Income investors face a wide variety of investment options, each featuring many different characteristics. This panoply can make it difficult to construct a portfolio with a desired profile. In this article we take a look at the key investment characteristics of credit funds, their interaction and overall impact on portfolio performance as well as how investors can go about constructing portfolios with attractive profiles – their ultimate goal. We use the corporate credit sector as a case study, particularly the high-yield subset which is particularly rich in different types of securities and fund options.
In our own Income Portfolios we try to combine funds with the right set of characteristics which not only drives income and total returns, but also allows for diversification and portfolio resilience over the longer term. It is often tempting to populate an income portfolio with the highest-yielding options, however, doing so can often result in permanent capital and income loss. It can also reduce the potential to take advantage of attractive opportunities during drawdown periods leading to lower total wealth.
Our key takeaway is that it is important to know the role each security plays in the portfolio, whether it is yield, drawdown control, total return, etc. This is because no single investment can perform best along all the relevant roles. The role each security plays in the portfolio is determined largely by its characteristics, such as credit quality, investment wrapper, duration and others. We discuss the link between these characteristics and how they can translate into overall portfolio performance.
We also highlight a number of funds that look attractive to us and that we hold in our portfolios, including:
- Invesco BulletShares 2023 High Yield Corporate Bond ETF (BSJN)
- Vanguard Long-Term Corporate Bond ETF (VCLT)
- Western Asset High Yield Defined Opportunity Fund (HYI)
- Eagle Point Credit Company 6.75% 2027 Notes (ECCY)
Security Characteristic and Portfolio Outcomes
It’s easier to think about the large number of different types of credit funds at the disposal of income investors when we break them down along a small number of dimensions relevant to portfolio construction and tie these characteristics into likely portfolio outcomes.
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The key fund characteristics to consider, in our view, are the following:
- duration – the sensitivity of the security to changes in interest rates
- credit quality – the resilience of the security to macro shocks
- active vs. passive management – active management can but does not always deliver outperformance in credit; it also is more expensive.
- investment wrapper e.g. senior security like preferred or baby bond or open-end / closed-end in case of fund. CEFs tend to see higher volatility and larger drawdowns than their open-end counterparts due to the use of leverage as well as the discount dynamic. CEFs also tend to feature active management, have the ability to invest in less liquid assets and boast higher yields and fees.
And the way these characteristics translate into portfolio outcomes is through:
- yield / income level – how much cashflow the security generates, primarily linked to credit quality and duration
- drawdowns / volatility – the top-to-bottom drop and return variability of the security, linked primarily to its credit quality, duration and investment wrapper.
- resilience / total returns – whether the security is able to claw back its losses. Leveraged CEFs can struggle to do this if they are forced to deleverage during a drawdown.
The overall decision framework looks something like this. The process of selecting appropriate securities for the portfolio is complicated by the fact that each security has characteristics that typically point in different directions with respect to overall portfolio goals (e.g. higher-quality securities tend to have smaller drawdowns but also generate lower levels of income).
Source: Systematic Income
Sometimes the ways different security characteristics translate into investment results is not completely intuitive. For example, it makes sense that short-duration high-yield funds will have higher yields and lower resilience than longer-duration investment-grade funds. But it is less intuitive that they could have smaller drawdowns as the interplay between duration and credit quality is not always straightforward. This allows investors to focus more precisely on their desired portfolio objectives without necessarily having to sacrifice income in the process.
The large number of investment options available in the market can obscure the ultimate investment goals. This can make it easy to overlook some of the relevant security characteristics. For example, investors who want to hold part of their portfolio in relatively defensive assets will often focus on credit quality while overlooking the role of the investment wrapper. This can cause them, for example, to pick investment-grade CEFs to fulfill this portfolio role even though CEF discounts will typically widen sharply during risk-off periods, irrespective of portfolio quality.
Why not just hold one fund that captures all the relevant factors? The problem is this just isn’t possible. No single fund can be “best” at all the different roles. A fund that is high-quality and low duration will have smaller drawdowns but will also feature very low levels of income. A fund that has a high income level will tend to have large drawdowns and lower resilience. It’s a feature of the market that different funds are better or worse at providing access to a particular factor. This doesn’t necessarily mean that investors should hold all different types of factors in equal measure, it just means they can achieve better investment results by a careful selection among the available securities.
