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.
“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”
- Ben Graham
Markets have returned to their prior highs set near the end of the third quarter. It was a very fast recovery from the bear market of the fourth quarter. Just four months ago, the word recession was being thrown around by the financial media constantly. The thesis was predicated on the soon-to-be (at the time) inverted yield curve, ongoing trade tensions, and the thought that global growth was slowing to a crawl.
However, global growth was slowing, not decreasing, which is a far different thing. In 2017, the world was seeing a synchronized global growth story whereby most countries were growing at least moderately. The chart below (Global PMI data) shows that growth story noted by the darker green color for the latter parts of 2016, 2017, and in some cases, into 2018. But notably in 2018, we started to see some yellow bleed back into to the developed countries PMI.
The yellows denote slower growth, not stagnant growth nor outright contraction. And yet, the economic pundits were all over this story suggesting that the economy was flailing and likely to 'go negative' meaning enter a recession. As we noted in the January letter:
The markets had a great year for the first three quarters of 2018 but quickly gave up all of those gains and then some in the fourth. It comes when we least expect it and how we react becomes the vital to our outcome.
The key question remains: should investors accept the market's warning signs of a downturn or embrace risk amid cheaper prices.
This is the time for 2019 predictions and outlooks. We have read a multitude of them (>30) and the forecasts range from downright gloomy and recessionary to substantially bullish. Most centered on the Fed and the forecast for interest rates over the next year. In fact, Goldman Sachs is contrarian offering up the prognostication that they would likely to raise rates 4 more times in 2019 to bring the terminal rate to 3.25% to 3.50%. This is two-and-a-half hikes above the market forecast. (and now two days after I wrote this, they backtracked to just one hike).
Downside risks continue to mount but the rationale for the global equity sell-off seems rather benign. It is possible that the worrying signs of the length of the bull market and expansion, along with the memory of the last downturn being so sharp and catastrophic in a relatively short period of time, could be sending investors to the exits.
Our goal at the time was to put our chips into the game and capture the snap back in discounts and NAVs overall. The reasons for the sell-off as we wrote, appeared rather benign. Unknown to us at the time but we experienced one of the fastest recoveries from a bear market in history. In fact, the first 78 trading days of this year was the sixth best since 1928.
One data point we keep a close eye on is the leading economic indicators index (LEI) to see how the data is flowing. The March data came out a couple of weeks ago showing an increase of 40 bps, far better than expectations. This now brings the index back to the September 2018 highs. It would be VERY hard for the index to be at these levels and indicate a recession in the next six to nine months.
Schwab recently had a blog post showing the individual 10 components of the LEI index and the trend associated with each. The trend of the data, like in closed-end fund fundamentals, tends to mean more than the actual levels of the data. The table shows that of the 10 leading indicators, four were improving and three were stable. Just three were lower with one of the being the yield curve spread.
The caveat to all this is that the year-over-year trend is slowing. But this has happened at least twice in during this now ten-year expansion. The first was in the latter half of 2011 and the second was in 2015-2016. It appears we have started to experience another slowdown but again, not an outright decline in growth.
The economy appears to be doing well. It is certainly not in the former +3% GDP mode that it was in for most of 2017, but seems to be ratcheting back to its prior post-recession trend of ~2% growth. We do not foresee a recession this year and think investors should remain at their target allocations and maintain their strategy.
One thing we've seen/heard from many members is that they were waiting to get back to their "all time highs" of where they were back in September and then they're going to "get out." We would recommend not doing this. You could de-risk a bit but a wholesale and fundamental shift in the investment strategy would likely not be a wise move.
As you'll note from our high yield and floating rate update as well as from our commentary in the Core Portfolio section below, we are looking at taking down the risk of the portfolios we manage as well, but not making a wholesale change. The discounts have tightened and unless we see an increase in volatility, are likely to remain tight with few decent buying opportunities.
Location, Location, Location!
