What To Expect From The Next Income Drawdown

A recent discussion with subscribers touched on market drawdowns and how they have impacted different income sectors. On the service, we track some of the key metrics of various income sectors such as yield dynamics, risk indicators, correlations, and others. We also track a number of drawdown periods and how each sector responded. This includes the 2013 taper tantrum, the 2015 Energy market crash, the 2018 Fed autopilot comment, COVID, and the 2022 rate shock.

These are clearly not the only market drawdowns of recent memory, but they are the most salient, and they are enough to identify two types of market drawdowns. The first, such as those in 2013, 2018, and partly 2022, we can call “rate shocks” and they were driven primarily by things like inflation surprises and Fed miscommunication. The other type of drawdown such as those in 2015 and 2020, we can call “growth shocks” as they were primarily driven by recession worries. 2015 was a relatively minor growth shock and was primarily concentrated in the Energy sector.

If we combine the last rate (2022) and growth (2020) shocks into a single sector drawdown chart, it looks like the following.

We can see a few patterns. One, higher-quality sectors such as Munis, Agencies, and Treasuries generally outperformed. Investors may not feel like Munis outperformed the 2022 drawdown however that may be due to positions in Muni CEFs which tend to hold longer-duration bonds, carry leverage, and saw their discounts widen substantially in 2022, causing significant underperformance – more on this below.

Two, floating-rate assets generally did OK during the rate shock, which was likely due to the swift rise in short-term rates and, hence, higher carry. Loans did not move a whole lot and BDCs, which absolutely collapsed in the 2020 growth shock, had a less than 10% drawdown.

Three, some sectors fared badly in both types of drawdowns, particularly equities/convertibles and REITs (including mortgage REIT common stock and hybrid mortgage REIT preferreds – listed as MREITHPREF).

As hinted above in the context of Muni performance, the other dimension of income investing we need to investigate is the performance of CEFs against their underlying assets. This is because investors may be surprised by how much the performance of, say, a Muni CEF diverges from that of municipal bonds, broadly speaking.

The chart below shows how CEF sectors fared against benchmark ETFs in 2022. For example, the Muni CEF sector was down around 23% in total price terms against the benchmark ETF, which ended up down around 7%. What we see is that all CEF sectors underperformed benchmark ETFs. As highlighted above, that was largely due to the combination of leverage and discount behavior.

We saw similar underperformance by CEFs in 2020 as well, for the same reasons.

In discussing drawdowns, there are two important questions to consider.

The first question to ask is whether investors should bother preparing for the next drawdown. One school of thought has it that, since most investors cannot time the market, they should avoid doing so and be “all in” at all times. We have some sympathy with this view. However, it’s important to distinguish here between growth assets like stocks and mean-reverting assets like bonds.

In our view, mean-reverting assets like bonds lend themselves to countercyclical allocation – reducing risk when valuation is expensive and vice versa. Doing this with growth assets like stocks is much more difficult, given the historic uptrend and a high opportunity cost of being out of the market.

If we zoom in on how “bonds” perform, proxied by the high-yield corporate bond ETF HYG shown below, we see that there are periodic gaps in the price – all of which were from a tight level of credit spreads – the same level we observe today.

For credit CEF investors, the news is even better. Not only do credit assets mean revert, but so do CEF discounts, as shown below.

This meant that the end of 2021 was a particularly good time to reduce an allocation to CEFs, particularly credit CEFs. Checking in on our “swirlogram” we see that we are now approaching the unfavorable valuation quadrant in the top left. We are not quite there yet as discounts are only slightly expensive, rather than very expensive. And for higher-quality assets, nominal and real rates are significantly higher than at the end of 2021. That said, it’s clearly not a great time to be adding a lot of risk.

Our answer to the first question is that preparing for the next drawdown is both relatively cheap as the additional yield of lower-quality securities is comparatively small and straightforward given the historic patterns in mean reversion across credit spreads and discounts.