In the sections below we go through different types of credit funds, the roles they can play in investor portfolios and our views.
Higher-Quality Longer-Duration Open-End Funds
These funds are designed to support the portfolio during certain types of drawdowns, in particular drawdowns that are linked to economic shocks. Such shocks tend to see sharp falls in long-term rates, in expectation, of lower policy rates by the Fed. For instance, we saw just this kind of dynamic in this year’s drawdown when risky assets fell alongside risk-free rates.
These types of funds have three factors that will support their valuation during risk-off periods: their higher-quality, their longer-duration and their open-end format.
In terms of actual funds the obvious choice here are long-term Treasury funds though at current yields they are not going to provide a lot of yield. Longer duration investment-grade funds such as the Vanguard Long-Term Corporate Bond ETF (VCLT) boast a yield close to 3%. To be fair, this fund did fall more than 20% due to the short-lived widening in investment-grade credit spreads and the fund’s long duration. However, it bounced back nearly fully back by early April.
In this category it may be more appropriate to combine Treasuries or Municipal bonds with longer duration and stick to intermediate duration with investment-grade bonds for investors who want to limit the drawdown potential, leaving more dry-powder to reinvest into lower-quality assets during risk-off periods.
The open-end fund wrapper also keeps a lid on additional fund volatility due to discounts. As we discussed in this article CEFs that hold higher-quality assets are not nearly as resilient and tend to see a widening of discounts just when you need them to maintain their valuations.
Short Duration High-Yield ETFs
A number of fund companies provide ETFs holding bonds maturing around the same year, giving investors the ability to tailor the duration profile of their portfolios.
Invesco BulletShares are different sector-based funds that hold bonds with similar maturities ranging from 2020 to well into this decade. High-yield Bullet Shares have fund options with a decent yield, on the order of 4-5% and the low duration and open-end fund structure mitigates the potential drawdowns.
Investors can choose the combination of yield and drawdown that feels right for them.
Source: Systematic Income
We hold both the 2022 HY Fund (BSJM) and the 2023 HY Fund (BSJN) across our Income Portfolios. The 20%-odd drawdown this year sounds fairly high however that’s well below the 28% drawdown of VCLT this year.
Compared to VCLT these funds have a higher yield and a lower drawdown. However, they are not as resilient as they don’t benefit as much from lower rates, a quicker snapback in investment-grade spreads and suffer a drag from a higher default rate. This pair of funds are down about 2-3% year-to-date while VCLT is up around 8%.
Open-End Beta Funds
Sometimes it’s useful just to pick up some broad exposure to the sector and this can be done using a wide array of high-yield funds. A few considerations here are active vs. passive management, fund fees and risk factor exposure.
In the unleveraged fund space, mutual funds will tend to give investors access to active management. Historically, it’s not clear that active management has outperformed passive management in the sector, however. For instance, the average ETF has delivered higher performance versus mutual funds over the last 1 and 5-years and only slightly loses out over the past 10 years.
Source: Systematic Income
Part of the reason, of course, likely has to do with the significantly higher fees – about 2.5x or 0.6% higher than that of ETFs. Currently, it is possible to find an actively-managed ETF for a low fee – the JPMorgan High Yield Research Enhanced ETF charges just 0.24%, a fee below that of the larger passive ETFs.
One strategy that continues to outperform in the sector is the so-called fallen angels strategy. Fallen Angels refers to bonds that have recently been downgraded. Intuitively, this strategy works because investment-grade funds may have to sell out of the holding which can put technical selling pressure on the bond providing an opportunity for funds that are designed to scoop up these bonds.
Two funds that follow this strategy are:
- VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL)
- iShares Fallen Angels USD Bond ETF (FALN)
FALN has a lower fee and has outperformed ANGL over the past year so it remains our pick in the pair.
Another attractive feature of these funds is that they tend to hold higher-quality bonds within the sector – since these bonds were recently investment-grade and were likely downgraded to BB – the strongest rating in high-yield. This should allow these funds to be more defensive (both hold on the order of 90% in BBs) though lower-yielding versus broader high-yield funds. In reality, however, these two ETFs have seen larger drawdowns this year and actually boast higher current yields than the broader high-yield ETF space which is possibly due to a sector mismatch with the broader sector.
