Yield Hunting Newsletter | April 2019 Commentary And Sheets

Typically the Monthly Newsletter is used to focus on economic views, portfolio construction, and retirement strategy. The Weekly Commentaries (out each Sunday evening) are more specifically directed towards closed-end funds and individual security opportunities. To all our new members, you have joined at an exceptionally good time. For existing members, we believe the first half of 2019 will be significantly better than the back half of 2018.

“The greater the passive income you can build, the freer you will become.” ― Todd M. Fleming

Keep Calm and Collect Income

Last month, our topical headline was titled "Is The Outlook Too Negative" where we discussed the near-term economic forecasts.  We wrote about how the media and discussions on the chat had become decidedly negative.  One idea we've been more focused on lately is behavioral finance and looking at recency biases effecting our investment strategy.  We wrote last month:

One thing we noted last week and would reiterate again is beware of herd mentality. Reading what others are doing can influence your own behavior and shift your risk goalposts. Many investors/members have been selling appreciated positions to raise cash. Some have noted that their cash levels have reached 20%, 30%, and even 40%.

Certainly some tactical shifts are warranted including during downturns.  For instance, in the fourth quarter we reduced cash levels to essentially zero only holding a couple of open-end mutual funds (bond focused) like SEMPX while allocating as much as we could to closed-end funds ("CEFs").  By Christmas, CEFs, were on sale.  Deeply discounted.  It made sense- at least for me- to load up totake advantage of the selloff with a view towards holding for 6-12 months.  

As it turns out, we only had to hold for about two months before prices recovered- a relatively short amount of time compared to historical instances of dramatic selloffs in the space.  

But getting back to behavioral investing.  The one primary benefit of having a financial advisor is not the planning (you can get a fee-based plan for about $3,000 and have it updated every few years for much less) nor the asset management (selecting individual investments).  It is the behavioral restrictions on what is typical retail investor behavior.  In other words, preventing the client from doing something stupid is why you pay an advisor.

Behavioral finance's whole existence rests on the notion that the 'rational man' does not really exist.  The study of human behavior in investment decision making goes back more than one-hundred years with the publishing of "Psychology of the Stock Market" by G.C. Selden in 1912.  Over the last 60 years, most investor psychology and investor behavior can be found in the art of technical analysis.  

Each year, DALBAR, an independent consulting firm that evaluates business practices, releases their study on investor behavior.  Now, there are many flaws to the study but it also has grounded theory.   The study uses fund cash flows to estimate what the average investor did throughout the year.  The latest research showed that the average investor lost 9.42% in 2018, compared with a 4.38% decline for the S&P 500.  

Most of the issue comes from being out of the market during the recovery- selling and going to cash when they just couldn't take the losses any longer.  This is often called capitulation and often marks the bottom in markets.  Investors then get back in when they see that the markets have indeed bottomed and are recovering but often miss the initial significant move. 

Investors tend to be their own worst enemy, failing to exercise the necessary discipline when investing in public markets.  Market timing and performance chasing are the largest culprits that de-rail investors.  As we'll explore below in the portfolio construction section, we want investors to have a plan.  A plan for long-term asset allocation.  A plan for short-term strategies, and a plan for down markets.  

It is the latter that can be especially positive for investment results over time.  

For now, the market appears to be in consolidation mode and is looking for direction.  We would stress maintaining exposure and not making drastic changes to overall asset allocation.  While global growth has slowed, it doesn't appear to be going negative.  We would not be going to cash but be neutral on your asset allocation.

For example, in my portfolio I used up nearly all of my cash in December buying CEFs.  By mid-February I was back to selling them raising up the cash I had spent down.  The goal was to get back to my long-term cash level of 8% (12-15% total in safe bucket assets).  I am there today and will likely look to be adding on any sell offs rather than adding more cash.  

My cash bucket today is generating about 3.72% annual forward yield, which is not bad and reduces the carry cost compared to just a couple of years ago.  

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Here is the link for the new portfolio list:

April Google Sheet

Introduction

We are continuously revamping and trying to improve our service given the amount of information we provide along with the complexity of it. In the next couple of months, we want to introduce a procedure for implementing the "system" in a straightforward manner.

