The recovery period across markets after the drawdown earlier in the year has hit its six-month anniversary. Investors who have taken advantage of the bounce-back may be looking to preserve their gains and tilt their portfolio toward more robust assets. In this article, we take a look at some niche income sectors that may be overlooked by investors but that have been able to maintain their value through time while offering yields of around 7% or more.
We also highlight a number of securities we like in these sectors:
- Armour Residential 7% Series C (ARR.PC)
- Oxford Square Capital Corp. 6.5% 2024 Notes (OXSQL)
- Eagle Point Credit 6.6875% 2028 Notes (ECCX)
What Is Resilience?
There are different ways to measure resilience. Two of our favorites are drawdowns and 1-year total return. Drawdowns give you the peak-to-trough move of the security or sector over the past year and the 1-year total return is self-explanatory. It is possible for these two metrics to point in different directions. For example, you could have a sector that had a very large drawdown – let’s say on the order of 50% but ended up pretty much where it started with a positive 1-year total return.
Drawdowns can be problematic in two cases in particular. First, they are difficult for leveraged investors, that is, investors who use margin loans because they may require a deleveraging and a repayment of the margin loan. And secondly, they can cause an investor to lose conviction in a position leading to a liquidation and a potential failure to recapture the bounce-back.
In this article, we focus on the 1-year total return as the main resilience metric for two reasons. First, large drawdowns are nearly impossible to avoid for sectors with a non-negligible yield. When the market seizes up as it did this March, the behavior of assets can be all over the place. In fact, the market can deliver counterintuitive results – Treasury yields can spike from unwinds of hedge funds carrying out bond vs. futures arbitrage, agencies can fall due to leveraged player unwinds and investment-grade corporate bonds can drop because of their typically longer duration.
This is why for income investors, who tend to be unleveraged and build portfolios for the longer term, the 1-year total return is a better metric, particularly once the market returns to a sense of normality. It provides a better indication of how fragile or resilient a given sector is once these technical pressures are out of the way. Sectors that continue to trade well below their pre-drawdown peaks i.e. those with a negative 1-year return are simply less resilient to macro and market shocks.
What can drive this lack of resilience? The key factors are credit quality, investment wrapper characteristics and duration exposure. The impact of credit quality is obvious – higher quality credit can withstand greater shocks. Investment wrapper characteristics such as leverage and discounts are strong drivers of total returns. For example, leveraged funds holding volatile assets such as CLO equity or MLP CEFs have had a tough time dealing with drawdowns due to the need to deleverage, locking in capital and income losses in the process.
Longer-duration funds have ultimately benefited due to the collapse in risk-free rates – a feature of the market that is very common during risk-off periods. Some of these factors can cut in different directions. For example, CEFs holding higher-quality assets can have resilient NAVs but sharply lower prices due to discount widening. High-yield portfolios can be hurt due to their lower credit quality but also benefit from their duration exposure.
A Look At The Sectors
The sectors that we wanted to highlight are the following:
- CLO Equity preferreds and baby bonds
- Credit CEF preferreds
- Equity CEF preferreds
- Agency mREIT preferreds
- BDC baby bonds
- Utility preferreds
The chart below summarizes the trajectory of 1-year returns across these six sectors. The chart shows that while these sectors have seen different drawdown levels, all boast positive total returns over the past year.
Source: Systematic Income
For those keeping score at home, this is how the sector drawdowns look like this year.
Source: Systematic Income
It is worth asking what seems like the obvious question of what is the point of holding resilient sectors? This question is a valid one because more resilient sectors tend to both have lower yields and lower total returns during calm markets than less resilient sectors. This means that investors are giving something up when they allocate to more resilient sectors. Sure, they gain by lowering their portfolio drawdowns and volatility and improving their risk-adjusted returns but you can’t pay your bills with risk-adjusted returns.
In our view, there are two primary benefits of more resilient sectors. The first one is purely behavioral – that is, how investors choose to respond to losses in their portfolios. The greater the loss in the portfolio, the harder it is to maintain conviction in it and the lower the conviction, the more likely investors are to liquidate the portfolio in search of safety like cash. Because income assets tend to be mean-reverting, investors who do this are likely to miss out on the recovery of these assets.
How relevant this factor is depends on the individual investor. Some investors, no doubt, will be more than happy to see their portfolio cut down in half as it would expose additional opportunities to deploy capital. One’s ability to deploy this capital depends in large part on how different parts of the portfolio have held up. In other words, and to make an extreme example, imagine an investor with 100% of their portfolio allocated to a single security – if that security drops by 50% and the investor wants to add more shares at this lower and more attractive price, she has no means of doing so since all their capital is already deployed in that security. Being able to reallocate capital into the desired security requires another part of the portfolio that has maintained its value. The better this part of the portfolio has been to maintain value the more longer-term wealth and income the investor can generate from rebalancing into the desired security.
Finally, and this is not always obvious, but sectors that are better at maintaining value from a total return perspective keep investor wealth ticking along. Some income investors act as though the only thing that matters is income and total wealth is just secondary. But the two are very tightly interlinked. In other words, the more wealth there is, the more income the portfolio can generate. There is no magic here – it is always tempting to go for securities with very high distribution rates but these either allocate to extremely risky securities such as CLO equity or behave like annuities, returning the investor principal back in the form of distributions which does not do much in growing total wealth.
In the next section, we highlight some securities across the sectors mentioned above that we currently hold in our Income Portfolios.
Within the fixed-rate agency mREITs, the Armour Residential 7% Series C (ARR.PC) looks attractive relative to the Annaly 7.5% Series D (NLY.PD). The two preferreds are trading at comparable stripped yields of about 7.45%, however, NLY.PD is trading at a negative yield-to-call suggesting that further upside is limited. NLY.PD also boats the highest coupon which suggests it is the most likely series to be called among the Annaly preferreds which increases the risk that investors will take a loss in the event of the call if the stock continues to trade above “par.” ARR.PC, on the other hand, is still about 1.5 points below “par” which leaves it more room for further capital gains.
Within the BDC baby bond space, we continue to like the Oxford Square Capital Notes. The company has an unusual portfolio that holds not only first and second-lien loans but also CLO equity tranches. However, in our unsecured debt recovery stress estimates where we assume zero recovery for CLO equity, the bonds come out quite well, partly because there are no secured holders at the head of the queue. Since we discussed these bonds, their yield has fallen over 1% however, they still offer value here, particularly the 6.5% 2024 Notes (OXSQL) at around 7.3% yield.
In the CLO equity space, we continue to like the Eagle Point Credit 6.6875% 2028 Notes (ECCX) at a 7.1% yield. The two baby bonds of the issuer offer the most senior position in the CLO equity capital structure available to retail investors. We estimate current coverage at nearly 4.5x – well above that of preferreds in the sector which are sub-3x.
The increased volatility in the income space over the last week illustrates the attraction of having more robust and resilient securities in the portfolio. Though sharp drawdowns are difficult, if not impossible, to eliminate entirely even in the very high-quality assets, it is still possible to build the portfolio around securities that have been able to maintain their value through time. These securities not only support portfolio wealth through time but also give investors additional opportunities to reallocate into attractively priced assets.
Check out Systematic Income and explore our Income Portfolios, engineered with both yield and risk management considerations.
Use our powerful Interactive Investor Tools to navigate the closed-end fund, open-end fund, preferred and baby bond markets.
Read our Investor Guides: to CEFs, Preferreds and PIMCO CEFs.
Check us out on a no-risk basis – sign up for a 2-week free trial!
Disclosure: I am/we are long NLY.PD, ECCX. 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.