The most well-known saying in real estate investing is "location, location, location." The same could be said about where you place a security in your portfolio. The bite of taxes can be significant and we believe that most investors tend to look at gross returns rather than calculate net after-tax returns. After all, it is not what your earn its what you keep!
Most investors and advisors spend countless hours covering asset allocation with a focus on diversification and modern portfolio theory acronyms. But the rise of tax-deferred accounts in the last few decades, along with the recent tax reform limiting some deductions, asset location is becoming more prominent. Future returns are likely to be lower which means tax drag will be a more significant player in the future as well.
Asset location is simply the type of account (qualified, non-qualified, etc.) that you place your securities. The end-result is a focus on maximizing the overall tax efficiency of the portfolio to reduce the tax drag. Like tax loss harvesting, focusing on asset location takes some work but is generally universally agreed to be worth it, especially for those with high income.
Most advisors simply ignore asset location. It's much more labor-intensive and lowers margins. This is why an advisor can help fill the holes:
Putting The Pieces Together: Asset location is about putting together all of the different accounts into one global macro picture. Then applying tax strategies and customization in order to asses the need of that individual client. It is very hard to get this drilled down accurately without the point person (if its an advisor) overseeing all of the assets.
Different Every Time: Unfortunately, this is not a systemic formula that one can apply to their own unique circumstances and get a defined solution. Finding the right strategy is both trial and error, analysis, and a bit of art. This is especially true if you have a dynamic and complex financial plan.
Constantly Evolving: Asset location changes over time as we discuss later on. It is something that has to be constantly reiterated and analyzed. We recommend looking at the tax ramifications at least every six months. The individual positions may change their tax characteristics in addition to the constant shifts in tax/regulatory policy, market conditions, and your own particular circumstances and tax rate.
There's a simple version of asset location and then there's a complex version. The more complex version may require the use of a financial advisor for those that are less sophisticated or do not have the time to devote to it. But in its simplest form, asset location rests on placing your more heavily taxed investments in your qualified (tax-deferred or tax-sheltered) accounts.
There are several types of investment income- dividends, capital gains, and interest. And each of those have different rates and sub-rates depending on the time held, income levels, and a host of other items like 199a and qualified dividends, which we've covered in other reports.
So the goal is to put the higher taxed securities into your tax deferred account structures. Simple!
There are many things that make this not so simple to execute. Here are a few to consider:
Limited Capacity: Some investors like former business owners tend to have smaller IRAs which means it may be hard to place a significant amount of those high-tax positions into it.
Tax Issues: For those in distribution mode, it can be tax inefficient when placing all higher-ordinary income position in the IRA
Complex Assets: In reality, assets are 'deeper' than just stocks vs. bonds. Each investment may have its own varying tax treatments between ordinary income, qualifying dividends, and gains.
Back to where it gets complex. If you're retired but not over the age of 70.5, your big income producers are sitting in your IRA. If you take the income for your spending needs in retirement, you are creating a taxable event. In other words, investors need to balance the tax efficiency with the tax drag, especially during distribution. In order to know the tax drag, you have to make assumptions as to the expected return of the asset. After all, if a position is going to make a very low rate of return, either via interest income or capital gain, possibly because it is ultra-safe, then it doesn't really matter where you put it.
As an example, an equity fund that earns 10% in each of the last three years likely has more tax drag than a short-duration fixed income fund that produced 2% each year- even though the equity fund pays the lower capital gains rates and the fixed income ordinary interest.
The primary drivers of asset location prioritization is that expected return level of the asset itself plus the tax efficiency. The tax efficiency will vary with each individual. This chart comes from a paper written for the Journal of Financial Planning by Gobind Daryanani and Chris Cordaro in 2005. It attempts to assess the trade off between the better location for an asset using both tax efficiency and expected return.
