Income Investing in an Uncertain World | Part 4

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

In the third part of this series, we extended our simple ranking system to include risk targeting. This extended analysis produced a portfolio that could deliver higher risk-adjusted returns than a simple ranking system and still deliver a yield in excess of the Bloomberg Barclays Global Aggregate Bond Index. In the final part of this series we will look at the same strategy and examine its sensitivity to changes in interest rates.

Why Does High Income Help Protect Against Changing Interest Rates?

Let’s begin by looking at why high levels of current income can potentially protect against rising interest rates. To examine this phenomenon, we will start with a very simple analysis comparing high-yield bonds to Treasurys. We will assume we have a high-yield bond with a duration of four years and a yield of 5.85% and a Treasury with a duration of four years and a yield of 1.71%. These numbers are based on the December 2016 benchmark yield curves.

Next, let’s assume that we had a relatively smooth year and then, suddenly, we are surprised with a 1% increase in benchmark interest rates. Figure 1 below shows the net impact.

Figure 1: Hypothetical Impact from a 1% Increase in Rates with a $1 Million Initial Investment

December 2016

Treasury Bonds High-Yield Bonds
Annual Income $ 17,100.00 $ 58,500.00
Loss of Capital $ (40,000.00) $(40,000.00)
Net Change $ (22,900.00) $ 18,500.00
Sources: Salient Partners, L.P., Bloomberg, as of 12/31/2016

In this case, the high-yield bond investor walks away with some money in their pocket while the Treasury bond investor has lost over 2% of their initial investment. There are other ways this could play out because high-yield investors are affected by other macroeconomic events. However, in terms of interest rates, this analysis is fair. In short, higher income is one way we can protect against rising interest rates.

Expanding Our Risk Targeted Yield Portfolio

Before we look at how our risk-targeted yield portfolio would protect against rising rates, let’s give it a leg up on the competition by allowing the portfolio to hold stocks when it fits within the targeted level of risk. Stocks have a lower sensitivity to changing rates than bonds. By including them, we will naturally reduce our exposure to changing rates. Additionally, certain stock asset classes sometimes offer yields that are in excess of bonds, which will offer even more opportunities for income. Figure 2 lists all the asset classes we will include in this analysis. Finally, we will give a little more room to allow for stocks by increasing the risk target to 6.5%—the long-term standard deviation of a blended benchmark of 15% MSCI All Country World Index and 85% Bloomberg Barclays Global Aggregate Bond Index.

Figure 2: All Assets

Investment-Grade Credit Foreign Developed Stocks
High-Yield Credit Emerging Market Stocks
Treasurys Utilities
Emerging Market Bonds U.S. Real Estate
Municipal Bonds International Real Estate
High-Yield Municipal Bonds Cash
Preferred Stocks U.S. Stocks
See asset class key for more details.

The results below show the initial analysis compared to the prior risk-targeted yield portfolio of 5% and the blended benchmark.

Figure 3: Risk-Targeted Yield Analysis With and Without Stocks

August 1998–December 2016

Risk-Targeted Yield With Stocks Portfolio Risk-Targeted Yield Portfolio Blended Benchmark
Annualized Return 9.09% 7.37% 4.95%
Annualized Volatility 7.41% 5.09% 5.90%
Sharpe Ratio 0.80! 0.83! 0.30!
Max Drawdown -15.38% -8.85% -14.20%
Avg. Annual Yield 6.68% 6.72% 2.97%
Sources: Salient Partners, L.P., Bloomberg, as of 12/31/2016

By adding stocks and increasing the risk target, we increase the volatility of our initial portfolio, but the similar Sharpe ratio indicates that the extra risk is made up for. Plus, it is still superior to simple benchmark exposure. Going forward, we will refer to risk-targeted yield as the version that includes stocks. Now we need to examine how sensitive this expanded yield portfolio is to changing interest rates. However, before we move on to that topic, let’s get a quick refresher on the relationship between interest rates and bond prices.

An Inverse Relationship

Imagine that we bought a bond at par for $1,000 that was paying a 5% coupon, which means each year we will receive interest payments in the amount of $50. Presumably at the time we buy that bond, a 5% coupon is in line with the current market rates. However, a year later, the market rates for similar bonds have a coupon of 6%; in other words, interest rates rose. A bond that pays 5% can no longer be sold for $1,000 because similar bonds with the same value are now paying more interest. So the value of the bond needs to be marked down in order to make up the difference in interest payments. On the other hand, if a year later the market rate for similar bonds falls to 4%, that means the interest rates declined, which makes our 5% coupon bond more valuable because it pays more interest than the current market rates. As a result, the value of our bond rose.

Now that we have the basic relationship between interest rates and bond prices, let’s examine what happens to our risk-targeted yield portfolio.