One interesting feature of the ETF market is that during sharp drawdowns the gap between the price and NAV can open up dramatically. This tends not to happen during normal market operation due to the arbitrage mechanism embedded into the ETF structure. The consensus appears to be that the reason the gap opens up is because ETF NAVs are stale and that their price reflects the true value of the underlying assets at the time. However, because mutual funds transact at the NAV they may allow mutual fund holders to take advantage of this dynamic by selling their mutual fund holdings and buying similar ETFs, potentially locking in the price-to-NAV differential. The two securities are not going to hold identical portfolios and so this is far from an arbitrage but it can benefit mutual fund holders and could be one reason to hold mutual funds over ETFs into a market drawdown.
Unleveraged CEFs may sound like an oxymoron, particularly in the fixed-income space where the vast majority do carry leverage. The 1940 Investment Company Act allows both open-end and closed-end funds to carry leverage however the rules for closed-end funds are notably looser which allows them to carry a higher level of leverage and consequently generate a higher earnings stream.
So for those CEFs that carry no or very little leverage it seems that a CEF structure offers little benefit. This is not the case, however, for three other reasons. First, CEFs offer active management, secondly they can trade at a discount and thirdly, they can hold a wider array of securities, including less liquid ones.
Because CEFs can trade at a discount they can, in effect, provide a subsidy to the fund’s management costs. In some instances this has the effect of making up for almost the entire management fee and making the fund cheaper than many passive alternatives, giving investors active management at a cheaper cost than passive management.
The high-yield CEF sector has 5 CEFs with no leverage, 4 of them being term CEFs. It is quite common for term CEFs, particularly near their termination date, to carry no leverage. The combination of no leverage and term structure is quite attractive particularly if the CEF is trading at a discount because it can often generate the same total yield (current yield + pull-to-NAV yield) as perpetual leverage funds but without taking as much risk as the leveraged funds.
The one perpetual CEF with no leverage is the AllianceBernstein Global High Income Fund (AWF) though technically the fund uses a small amount of credit default swaps to boost income and add risk. The fund is trading at a 1% lower current yield, 1% lower covered yield and a 6% wider discount than the sector average. The fund’s discount effectively lowers the fund’s management fee to a level below that of the larger passive high-yield ETFs, making it a relatively attractive alternative to open-end funds. That said, because it is in a CEF wrapper it will likely see larger drawdowns than open-end funds. The other benefit of low-leverage CEFs is that they will not be forced to deleverage which makes them more resilient than their leveraged counterparts.
Term CEFs are funds with a scheduled termination date. Target term CEFs are a subset of term CEFs which also attempt to return a certain NAV back to investors on a scheduled date.
Term CEFs can raise a few additional concerns. First, is the chance that the fund company tries to turn the fund into a perpetual fund, which it is incentivized to do so as not to lose the ongoing management fees. Secondly is the deleveraging that term CEFs tend to go through if they do indeed terminate which can create a cash drag and lower distribution rates. And thirdly, some investors worry about the fund having to sell down its assets into an illiquid environment, suffering losses, which is possible but poses a very small risk (there is yet to be an instance where this happens) relative to the much larger benefits of the structure.
We are big fans of term CEFs and hold a bunch of them in our Income Portfolios. In our view term CEFs, in effect, square the circle. They allow the fund to trade at a discount, providing yield enhancement and / or a management fee subsidy depending on one’s perspective. But they also offer a degree of risk control, both in their lower volatility and drawdowns as well as eventual discount tightening in case of termination. Another major benefit is what we call the pull-to-NAV yield which is the annual tailwind due to the expected discount compression towards zero on the termination date.
A term CEF that we continue to like is the Western Asset High Yield Defined Opportunity Fund (HYI) which is expected to terminate in 2025 and which provides a 1.5% tailwind due to its current discount of 7.6%. The fund’s total yield of 9.3% makes it one of the highest-yielding funds in the sector while allowing it to remain relatively defensive as it carries no leverage.
Source: Systematic Income
Perpetual CEFs are the standard CEF structure that most income investors are very familiar with. The basic question for many investors will be whether to go for open-end funds with their lower yields and lower drawdowns or closed-end funds with higher yields and higher drawdowns. We covered some aspects of this decision process in more detail earlier.
Perpetual CEFs will be the bread-and-butter of higher income portfolios for many investors. The basic bargain of CEFs is that they provide investors with higher earning and distribution yields.