In addition, as the macro environment changes, so to will the assumptions of where a certain asset class goes. Interest rates, for example, are still really low and most bond funds (open-ended mutual funds) fall primarily into the blue zone- where it doesn't matter which bucket (qualified vs. non-qualified) you place it. In these instances, for those individuals with skewed global portfolios (large IRAs or large taxable relative to the other).
Summing it up, we must calculate the expected return while applying a tax efficiency ratio to each investment- a very daunting task! But if you are paying a financial advisor, it is one that they should be calculating (likely with the help of some firm software using capital asset pricing model assumptions and Morningstar tax efficiency data).
As the graph shows, unless the bond fund is a CEF, it is likely going to go into the taxable account or which ever account is larger. Your most risky assets (call it, home run potential investments) should be placed into the Roth- the most special account type from an asset location standpoint. Taxable bond CEFs should be in the IRA, as a priority. PIMCO Dynamic Income (PDI) and PIMCO Dynamic Credit and Mortgage (PCI), both of which distribution over 9% (when including special distributions) would be top priority in the IRA. All that income is ordinary taxed at the highest rates on your marginal bracket.
The most tax inefficient but also higher return investments should be in a qualified account
The most tax efficient high return investments should be in the taxable account.
The lower return investments, whether tax efficient or tax inefficient, should go wherever you have excess capacity.
And placing all the equities into the non-qualified account has ramifications based on turnover. If you buy a dozen high quality stocks and hold them in perpetuity, you are only paying tax on the dividends those stocks pay and at the lower dividend rate. But if you own a fund of equities, especially one with a strategy that results in higher turnover, the tax drag from that turnover can be significant. This is a chart I pulled from Michael Kitces which shows the ending balance after thirty years of a taxable account with varying levels of turnover.
A key exercise to conduct would be to look through all your holdings and the type of distribution it pays. The possibilities include: ordinary income, short-term capital gains, long-term capital gains, dividend income, qualified dividends, and 199a.
Asset location can have a dramatic and immediate effect to your returns. The paper cited above estimates that a well-executed asset location strategy can produce 20 bps per year of excess return. If you compound that over 30 years, it can make a fairly significant difference, especially in a lower return environment. Morningstar goes farther estimating as much as 50 bps of excess return depending on the tax bracket and returns assumed.
Tax asset location strategies can change over time. For example, in the 1980s and especially the 1990s, variable annuities became popular as a means of deferring tax liabilities. Many financial advisors would stick a lot of their bonds that paid larger coupons in a non-qualified variable annuity to shelter some of the taxable interest. As interest rates plummeted, the utility of the variable annuity has waned.
This is one of the few times you'll hear (read) say this, but this is where a financial advisor can probably be useful. This is especially true if you are currently distributing from your portfolio for spending/lifestyle needs. The advisor can help manage the macro picture - what we would call the global macro allocation- quarterbacking the placement of assets more so than the selection of them.
Tax strategies and planning within the realm of financial planning is where the actual need of a financial advisor can come in. Unfortunately, most think their job is to setup an initial asset allocation and babysit the assets collecting the fee while they attempt to get the next new client. This is probably what 95% of advisors do. But there are 5% of advisors who are worth their fee- and then some. These are the advisors who don't just select good positions for the portfolio but know how to actually build the portfolio with an eye towards reducing tax liability while achieving your goals and legacy needs.
Asset location is an important part of that planning- though I would admit it takes second to more important aspects of advice including withdrawal strategies and tax/estate planning.
We will be issuing a regular tax-sensitive report (monthly) that shows a blended tax rate and possible buy candidates.
The Core Portfolio
The Core Portfolio continues to see reduced discounts and few buying opportunities as spreads collapse. As long-time readers know, discounts are driven primarily - at least in the acute stages- by volatility. The VIX is a great proxy for near-term discounts. As the chart below shows, the VIX spiked shortly after the start of October and discount followed suit. With the VIX back towards pre-fourth quarter lows, the tailwind for tighter discounts is likely over in a general sense.