The Impact of Rising Rates

Below is the correlation and beta of the Bloomberg Barclays Global Aggregate Bond Index and the expanded risk-targeted yield portfolio compared to changes in Treasury yields. Note that the signs of beta and correlation are reversed to make is easier to relate the change in interest rates to changes in overall portfolio value. I reverse the sign of beta and correlation because the relationship between prices and yield is inverse.

Figure 4: The Relationship to Changing Interest Rates

August 1998–December 2016

Beta Correlation
Bloomberg Barclays Global Aggregate Bond Index 0.80 79.4%
Risk-Targeted Yield Portfolio -0.03 -1.90%
Sources: Salient Partners, L.P., Bloomberg, as of 12/31/2016

This analysis demonstrates that roughly 80% (indicated by the beta of 0.80) of the benchmark’s return can be explained by changes in interest rates and roughly 80% (indicated by the correlation of 79.4%) of the benchmark’s weekly returns are in the same direction as changes in interest rates. So as rates go up, prices go down. This dynamic is not the case for our risk-targeted yield portfolio, which shows numbers closer to 0, meaning the relationship is statistically insignificant. This means risk-targeted yield portfolio is less exposed to the risk of changes in interest rates.

We can also do a historical analysis as well by looking at interest rate changes in excess of +/-0.25% a month. Below are the results of that historical analysis.

Figure 5: Average Monthly Return in Different Rate Environments

August 1998–December 2016

Returns in Periods of Declining Rates Returns in Periods of Rising Rates
Bloomberg Barclays Global Aggregate Bond Index 1.63% -1.21%
Risk-Targeted Yield Portfolio  1.12%  0.05%
Sources: Salient Partners, L.P., Bloomberg, as of 12/31/2016

There is clearly a statistical representation of lower risk in the Risk-Targeted Yield Portfolio, as seen in Figure 4. And here in Figure 5 we see that, empirically, the Risk-Targeted Yield Portfolio has been less exposed to interest-rate risk. Next, we can take our newfound knowledge and put it into action.

Putting It All Together

Finally, we will review how a combined portfolio of traditional bonds and the risk-targeted yield portfolio operates and what the impact would be to changing rates in Figure 6. I will also expand our universe to explore the possibility of using only Treasurys or munis as the bond component of a blended portfolio.

Figure 6: Combining Bond Assets With the Risk-Targeted Yield Portfolio

August 1998–December 2016

Risk-Targeted Yield Portfolio (RTY) Global Bonds Treasurys Munis
Annualized Return 9.09% 4.35% 4.64% 4.77%
Annualized Volatility 7.41% 5.82% 4.48% 4.23%
Sharpe Ratio 0.80 0.20 0.33 0.38
Max Drawdown -16.78% -10.08% -4.98% -6.21%
Avg. Annual Yield 6.86% 3.30% 3.09% 3.58%
Correlation to Treasurys -1.90% 61.22% 100.00% 55.67%
Beta to Treasurys -0.03 0.79 1.00 0.53
Sources: Salient Partners, L.P., Bloomberg, as of 12/31/2016

 

50% RTY/50% Global Bonds 50% RTY/50% Treasurys 50% RTY/50% Munis
Annualized Return 6.77% 6.94% 6.98%
Annualized Volatility 5.42% 4.29% 4.84%
Sharpe Ratio 0.67 0.88 0.79
Max Drawdown -8.08% -6.09% -9.25%
Avg. Annual Yield 5.08% 4.97% 5.22%
Correlation to Treasurys 31.55% 50.58% 22.87%
Beta to Treasurys 0.38 0.48 0.25
Sources: Salient Partners, L.P., Bloomberg, as of 12/31/2016

Now we’re cooking with gas! As suspected, including risk-targeted yield into the core bond asset classes dramatically improved performance, raised the yield and cut in half the sensitivity to interest rats changes. The most surprising of the bunch is the combination with Treasurys, which has the highest Sharpe ratio of any of the portfolios. This outperformance actually makes sense considering the Treasury portfolio and risk-targeted yield portfolio are uncorrelated with each other; in other words, risk-targeted yield is a great diversifier for a traditional Treasury portfolio. The muni combo is also attractive, but the analysis doesn’t factor in any tax benefit. If we added in an after-tax return, the Sharpe ratio would likely be similar to the Treasury portfolio.

This draws to a close our series on Income Investing in an Uncertain World. We learned that by applying active selection through carry and/or momentum analysis can greatly improve the yield and risk-adjusted return of an income portfolio. We also saw that by adding in some risk management in the form of risk targeting, we can dramatically improve the active selection process. Finally, we took what we learned and constructed an income portfolio that draws from our risk-targeted yield and traditional bond asset classes in order to create a portfolio with excellent risk-adjusted performance, higher income and a lower overall sensitivity to interest rates changes. Not a bad start to any income portfolio!

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 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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