A Global, Asset Allocation Approach to High Income Investing

 

The Global Financial Crisis of 2008 arrived at an inopportune time for the baby boom generation nearing retirement age. First, the large decline in equity markets (albeit temporary in hindsight) forced workers on the cusp of retirement to scale-back goals and/or reconsider their timing. It also may have caused them to make investment decisions they would come to regret, like selling some or all of their portfolio equities. Second, the prolonged decline in interest rates in the aftermath of the crisis added insult to injury with the paltry income streams available from bonds — the very income retirees might need to replace their wages.

Saturna Capital's Approach to High Income Investing

The Sextant Global High Income Fund offers a unique approach to high income investing, beginning with an asset allocation strategy rather than adhering to a specific asset class or "style box" from which to select high income investments. This asset allocation strategy entails a set of constraints designed to allow flexibility in management of the fund's asset allocation within minimum and maximum thresholds, consistent with the high income investment objective.

Within these thresholds, the portfolio managers have ample latitude to select attractively valued securities by country or economic sector. Compared to single asset class funds, which we will talk more about later, we believe our asset allocation approach should provide superior risk-adjusted returns over a full investment cycle.

 

Impact No more than 50% in common stocks Limits the impact of equity volatility No more than 50% in securities of US issuers Maintains global diversification No more than 50% in bonds rated A3 or higher Puts a ceiling on credit quality in order to limit portfolio managers' ability to "hide out" in low-yielding, higher quality bonds No more than 33% in securities of emerging markets issuers Limits the concentration of foreign investment risk that tends to be magnified in emerging markets

The other important aspect of our approach to high income investing complements our asset allocation strategy and its constraints, and that is our philosophy of, and attitude toward diversification and fundamental valuation.

We believe diversification comes not only in the form of asset class, geographic, or sectoral diversity, but in diversity of quality, cyclicality, value, and growth factors.

For example, it seems self-evident to mention that so-called "junk bonds" tend to be issued by lower-quality companies. However, higher-quality enterprises with stable revenues and earnings, but minimal growth, such as regulated utilities and pipelines, also tend to command higher yields for their common stocks. Likewise, cyclical factors can lead to widely varying yields available among various sectors and countries. We believe that diversification along the continua of quality, cyclicality, and value can add an important dimension to diversification along traditional lines.

Saturna Capital has a heritage of investing based on fundamental values, so we also favor securities we believe to be attractively valued, and we structure the portfolio to underline our convictions across the range of diversification dimensions we discussed previously. We emphasize three aspects of fundamental value in selecting securities and their weights for this fund:

• MEAN REVERSION:
  How far is a security's value from our appraisal of its long-term equilibrium value?
• CONTRARIANISM:
  Are there reasons to believe that securities prices have been influenced by excessive optimism or pessimism, and can we justify a contrary point of view?
• TIME-HORIZON ARBITRAGE:
  If securities prices reflect myopic overreaction to recent events or trends, do we expect these short-term issues to eventually become outweighed by longer-term trends working in our favor?

In summary, we believe our asset allocation strategy supports our objective of high income with wide diversification across multiple dimensions. And by not confining our investment selection to a single asset class or geographic region, we can better align our high-level views on relative valuation to construct our portfolios.

 

Other Approaches in the Market

Investors and their advisors, eager to find sources of high income, have flocked to a number of alternative income product types:

• High-yield Bond Funds
• Leveraged Loan Funds
• Equity Income Stock Funds
• Total Return Bond Funds
• Unconstrained Bond Funds

As should be evident from their descriptions, these products almost exclusively confine their investments to a single asset class, or in some cases — such as high-yield bonds and leveraged loans — to niches within these asset classes. This is typical of the traditional style box approach to building products and comparing fund managers. The general idea is that investors and advisors want to be able to evaluate and compare similar funds. In theory, it also allows them to tailor their allocations to asset classes, or even niches within asset classes.

We believe there are several drawbacks to the style box approach that should be considered, particularly for the case of alternative or high income strategies:

Apples to oranges

Even within some of these product types, such as total return bond funds and unconstrained bond funds, there may be significant differences in the investment strategies employed, strategies which may include the use of leverage, derivatives, and short-selling, that make comparison of competing funds and the sources of their returns a challenge, if not meaningless. Total return funds also attempt to profit from forecasting changes in interest rates, with a secondary focus on providing income.