Of course, volatility isn't the only factor driving tighter discounts. The Fed pivot is another key variable that is likely to place a floor under discounts for the near-term. The pivot helped formulate our thesis that some discounts, primarily muni CEFs, would not only surpass their one-year averages but were likely to produce new 52-highs. We've seen that occur in many of the top yielding funds.
That lower for longer message made it safe to own duration again - the measure of sensitivity of a bond position to changes in interest rates. A year ago, most investors including most financial advisors, had crowded into the short-end of the yield curve, petrified that rates were about to rise wiping out years worth of interest income. The dovish message from the Fed essentially removed that overhang and with rates falling, bonds have rallied significantly.
Treasuries in the last month have backed off a bit with the long end losing about 2% overall.
YTD, all of these assets are up nicely. The numbers below are great ones for the year, let alone four months.
The average discount in the Core Portfolio is down to 6.15%, contracting another 25 bps. The Core model made about 1.33% in the month of April and is now up 10.35% YTD. When compared to the bond index (AGG), the Core did better primarily because of rising NAVs from high yield and loan funds along with closing discounts.
The weakness on a price perspective came from Nuveen Real Assets & Inc (JRI) which suffered from a small bump up in rates and relative REIT weakness. In addition, PIMCO Dynamic Income (PDI) split a bit from sister fund PCI and fell by 1.7%. Interestingly enough, from a YTD perspective, PDI is one of the weakest funds in the portfolio barely breaking into double-digits at +10.46%.
Let's go through some of the NAV numbers for the month:
Obviously, the portfolio is tilted towards high yield bonds and leveraged loans. That is the goal for the time being. Just yesterday, AllianceBernstein had a great piece talking about how high yield can help de-risk a portfolio. I know that sounds counter-intuitive but remember it has to do with from where the capital invested in high yield is derived. If it comes from munis or cash, then you just increased your risk fairly substantially. If it comes from your equities, then you did just de-risk a significant amount.
First, high yield bonds provide investors with a consistent income stream that few other assets can match. This income - distributed semiannually as coupon payments - is constant. It gets paid in bull markets and bear markets alike. It's the main reason high yield investors have historically looked at starting yield as a remarkably reliable indicator of future returns over the next five years - no matter how volatile the environment. After accounting for maturities, tenders and callable bonds, the high yield market typically returns anywhere from 18% to 22% of its value every year in cash.
Along with these payments, high yield bonds also have a known terminal value that investors can count on. As long as the issuer doesn't go bankrupt, investors get their money back when the bond matures. All this helps to offset stocks' higher level of volatility - and provide better downside protection in bear markets.
While spreads are down to 373 bps, down significantly from the levels at the start of the year, the risk-return trade off compared to stocks still makes high yield a decent place to allocate capital. The question is, how much?
We think we will be heavy into both bonds and even greater into loans for the next six months. While markets have recovered from the late 2018 lows, we don't think it is time to "go to cash" or significantly shift the target asset allocation. Reducing some risk is certainly a valid move but we would still avoid making drastic changes.
The Core is likely to be a coupon clipping portfolio for the next several months as valuations are high. Though we can expect some bouts of volatility allowing us better times to buy some funds.
In the last month, we haven't bought too much outside of the muni space. The most attractive opportunities today are:
Blackstone/GSO Strategic Opps (BGB)
JH Investors (JHI)
Putnam Premier Income (PPT)
Nuveen Floating Rate (JFR)
EV Senior Floating Rate (EFR)
Other More Tactical Trades To Consider:
Consider selling or swapping:
Guggenheim Taxable Muni Bond (GBAB): The valuation for GBAB is high, though the risk from calls is not likely to start significantly effecting the fund until early next year. This fund is about collecting safer taxable muni income so making a tactical trade is not recommended. Another option is BBN which has performed a bit better on NAV, although it's not much cheaper in terms of valuation.