Source: Systematic Income
This is in exchange for greater drawdown potential.
Source: Systematic Income
Another risk which comes with CEFs is a potential deleveraging. This can be caused by a drop in the fund’s NAV which causes it to breach its asset coverage requirements leading it to shed assets at an unfavorable time. This can lower the fund’s upside recovery during a rebound as the following chart illustrates.
Source: Systematic Income
Ultimately each investor has to decide whether the additional yield provided by the CEF is attractive given the additional drawdown and deleveraging risk. Coming out of the March drawdown credit spreads were very wide, leverage costs fell to rockbottom levels and CEFs that had to deleverage had already done so. This created a very attractive time to move into CEFs, particularly for those investors who were waiting out in open-end funds. At this point in time with credit spreads at much tighter levels the situation is less clear cut. That said, leverage costs will continue to be low for an extended period of time and rising asset prices will allow CEFs to releverage, further growing their earnings. High-yield sector discounts also stand roughly in the middle of their 5-year range. All in all, the additional yield provided by CEFs over and above sector open-end funds will likely remain elevated making it marginally more attractive to be in CEFs than in open-end funds.
Mixed Sub-Sector CEFs
Mixed-subsector credit CEFs are those that can invest across a number of credit assets such as loans, bonds, CLO mezz and CLO equity. A couple of funds that pursue this strategy are:
- BNY Mellon Alcentra Global Credit Income 2024 Target Term Fund (DCF)
- Ares Dynamic Credit Allocation Fund (ARDC)
These funds have a number of attractive features. First, their wider mandates give their managers a wider playing field to find attractive opportunities. Secondly, by holding floating-rate assets they lower the duration exposure of the fund making it less sensitive to rising interest rates. Although lower short-term rates also caused a drop in coupons generated by floating-rate securities, the now rockbottom level of LIBOR has put this to an end. Thirdly, these funds can dabble in the CLO space to significantly boost earnings given the sharp dislocations that this part of the market has gone through this year.
We currently hold DCF in two of our Income Portfolios given these attractive features as well as its term structure and high pull-to-NAV yield.
CLO Equity Senior Securities
CLO equity funds are the highest-octane fixed-income vehicles available to retail investors. This makes them attractive yield vehicles – only a small allocation in an income portfolio can significantly boost the overall yield.
Our approach in this sector has been to allocate primarily to senior securities rather than common shares. Doing so can still generate yields in the high single-digits without exposing the portfolio to the fragility of the common shares. For example, the common shares of CLO equity funds have delivered around a -40% return over the past year while the senior securities of the sector are all in the green. And because CLO equity funds hold extremely volatile assets they are liable to heavy deleveraging which we indeed saw earlier in the year. This has not allowed these funds to capture the recovery in the market and has depressed their distributions. In effect, investors who acquired the common shares prior to the drawdown have a lower yield on their cost basis than holders of senior securities despite the much greater resilience and seniority of the preferreds and baby bonds in the capital structure.
This is why we hold a number of CLO equity senior securities in our portfolios. For example, we continue to like the Eagle Point Credit Company baby bonds which boast a yield north of 7% with a 4x+ asset coverage level. The bonds have traded up nearly all the way back to “par”, illustrating their resilience in contrast to the common shares of the fund.
Our approach to the common equity of these funds has been much more tactical. In particular we have avoided Oxford Lane Capital Corp (OXLC) due to its persistent high-premium valuation. We initiated a small position in OFS Credit Company (OCCI) when its estimated discount widened significant as highlighted in the chart below and scaled back when it subsequently tightened – delivering a double-digit return in short order. Since there is little visibility around the discount valuations of these funds, we expect the common shares to continue delivering opportunities to generate high amounts of alpha.
Source: Systematic Income
The number of investment options in the credit space is enormous, which can make it difficult for investors to easily construct portfolios that align with their goals. By focusing on a few salient investment characteristics of credit funds as well as the typical investment outcomes of these characteristics, investors can increase the chance their portfolios perform in line with their goals. The last few months have clearly illustrated the need to develop a robust portfolio construction process that allows investors to not only generate sufficient levels of income but also ensure that they can take advantage of periods of increased volatility in order to build long term wealth.
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Disclosure: I am/we are long BSJN, ECCX, DCF, HYI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.