The second question to ask is why does this matter? In other words, what is the point of countercyclical investing? Once investors accept that some assets tend to be more vulnerable during drawdowns, it’s easy to understand that they can use more resilient assets to buy assets that fell harder in a drawdown. This can allow investors to achieve a sustainable pick-up in yield as well as grow their portfolio wealth over time. Investors who are always “all in” don’t benefit as much from rebalancing opportunities as there are fewer “dry powder” positions in the portfolio.

What could the next income drawdown look like? Obviously, we don’t know for sure. That said, a macro shock is much more likely in our view than a rate shock. This is for several reasons. One, the economy is clearly slowing down, the latest GDP print notwithstanding. We can see this across any number of indicators spanning the labor market, new orders, construction, discretionary spending, etc. A rate shock is also less likely in a period of relatively high nominal and real rates, disinflation, and a monetary policy stance that is objectively too tight for the current environment. Another thing we don’t know is the magnitude of the next drawdown but, barring a black swan event, it is likely to be a “polite” one rather than the batten-down-the-hatches experience in 2020.

A final point is that while it makes sense to position with the next drawdown in mind, income allocation is never an all-or-nothing affair. We don’t know when the drawdown will come and how large it will be. This means that we have several pockets of higher-yielding/higher-beta securities in our portfolio as well. Rather than move from one type of security to another wholesale, we have been marginally adjusting our positioning by reducing exposure to expensive leveraged assets such as CEFs and BDCs. The actual amount of dry/drier powder varies by investor and depends on their specific goals, risk appetite, and views.

Ideas

We view three types of assets as potential candidates for drier-powder securities that can be put to work in the next drawdown to sustainably increase portfolio yield.

One is shorter-maturity, decent-quality assets. The short maturity lowers the beta of the security, all else equal. A short maturity should not be confused with short duration as short duration (as in interest rate duration) assets such as floating-rate securities can be very volatile as they can have a high credit spread duration due to their longer maturity.

This can include high-quality assets such as TIPS via the iShares 0-5 Year TIPS Bond ETF (STIP) with an SEC yield of 5% and a duration of 2.3 and Agencies via the Simplify MBS ETF (MTBA) with a 5.3% SEC yield and a 3.5 duration.

On the higher-yielding side, they can also include baby bonds such as the Ready Capital 2026 bond (RCB) with an 8.5% yield and CEF OXLC 2027 bond (OXLCZ) with an 8.2% yield.

Two, as we saw in the CEF/ETF charts above, investment vehicles that are unleveraged and don’t trade at discounts can be much more resilient during downdrafts. At this point, open-end funds do not have a high opportunity cost in terms of the yield they generate internally over CEFs. This is because CEF discounts have tightened significantly and most carry high costs of leverage, which only increases price volatility and does not increase net income appreciably.

Here we like ETFs such as the First Trust Institutional Preferred Securities and Income ETF (FPEI) with a 7.1% portfolio yield-to-worst and a mostly investment-grade allocation, iShares Fallen Angels USD Bond ETF (FALN) with a 6.9% yield and a mostly BB-rating profile – well above the typical High Yield corporate portfolio and the Janus Henderson B-BBB CLO ETF (JBBB) with a 9% portfolio yield-to-worst and an investment-grade CLO allocation.

Finally, we like longer-duration/higher-quality assets such as Municipal bonds. This is because, in a typical macro shock, Munis tend to outperform due to both their credit spread resilience (credit spreads tend to rise roughly proportionally so tighter-spread sectors like Munis outperform) and longer-duration profile as longer-term rates tend to fall in macro slowdowns.

Here we like two tax-exempt Muni CEFs MVF and EIM with 9% discounts and conditional tender offers which generate additional alpha for shareholders. The wide discounts of the funds mean they are relatively less vulnerable to sharp discount widening such as what we saw in 2022. Current yields are 5.9% and 4.9% respectively.

Takeaways

While drawdowns can be painful on portfolio values, they also offer excellent opportunities for investors to sustainably increase the yield on their portfolios. Taking advantage of drawdowns, however, requires carrying holdings in the portfolio that can maintain a measure of resilience as well as gauging the type of drawdown we are likely to see next. In our view, even a small allocation to the three types of securities discussed in this article puts investors in a good position to take advantage of the next slide in markets to boost their income levels as well as grow portfolio wealth.