Apollo Senior Floating Rate (AFT): Consider swapping from AFT to AIF which has a superior yield and cheaper valuation. AIF made a surprising very small distribution cut for April going from $0.107 from $0.104. AIF has 9.2 cents of UNII plus has coverage of 106%, which is why the cut was a bit of a surprise. Very small difference in holdings but they are both mostly loans with a small allocation to high yield.
JH Investors (JHI): For newer members that are waiting for better entry points into some of the Core funds, this is an optional substitute that you may want to hold until those opportunities open up. This is a decent BTZ/BIT looking fund with a multisector bent. The yield is a bit lower but it does have less junk compared to some other funds. It's about 25% investment grade/ 75% high-yield. NAV is rising nicely and there's a decent chance that on June 1, the QUARTERLY distribution is increased really bumping the price.
The Blackstone/GSO sister funds are very similar floating rate funds from a solid sponsor. The main difference is that BGB is about 3X larger than BGX which means BGX typically trades more 'violently' than BGB. It is likely that BGX reverts back to the same discount levels of BGB, which seems more appropriate than where it trades today. Of course, there's a smaller but still decent chance BGB moves up in valuation towards that of BGX.
Top "Quality" Funds
These are funds with coverage ratios in excess of 98%, UNII that we deem to be strong or improving, and a z-score below -1.
(1) Blackstone/GSO Strategic Credit (BGB): The fund is a term trust that is slated to liquidate in 2027. While that 8 years is a long way away from today that we do not think a convergence trade will materialize based on it, the fund is undervalued. The current yield is 9.25% and the NII yield is actually 9.95%.
(2) Nuveen Floating Rate Income (JFR): This is one of many floating rate funds we could have selected. This may be more than a one month play but we think the opportunity here is high. The fund is trading at a -12.4% discount to NAV and pays a 7.52% current distribution yield. Coverage is right at 100% and UNII is at zero. The one-year z-score is -1.00 which is one of the few funds that have a z-score that low.
(3) JH Investors (JHI): Keeping this one on the list as we do not see anything more compelling. The next distribution will be announced about June 1. I would really like to see them institute a monthly distribution system which would likely close the valuation nicely. 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.
Top Convergence Trade Opportunities
These are funds that have solid total return opportunities that could be realized shorter-term. The current list to select from is one of the smallest of the last couple of years which should tell you about the valuations of the CEF universe today.
(1) Cohen & Steers Global Income Builder (INB): This fund has been performing well though the price hasn't been rising as fast as the NAV. This is creating a widening gap between the two with a nearly -11% discount compared to a -8.5% average. The one-year z-scores are around -1.00 which is cheap but not crazy cheap illustrating the valuations in today's market.
(2) Nuveen Floating Rate Income (JRO): Like JFR above, this fund is trading wide though doesn't quite have enough coverage to reach the "quality" list. The discount is -12.3% and the yield 7.7%. The recent price action is negative but the NAV has been trending higher nicely on the back of a strong risk market (high yield and equities). If floaters start seeing positive flows again, look for JRO to trade better than a -10% discount.
(3) ClearBridge Energy MLP Opps (EMO): One of the rare times you'll see an MLP operator on either of these lists. The 9.60% yielding MLP fund has most of the top "quality" MLP names in its top ten holdings list. The fund is now trading at a -12.2% discount which is near the 52-week lows of 13.3%. The one-year z-score is -1.40. The wider discount is due to the distribution cut to the latest quarterly payment. However, the fund is still paying $0.23 per quarter which places it near the middle of the pack for MLP funds in terms of distribution yield. And of course, given the rebound in oil we've experienced recently, it is likely that NAVs will rise and the cut to the distribution could reverse. Still, our bet is that investors bid up the price some.
Reviewing Top 'Quality' Funds from last month
Last month, our top quality picks were:
One month returns:
Reviewing Top Convergence Opportunities from last month
These are funds that look very cheap but may not have the fundamentals for us to hold it long-term.
Our picks from last month were:
One month returns: