Rediscover income-focused investing

Dec 4, 2018

Patience can pay, generating a little income a lot of times

Highlights

  • We think it’s vital for investors to remember that return derived from income makes up the lion’s share of total returns in credit markets, and price return appears considerably less important in a late-cycle, post- Quantitative Easing World.
  • A long-term investment time horizon, in other words behaving more like an investor and less like a trader, can reduce the chances of sustaining permanent capital losses in an income-styled strategy.
  • Further, long-term investors can capitalize to a greater extent on capturing liquidity risk premia, which we argue is a solid potential source of alpha for investors who can be patient.
  • That said, being a long-term investor does not imply that one is lazy, selectivity pays greatly in credit markets, as simply buying the highest-yielding assets exposes investors to greater risks over time.
  • Finally, we believe it is vital to recall that beyond selectivity, well-devised diversification of income-producing assets helps to reduce a portfolio’s overall risk profile and reduces the chances of extreme left-tail risks.

Income is a powerful force investors can harness in an effort to generate returns in the bond market, but a prudent, disciplined, and steady approach to helping generate these returns is vital to embrace. Income is a long game, so it’s important to take a considered approach. Risks that may seem remote over a carry-focused investor’s long holding period can materialise quite quickly. As such, portfolios constructed out of weak building blocks will likely display their flaws as time passes. Further, we believe investors must remember that eye-popping returns over a one-month, one- quarter or even one-year time horizon aren’t the hallmark of an effective income strategy. Rather, an effective income strategy seeks to achieve solid, reliable, and durable performance over a longer-run five-to-10-year investment window.

Setting the stage for an effective income-oriented investment approach

To be clear, having a long-term horizon doesn’t mean taking an indolent approach. We don’t believe in a “set it and forget it” type of portfolio construction, but rather we think it’s important to be deliberate in decision making throughout a portfolio’s life. Moreover, diversification is crucial and we should seek to generate a little bit of income a lot of times.* (Diversification does not guaranty a profit or eliminate loss). It may be true that this approach won’t swing for the fences by taking an outsized position in the du jour sector performing most strongly at any given point, but that also aids with risk management. Strategies seeking high income may find themselves invested in asset classes with meaningful amounts of risk imbedded in them, but as we’ll argue later, diversification may be able to mitigate some of that portfolio risk. Building an effective income strategy isn't just about prudent top-down portfolio construction; fundamental work is critical. When examined over a long period of time, it's not uncommon for an investment with poor fundamentals to go sour over time. So, chasing the investment with the highest optical coupon is often not the wisest approach. Instead, we think scouring fundamentals with a fine-tooth comb before investing, and on an ongoing basis afterward, is absolutely crucial. Furthermore, being focused on the underlying health of assets in the portfolio often helps with having the humility to acknowledge when a fundamental view was wrong and take appropriate action in an effort to protect the portfolio.

None of this is to say that the income-focused approach we describe is the best, or the only, way for every investor to achieve their goals in fixed income. These strategies aren’t designed to be ballast to an equity portfolio, or to be purely capital preservation strategies. We also believe there are a number of ways to harvest returns from the fixed income market. In our previous paper on active returns in fixed income1 we note that there are a number of ways investors can potentially generate returns from active management in the fixed income market. We'd be remiss not to mention that passive strategies, including those in sectors with high income, may be best for some investors. Each investor will find a different allocation to various fixed income strategies best for their needs. But, for income-seeking investors with a long-time horizon who are willing to tolerate some volatility, we believe there are opportunities to pursue effective actively managed income-oriented strategies.

Patience can pay with a long-term income strategy

Crucial to our approach to income is the idea that patience can pay. When we look over a period of many years, we find that the vast majority of returns in major bond indices come from income, or coupon. As a case in point, when we disaggregate the income and price return components of various fixed income indices, we can see that the income component, or the coupon, is by far the most dominant factor in delivering total return (see Figure 1). Said differently, an income-focused strategy is very much a back- to-basics approach to the bond market that seeks to capture the largest source of potential returns inherent in the asset class. We look to find the most efficient carry to own in a portfolio and to enjoy those returns over a long holding period. By looking at this Figure, one could hypothesise that generating returns by ‘clipping coupons’ is easy, or simple, yet it is not. We need to be mindful that there is no free lunch in investing, as asset classes that produce sufficient yield to attract many investors often come with a sizeable amount of risk inherent in them. Across different types of fixed income indices, we see that coupon, which accrues to investors slowly, accounts for the majority of returns.

Figure 1: Income, or Coupon, is a Vital Component for Bond Market Total Return

Income, or Coupon, is a Vital Component for Bond Market Total Return

The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

Source: Bloomberg; as of August 31, 2018; from left indices are: Bloomberg-Barclays Multiverse, Bloomberg-Barclays Global Aggregate, Bloomberg-Barclays Global High Yield, and Bloomberg-Barclays Global Aggregate Corporate. Note: Figure shows total returns by return source as a ratio of total returns since Jan, 2001, and the “other” category includes intra-month currency return for global indices and paydown returns for non-global. Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index. Please refer to the appendix for historical performance of the stated indices.

As shown in Figure 2, carry can be an especially impactful force in some of these higher-risk asset classes. Over a long enough time horizon, carry can over-power the periodic drawdowns that risky asset classes may endure. In Figure 2, we show rolling two year returns over the last decade, including through the Global Financial Crisis in 2008. In the higher-income asset classes we examine, we find it relatively rare to have negative returns over a rolling two- year period. For this reason, we believe a carry strategy may be well-suited for an investor with a longer time horizon.

Figure 2: Rolling 2-Year Returns by Fixed Income Sector Argues For a Longer Time Horizon

Rolling 2-Year Returns by Fixed Income Sector Argues For a Longer Time Horizon

The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

Index names:

Long TSY: Bloomberg Barclays US Treasury: 20+ Year Int TSY: Bloomberg Barclays US Treasury: 7-10 Year IG: Bloomberg Barclays US Credit HY: Bloomberg Barclays US Corporate High Yield

EM: Bloomberg Barclays EM USD Aggregate

Source: Bloomberg, data as of August 31, 2018. Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index. Please refer to the appendix for historical performance of and identification of indices.

In these strategies, having the appropriate level of confidence and risk tolerance can enable an investor to hold on to fundamentally good assets through the inevitable periods of market volatility. This long-term horizon means that bumps, hiccups, and moments that may feel deeply uncomfortable are an expected part of a strategy that we believe will prove profitable over the longer run. Still, the existence of meaningful risks in a carry strategy means that all aspects of portfolio construction should be considered with care and prudence.

Another potential benefit of being a patient, long term, investor is that this horizon makes additional tools for generating returns available. An investor with this outlook may be more comfortable taking greater liquidity risk, for example; if a carry strategy is intended to be a long term holding, an investor may be willing to forgo some ability to access capital easily and cheaply in exchange for higher potential returns. We believe that the ability to harness liquidity premia may be an important source of returns for investors in the years to come.

Figure 3: Liquidity Premia Can Serve as an Alpha Source for Investors with Patience

Liquidity Premia Can Serve as an Alpha Source for Investors with Patience

Index Names: CLO: JPM CLO Index (CLOIE) BB Spread HY: Bloomberg Barclays HY Index IG: Bloomberg Barclays US Credit Baa CMBS: Bloomberg Barclays CMBS Investment Grade BBB

Notes: In the figures above, note that the HY index is composed of below investment grade rated corporate bonds while CLOs are subordinated debt backed by pools of loans. In the second chart, the credit index contains bonds issued by a multitude of investment grade issues. CMBS refers to securitizations of cash flows backed by commercial real estate.

The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

Source: Bloomberg and JP Morgan, data as of August 31, 2018. Past performance is not indicative of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index. Please refer to the appendix for historical performance.

In Figure 3, we attempt to show liquidity premia in the fixed income market by looking at asset classes that have the same rating and similar fundamental economic risks, but have meaningfully different liquidity profiles. We compare various sectors of the securitised market to the corporate debt market. Given the similar ratings, it would be challenging to attribute such a large difference in spread to credit risk alone. The securitised markets we show below are often smaller and more bespoke than the corporate debt market, creating additional frictions to transaction. With the asset being harder to trade, investors will likely want to be paid an additional liquidity premium to compensate for the reduced ability to reallocate or reduce risk. While this liquidity premium is variable through time, we notice that it often is positive across the asset classes we examine. For an investor with a long-term horizon, the option to redeem an investment may not have all that much value, making potential yield pickup from taking liquidity risk attractive.

To be clear, not all investors in carry-focused strategies can, or should, want to give up a degree of liquidity— this tool is only a part of some investors’ toolboxes. Furthermore, ensuring alignment between the liquidity profile of a portfolio’s assets, and the liabilities the portfolio is intended to meet, should be considered critical. We believe that owning massive amounts of highly illiquid assets in portfolios with frequent redemptions may be irresponsible and detrimental to investors. Being patient may mean access to more tools; yet as with all aspects of investing in high- income strategies, we believe that prudence is crucial.

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