Most financial advisors do a significant amount of work on the front-end even if their 'systems' are cookie-cutter for all clients. This is what most do-it-yourself investors lack. They lack the plan and the structure preferring to lop together a bunch of stocks, bond funds, and cash into an allocation.

Please note that the Google Sheet is new this month as it is every month. There is a date at the top in the title of the sheet as well as the date in the spreadsheet itself. On the first of each month, we create a new sheet and link. Please bookmark it or access it via the "tools" drop down in the service.

New members should start with the "Welcome to Yield Hunting!" and should read our primer titled: "Yield Hunting | How to Get Started- A Primer on DIY Income" both found under the "Getting Started" menu drop down.

On the Google Sheet, we now have an "Instructions" tab as a quick guide for more novice investors.

Also please visit our new website at YieldHunting.com. It has all of our public articles and retirement articles.

Lastly, we now have 85 reviews on our service with nearly all being five-star. If you haven't left a review, we would very much appreciate you doing so. Click the link below which should allow you to write feedback.

We are going to start to separate out the newsletter and manage three real time portfolios: Core, Mini Core, and Flexible. Look for more direction on managing these along with more ideas centered around swapping and deep value. The general objective is to be buy and hold while also taking better advantage of opportunities in specific sectors- avoiding losses in others.

Yield Hunting: Alternative Income Investments - Marketplace Reviews

Stay Prepared, Stay Diligent, Maintain Your Discipline

Despite the negative rhetoric coming from the media, the U.S. economy remains fairly robust.  Though it is slowing from the cycle highs reached over the last year just above 3%, we are simply reverting back to the post-recession average around 2%.  That appears to be the long-term potential growth rate of our economy given demographic and fiscal challenges.

The biggest news item so far in 2019 has been the drop in rates that we've seen.  The yield curve is close to inverting (at the key levels) but has yet to really invert (10s/30s - 3mo).  And even when it does, we typically still have a year or more, on average, before the peak in the market.  

The maturing business cycle does indeed heighten uncertainties and tends to produce anxiety for market participants, especially those that tend to watch their portfolios daily (something I wish they wouldn't do).  Still, it appears that 2018 was an anomaly as everything beat cash in 2017, cash beat everything in 2018, and so far in 2019, everything is beating cash.  

Given that YTD 2019 returns have been so strong and we've seen the Fed pivot significantly to the dovish side, we must ask ourselves how much more monetary policy (Fed-driven actions) can drive the markets?  Its doubtful over the short term but we are now thinking the Fed will largely be driven by market expectations for rates rather than "data dependent" and thus a rate cut is increasingly possible.  By moving to an easing environment, it is likely that the expansion could last another couple of years and growth could re-accelerate in the second half.  

But it is increasingly looking like the Fed is less worried about our data and more concerned about global economies, especially China and Europe.  Last week, PMIs were weak, especially in Europe (but also the U.S. and more so Japan).  The pause by the Fed is now fully incorporated into bond prices, and likely equities as well.  We wouldn't be surprised to see this pivot last for a while (perhaps more than 1-2 years) as the Fed tries to overshoot on inflation meaning that TIPs and equities (and maybe gold) are likely to outperform bonds.  

One thing we consider is the narrative of the markets when planning direction for a global macro strategy.  That narrative is decidedly negative which makes us slightly positive given the lower rate environment.  Many are calling the negative rates a telegraph by the 'smart money' that a recession could be approaching.  However, it is more likely that the decline in rates is US rates following global rates down.  There are now over $10.9 trillion of global debt with a negative yield on it, up from $5.7 trillion at the start of 2018.  

Those negative rates, especially the 10-year German bund falling back to a slight negative level, is dragging down our yields as well.  The other mid-cycle "pauses" occurred in 1967, 1987, 1995, and 2016 and all resulted in the extension of the cycle. 

The yield curve inverted a bit last week but that was not due to the Fed tightening too much, instead it was because the market believes the Fed may cut rates later this year.  As JPM notes on their yield curve inversion note, since the 1960s, the recession has only followed when the 10-year yield has been at least 50 bps below the Fed Funds rates, a level that is far off today. 

The chart below shows the yield curve as of the last week of March.  You can see overall it is still upward sloping but we do have a bit of a trough in the intermediate belly of the curve.  This is not the typical shape of the curve when a recession is nearing.  

So where does that leave us?

We think fixed-rate high coupon debt continues to be attractive with the largest concentrations of exposure remaining in the non-agency MBS, municipals, and some areas of the high yield debt market (primarily higher quality).  

Where is floating rate?  

Loans remain attractive from a valuation level and we are not concerned about them from a default perspective as a recession would be needed for the current discount on the leveraged loan index to bring about the defaults implied.  

We recently sat down with an expert on floating rate to get his thoughts on the sector amid the dovish pivot by the Fed.  We were concerned about holding them this late in the cycle and into the next downturn.  Some solid data came out of it.  During the financial crisis, the cumulative default rate for the S&P/Leveraged Loan Index was ~15% for 2008-2010.  Recoveries averaged about 75%.  When including the coupon, the annualized total return for that three year period was just above +5%.  Of course, that was not a linear figure and included a massive drop in 2008 and the first half of 2009 and a sharp recovery thereafter.  

We are currently overweight it and would look for an opportunity to reduce exposure (more below).  However, we do want to maintain some exposure in order to reduce our interest rate risk should rates move back higher in the next 6-9 months.  That capital should be recycled into areas of the market like munis (both taxable and tax-free) along with preferreds.  While we prefer individual preferreds, there are several ETF and CEF options available as well.  

As you can tell, we are not overly bearish but very close to neutral in terms of our positioning.  While closed-end funds are not cheap, given the Fed pivot and likely lower borrowing costs filtering in, we should expect supportive NAV movements and better sustainability of distribution. 

Portfolio Construction

Many retirees are transitioning from a career that provided a regular paycheck for their bills.  But when they retire, those liabilities need to be paid out of savings.  Something that can cause a significant amount of anxiety for the retiree- just one of the many anxieties people face at retirement.

The most common question is, how can we structure our portfolio to produce income and what is the most we may take safely without running out of money?  

The two bolded words counter each other.  The more the retiree takes from the portfolio, the less safe their situation becomes.  If they want their income stream to be 'safer' then they would take the least amount they could for the quality of life desired. 

The 4% withdrawal rule is one of the most popular withdrawal methodologies for individual investors.  The reason it is so popular is its ease of use and the probability of success.  Walking through an example, there's John and Jane.  Both have $1,000,000 on the same day in the same portfolio.  John retires today and immediately starts a 4% withdrawal adjusted for inflation while Jane waits three years.

During that three year period, the market has a significant drop.  Jane's portfolio falls to $600K while John's to $480K.  The reason John's is lower is because he has been making withdrawals from his portfolio.  Under the 4% rule, John will take out $43,700 next year while Jane will start her initial withdrawal at $24,000 (4% of $600K).  

The odd part is Jane is now taking far less than John in withdrawals in the same year from the same investment mix with the same amount of money 3 year prior.  And even though she, in year 4, has more money than John ($600K vs. $480K).  Both John and Jane face substantial problems with John having longevity risk and Jane probably not being able to afford the kind of retirement she was previously envisioning.  In cases like this, the 4% rule is a bit irrational.  

The conclusion is that in the cases where the chosen retirement date results in a withdrawal rate that is too high (like at the end of a cycle and before a significant bear market), the outcome is a premature depletion of the retirement portfolio.  In other instances, like during the trough in the market or near the end of the bear market, the withdrawals are much less than needed by the retiree.  

The challenge for retirees today is that there is never a mention of valuation when initiating the first withdrawal.  The solution is to adjust the withdrawal rate based on the place in the cycle.  One way to do that would be to average your account balances over the last 7 years and use that as your starting value.  Another is to reduce the withdrawal rate from 4% to 3%.  

By taking a liability driven approach to our portfolios, we are obviating that risk.  Some points to consider:

  • Make sure the income you need from your portfolio is realistic.  Anything above 6% in aggregate is likely going to be a bit riskier for most investors.

  • Make sure to incorporate taxes and place as many of the taxable fixed income CEFs in tax-deferred vehicles.

  • Model out where each dollar of "spending" or income is coming from for the next year (or longer) and the tax ramifications of that dollar.  

  • Fill up your tax buckets!  If you are in the 22% bracket, it may make sense to draw some from IRAs and fill up through the 24% bracket. 

These small movements can be laborious in some cases but save you thousands and boost after-tax returns.  Every bp counts!  

Attributes of a successful investor

  1. Met or exceeded your annual savings/investing goal for the year (typically this should be at least 15% of your gross income)

  2. Avoided any unplanned withdrawals

  3. Started the year with an allocation consistent with your risk tolerance and growth needs

  4. Made sure your investments were allocated in a well-diversified portfolio

  5. Rebalanced periodically throughout the year to your target allocation

  6. Avoided emotional or reactionary changes to your investment strategy

  7. Avoided an unhealthy preoccupation with the financial news media

  8. Took advantage of tax advantaged and tax efficient investment strategies

  9. Harvested tax losses, as necessary, and made charitable contributions with long-term capital appreciated securities

  10. Stayed focused on your long-term goals despite short-term fluctuations in the market

  11. Have a plan developed by a fee-only financial planner that has been updated within the last 3 years.

The Core Portfolio

March was another solid month for the strategy but returns were not nearly as robust as the last two months as discount tightening slowed.  YTD, we are up 9.16% on the Core Portfolio, about 450 bps below the S&P 500 (without any significant equity exposure) and destroying the Barclay's U.S. Aggregate Bond Index which is up just over 3%.  

The PIMCO stars continue to chug along but have definitely not zoomed compared to most other CEFs.  They are up 4% and 5% total return on NAV, but are up 12% and 13% on price so far this year.  

Some of the high yield and floating rate funds continue to zoom as spreads contract.  Ivy High Income (IVH) continues to be a top performer and is now up a very strong 9.2% on NAV, and 14.26% on price, YTD. 

Nuveen Real Assets (NYSE:JRI) continues to be our portfolio leader thanks to the eREITs it holds.  It is now up 14.6% YTD on NAV and over 20% on price.  

For the munis (we included MHI though it was sold during the month), they continue to perform as rates have fallen. 

Core Portfolio Positions Total Return on Price:

Price actions was mixed during the month with munis doing the best rising between +2% and +4%.   The largest loser was Barings Corporate Investors (MCI), down 3.5%- it was sold out of the portfolio earlier this year.  

Commentary:

As we've been noting in our weekly summaries, valuations are no longer cheap and in some areas of the market, downright expensive.  We will continue to hold our positions and collect our income.  Right now, the best areas of the market remain munis, both taxable and tax-free, along with our core positions in non-agency MBS.  

For those that need more Core positions and are waiting, make sure you check out the open-end funds.  We will be reviewing those again fairly soon along with adding some new options.  Be sure not to make knee-jerk reactions like attempting to time a position or the market by blowing out a core that you deem "expensive" and going to cash.

Remember, it is our contention that discounts will continue to tighten as both volatility and especially short-term rates, bottom out.  On the Core and Mini Core portfolios, we did shift out many of the "sell over" thresholds as we believe the current Fed environment will be conducive for higher valuations.  As such, it may be difficult to find value in the near-term in any positions.

Trade Summary

Core Summary:

  • Adding Blackrock Invest Quality Muni (BKN) at 4%

Mini Core Summary:

  • Adding Blackrock Invest Quality Muni (BKN) at 4%

Top "Quality" Funds

These are funds with coverage ratios in excess of 98%, UNII that we deem to strong or improving, and a z-score below -1.  

