Max Drawdown -33.60% -20.73% -8.85% -10.08%
Sources: Salient Partners, L.P., Bloomberg, as of 12/31/2016

Not bad at all! When combining momentum-based active selection and risk management, the portfolio looks pretty good. Finally, let’s put the risk-targeted yield and momentum together and see what we get.

Figure 5: Combining Yield and Momentum

August 1998—December 2016

Risk-Targeted Yield Risk-Targeted Momentum 50/50 Yield & Momentum Benchmark
7.37% 7.37% 7.00% 4.65%
5.09% 5.09% 4.38% 5.75%
0.83 0.83 0.87 0.26
-8.85% -8.69% -7.18% -10.08%
6.72% 5.03% 5.78% 3.30%
Sources: Salient Partners, L.P., Bloomberg, as of 12/31/2016

Once again, when we combine the momentum and yield portfolios we end up with the best portfolio as measured by Sharpe ratio, but there is a problem. When we started this series, we examined the problems with a low-yield world and, while the combined portfolio looks great on a return and risk basis, it has a lower yield than the risk-targeted yield portfolio. Plus, the Sharpe ratio of 0.87 isn’t that big of an increase from 0.83, especially when the difference in income is close to 1% a year (which is a big difference). So the combined portfolio is attractive, but for income-seeking investors, risk-targeted yield is an even better strategy.

In our next post, we will examine a somewhat recent phenomenon. Following the 2016 presidential election, bonds had one of their worst performing quarters in 12 years due to a widely perceived belief that interest rates are likely to start rising. This belief isn’t unfounded since the Federal Reserve is telling us they intend to raise the benchmark rates. The final part of this series will discuss how high income helps protect against raising rates.

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 Corporate Bonds: CS Emerging Market Corporate Bond Index Investment-Grade Credit: Bloomberg Barclays U.S. Credit Index
Emerging Market Sovereign Bonds: Bloomberg Barclays EM Sovereign Bond Index Mortgages: Bloomberg Barclays U.S. MBS Index
Foreign Sovereign Bonds: Bloomberg Barclays Global Treasury ex-USD Municipal Bonds: Bloomberg Barclays Municipal Bond Index
High-Yield Credit: Bloomberg Barclays U.S. Corporate High-Yield Bond Index Short-Term Treasurys: Bloomberg Barclays U.S. Treasury Bond 1-3 Year Term Index
High-Yield Municipal Bonds: Bloomberg Barclays High-Yield Municipal Bond Index Treasurys: Bloomberg Barclays U.S. Treasury Index

DEFINITIONS

Credit Suisse (CS) 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 Bond Index 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 Index 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 High Yield Municipal Bond Index tracks the performance of noninvestment-grade U.S. municipal bonds with a remaining maturity of one year or more.

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

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

Bloomberg Barclays U.S. Treasury Index is an unmanaged index of public obligations of the U.S. Treasury with a remaining maturity of one year or more.

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

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

Momentum is the rate of acceleration of a security’s price or volume.

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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