Plowing through dicey conditions

We also strongly believe that conditions in the high-yield bond and leveraged loan markets can make them plainly unattractive from time to time. However, fund managers faced with heavy inflows may have no choice other than to plow ahead and purchase dicey new issues. And those very inflows also suggest a lack of awareness about the prevailing market conditions among investors and their advisors.

Beginners beware

Results achieved by investors and their advisors in allocating to these markets may depend, to a significant degree, on their timing. It may make more sense for investors who wish to invest in high income securities to outsource their investment allocations to professionals who specialize in these markets and can make informed appraisals of relative value across asset classes.

Low liquidity masks risk

We believe the less liquid types of fixed income assets, such as high-yield bonds and levered loans, may present an illusion of low risk because of their low day-to-day or week-to-week volatility.

By comparison, the Sextant Global High Income Fund does not permit the use of leverage, derivatives, or short selling. Our asset allocation approach limits the extent to which we become "forced buyers" of plainly unattractive issues, since there are usually pockets within the wide net we cast where we can find attractively valued securities.

Concerns for High Income Investors

Some Risks of High-Yield Bond Funds

We believe the high-yield bond market entails risks similar to equities but that it behaves in a way that is especially procyclical, moving in line with the economy. By this we mean the market is prone to virtuous and vicious cycles. It may be possible to avoid the worst of the vicious cycles by scrutinizing fundamental attributes such as credit spreads,¹aggregate issue quality, market structure, and investment flows in and out of high-yield funds.

Credit Spreads

The longest running index of high-yield bonds may be the Bank of America Merrill Lynch High Yield Master II Index, which has return data going back 30 years to 1986. Over the past 30 years, the monthly returns of this high-yield index have exceeded those of the comparable 5 to 7-year US Treasury index by an average of roughly 2%, annualized. However, if we use the benefit of hindsight to analyze the relationship between the realized 5-year excess return of the high-yield index and the credit spread, we can see there has been an approximately linear relationship between credit spread and realized returns.² Based on the best-fit line in Figure 2, investors should require a high-yield spread of 6.25% over US Treasurys to earn a 2% excess return, on average. Where has the remaining 4.25% of yield gone? Evidently it has been given up to default losses and changes in relative valuation. Figure 2 also shows that accepting high-yield credit spreads near the low end of the historical valuation range was perilous, as excess returns dropped most steeply into negative territory there. Conversely, some flattening evident in the upper right hand portion of the chart suggests there was relatively less to gain in return for demanding a historically high credit spread as compared to the best-fit line.

 

We believe another important fundamental indicator for investing in high-yield bonds is aggregate credit quality. According to the Investment Company Institute, investors poured almost $150 billion (net of outflows) into high-yield bond funds between 2010 and mid-2014. As they did so, high-yield credit spreads fell commensurately.

What this data demonstrates is that the yield premium available to investors in high-yield bonds is in part dependent upon the aggregate behavior of mutual fund investors.

A more insidious impact of the volumes of money flooding in and out of high-yield mutual funds is the impact on aggregate credit quality. Mutual fund managers faced with large inflows often need to go to the new issues market for supply. Interested in securing a minimum yield to maintain a competitive fund-level yield, they may be willing to negotiate covenant details with issuers. The aggregate impact of these negotiations has led to a proliferation of so-called "covenant-lite" bonds in the high-yield market. Thus, a survey of the credit spread alone tells only part of the story, and today's spreads are probably wider than they would be if adjusted for the lack of credit protection provided by the standard suite of bond covenants.

Finally, issues in the high-yield market tend to trade infrequently, so bond valuations are typically based on observed trades of similar bonds and the general movements in interest rates. Even if the subject bond has a trade, it may only be one component of its valuation that day. Implicit within these statistical valuation techniques is some degree of averaging that smooths returns compared with securities that are priced based on their own trading, like equities. This smoothed valuation effect is partly responsible for the lower volatility observed in high-yield bonds when compared to equity volatility. However, the low observed volatility during benign market conditions is likely to significantly underestimate the underlying risks of these bonds, and when market conditions deteriorate, these bonds may experience sudden and large swings in value that are more commensurate with the bonds' actual level of risk.

Leveraged Loan Funds

Our concerns about the procyclicality of the high-yield bond market are amplified by the nature of the leveraged loan market. The secondary market for leveraged loans has traditionally been very thin, and the arrival of mutual funds that invest in these securities threatens to become the proverbial bull in the china shop. Even setting aside liquidity concerns faced by funds that are supposed to be able to provide their investors with daily liquidity, a flood of new cash into these markets incentivizes investment banking underwriters to scour for borrowers in places they probably shouldn't look.