(1)  JH Investors (JHI):  This is a new fund for most members and one we have not mentioned much.  The fund is a lot like BTZ with a straddling of lower quality investment grade and high quality non-investment grade corporate debt.   The portfolio managers have the flexibility of investing across the full spectrum of bonds going where they think there is the most value.  Performance last year was not great but the fund is rebounding nicely thanks to falling spreads and solid positioning.  We think the discount could close by at least two points but even if it doesn't, there is a solid NAV trend.  Some of the drawbacks include a quarterly and variable payout and a relatively low yield.

(2)  Ares Dynamic Credit Allocation (ARDC):   

One of our Core positions, we would recommend topping off your allocation at these levels.  We think the price action is going to change as the NAV has been in a nice upward trend.  Pricing has been flat for the past two months while most CEFs have seen significant discount tightening.  The yield is nice and strong at 8.7% and the discount nearly 13%, about 1.5 points below the 52-week average and nearly 6 points below the 52-week high.  We believe there's an opportunity for at least 3 points for discount tightening while we collect the juicy yield.

(3)  Blackrock 2022 Global Income Opp (BGIO):  

This is a newer term trust from Blackrock that IPO'd two years ago.  The strategy is geared towards diversified global income with most of the debt between BBB and B (essentially 20% investment grade and 80% non-investment grade).  Most of the debt is slated to mature in five years.  As a term trust, there is no "target" NAV that it will liquidate upon.  When we selected it, the discount was near 6% but has since closed to about 4%.  For now, we will keep it on the list.  

Top Convergence Trade Opportunities

These are funds that have solid total return opportunities that could be realized shorter-term.

(1)  RiverNorth/DoubleLine Strategic (OPP):  This fund of funds has a managed distribution policy that pays over 13.3%.  The price has been languishing for the last few weeks while the NAV is starting to move higher, creating a nice alligator-like opening that we like to see.  

(2) EV Tax-Managed Global  (EXG):  This fund cut the distribution significantly three months ago.  We typically see selling pressure for 1-3 months following a significant distribution cut like the one they conducted.  We're making the call that it has bottomed and that it could be time to get in.  The fund now likely has some unrealized gains that should remove the ROC from the payout.  The last time they cut large in early '17, it took six months to return to their previous valuation levels- going from -9% discount to a -1%.

(3)  Neuberger Berman Real Estate (NRO):  This high-yielding "junkier" real estate fund has been on fire lately.  The addition to the list is more of the fact that the price hasn't kept up with the NAV adding to the discount over time.  The discount is now over 11% with the 52-week average being closer to 7.3%.  We think there's the possibility of at least a few points of discount closure, perhaps much more as the 52-wk high is -3%.  

Reviewing Top "Quality" Funds From February

Last month, our top quality picks were:

  1. THL Credit Senior Loan Fund (TSLF)

  2. EV Senior Floating Rate (EFR)

  3. Apollo Tactical Income (AIF)

All three of these funds are focused on the floating rate space and thus, underperformed during the month.  Most of that underperformance occurred during the last week of the month.  

A Closer Look At JH Investors (JHI)

We wanted to dive down a bit into JH Investors (NYSE:JHI) since it was out top quality fund trade this month.  According to the fund's website, the investment strategy is summarized as:

  • The fund seeks to generate income for distribution to shareholders with capital appreciation as a secondary objective.  

The fund is one of the oldest still in existence incepting way back in January of 1971.  Total managed assets are approximately $240M with leverage of 36%.  The fund hold 248 individual bond positions.

Key Statistics:

  • IPO Price:   $16.58

  • Last Price:  $15.77

  • Last NAV:  $17.53

  • Discount:  -10.04%

  • Distribution Yield:  6.23%

  • 1-year z-score:  -0.90

  • Total Net Assets:  $139.6M

  • Number of holdings:  248

  • Interest Rate Swaps:  0

  • Effective Duration:  4.6 years

About 64% of the fund's assets are in U.S. bonds with the rest coming from a myriad of other countries including Mexico (6.6%), the U.K. (3.6%), France (3.3%), and the Netherlands (3.0%).

The fund is fairly plain-vanilla investing in corporate bonds with a small smattering in other sectors.  

(Source:  JH Annual report 10.31.18)

The fund does not have a mandate about how much of the portfolio needs to be investment grade versus non-investment grade but the fund today is centered on the middle portion of the spectrum.  Approximately 30% of the portfolio is in investment grade including the 3.1% in U.S. government obligations.  

(Source:  JH Annual report 10.31.18)

The fund does not have a mandate about how much of the portfolio needs to be investment grade versus non-investment grade but the fund today is centered on the middle portion of the spectrum.  Approximately 30% of the portfolio is in investment grade including the 3.1% in U.S. government obligations.  

The fund pays quarterly and it uses a variable pay system - meaning it ties the distribution to earnings.  The chart below goes all the way back to 1989 and is a nice reflection of what interest rates did over that time period.  

All of the past several distributions have been ordinary income.  The last distribution was a bit lower than the prior four at $0.24 compared to an average of $0.29.  This is likely the cause of the recent underperformance. 

On their website, they have some interesting graphs including the following upside/downside capture chart.  What the chart demonstrates is the fund produces ~120% of what the Bloomberg Barclays Government/Credit Index does while capturing only about 30% of the downside.  

In the most recent annual report which is a bit dated now (October 31, 2018), they noted their investment posture:

With that said,we continued to pursue a fairly defensive approach. Instead of trying to boost the portfolio’s yield by establishing a large weighting in lower-quality issues,we emphasized bonds that offer attractive yields in relation to the underlying risks. Specifically,we sought securities with the potential for positive price performance stemming from favorable catalysts in the underlying businesses. The financials sector, where we identified a number of securities lower in the capital structures of investment-grade banks,was one such area of opportunity. In addition to featuring high yields relative to the risks of the underlying issuers,some bonds in this segment offer floating rates—an attractive attribute given the Fed’s current policy direction.We also liked the communication and cable/media industries due to their stable, subscription-based revenues. In addition, a number of issuers in these areas may benefit from merger-and-acquisition activity.

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We believe this strategy, which combines overweights in the higher-yielding credit sectors with a defensive posture and a continued focus on individual security selection, is well suited to an environment that features both healthy fundamentals and the potential for increased risk.

Performance has been strong ranking third in the category for three- year and five-year total NAV return.  

The shares trade at a 10% discount to NAV, which has historically been on the cheaper end of the valuation spectrum.  The current discount is about 1.5 points off the one-year average and over 4 points below the 3- and 5-year averages.

This is the "since inception" premium/discount graph.  The current one-year z-score is -0.90.  As you can see from the chart below, there has been several times in the last two decades where this kind of opportunity has emerged. 

Concluding Thoughts

The NAV has been on a tear as credit spreads have tightened and the fund has reduced the distribution.  At the end of October, the fund was earning nearly $0.30 per quarter ($0.10 per month).  The next semi-annual period just ended and we should be getting the next N-CSR in approximately 45 days.  That should tell us what has been happening in the fourth quarter and first quarter.

The current discount is likely wide because of the first quarter distribution being about 4-5 cents below average (-17%) from the prior quarters.  We do think given the rising NAV allowing them to turn up some leverage, improvements in the credit markets, and the current earning power of the fund that they will be able to increase that distribution back towards their recent average. 

This could cause the share price to gain about 2-3 points- at least- on the NAV, which is already seeing a nice upward slope.  While the yield is a bit lower, the fund is not a riskier bet despite the leverage and non-investment grade holdings.  The portfolio managers are positioning the fund with a defensive posture but still being able to participate in the rally. 

This is a great fund to have in the Core of your income portfolio, especially those that are still in accumulation mode and want a more total return approach.  If you have a traditional 60/40 asset mix, you can greatly improve your long-term performance by augmenting your fixed income with a fund like JHI.  We think the longer-term performance will be north of 6% and likely closer to 7%.

In summary, there is nothing special with the fund as they have no interest rate swaps on taking duration bets, no esoteric strategies like you see in many funds.  Again, this is a good time to establish a core holding in a fund that could be held for many quarters.  I don't see them switching to a monthly pay system but if they did, we could see an addition bounce in the shares of 2-3 points.