3 Unique Multi Sector Income Strategies
Written by Michael Fabian, April 24th, 2014
Ever since I began managing money I have always gravitated toward multi sector income funds in lieu of traditional aggregate bond strategies as a way of increasing income and lowering volatility. The innate problem with core bond strategies is that they traditionally weigh the balance of their holdings based on the total size of the U.S bond market. This translates into a nonsensical practice of lending the largest slice of a client’s assets to the most indebted issuers.
I believe this method is fundamentally flawed when evaluating the creditworthiness of an issuer and its ability to ultimately service its debt load. Conversely, seeking out responsible issuers on a global level that assume debt to fund productive assets or new processes can make for a more sound investment.
While market cap weighting may be a great strategy when applied to equities because investors share in the ongoing success of the company, when things don’t go as planned you often times find equity and debt investors protecting their interests from opposite ends of the table. For this very reason I believe fixed-income investing should be viewed through a different lens. Sector allocations should be sized by factors including: relative value, risk vs. reward, duration, creditworthiness, income, and capital preservation. Flexible multi sector income funds offer a great way to expose ones portfolio to the best ideas of firms with superior management expertise and unique credit research capabilities.
There are three multi sector income funds that we currently utilize for clients in our Dynamic CEF Income Portfolio. Each has been handpicked to exploit the strengths the management team possesses in security selection and strategy implementation in targeted areas of the market. They include the PIMCO Dynamic Credit Income Fund (PCI), the DoubleLine Income Solutions Fund (DSL), and the Blackrock Multi Sector Income Fund (BIT).
Beginning with PIMCO, PCI’s team of 5 portfolio managers is led by Daniel Ivascyn, an expert in the areas of mortgage backed securities and fixed-income derivatives. The portfolio is leveraged by roughly 40%, and is currently overweight mortgages, corporate high yield, and senior loans. With smaller positions in investment grade corporate bonds, distressed debt, and emerging markets bonds.
Probably the most unique characteristic that PCI has when compared to the other two is its extensive use of interest rate and credit default swaps. Since the 12/31/13 annual report and 3/31/14 holdings report, Mr. Ivascyn has nearly hedged the portfolio’s credit and interest rate exposure with a large position ($270 Million in notional value) in 30-year pay-fixed swaps. He has then subsequently offset that by adding quality back to the portfolio on the lower end of the curve with 5 and 10-year receive-fixed swaps.
This derivative structure is a setup to capitalize on the long end of the curve steepening and the short to intermediate end remaining low or even falling. Furthermore, he also has pay/receive fixed credit-default swap positions in low duration high yield indexes to likely further ballast the interest rate swaps, protect against a pickup in defaults, and improve the income generation of the portfolio.
PCI currently trades at a 5.67% discount to its NAV, which is slightly above its trailing twelve month discount of 6.96%. Its distribution policy is yielding 8.11% in relation to its market price.
Moving on to DoubleLine, DSL’s team of 3 portfolio managers is led by fixed-income guru and mortgage backed security expert Jeffrey Gundlach. DSL’s portfolio is designed to meet or exceed its distribution policy by deploying its portfolio, which is leveraged by 31%, to primarily below investment grade areas that he believes exhibit the best relative value characteristics.
I particularly like his over 80% weighting toward below investment grade and non-rated securities because Gundlach is old-school with his approach to portfolio execution. Where many would liken his management of multi-billion dollar fixed-income portfolios without the use of swaps as playing a basketball game with one hand tied behind your back. He clearly doesn’t see the need for the complex instruments, and relies heavily on traditional fundamental credit research, and his maverick ability to identify value in the most unlikely places.
Emerging market debt is where he currently sees future prosperity, as U.S. dollar denominated credits currently make up 45.1% of the portfolio, followed by non-agency/agency mortgages (17.4%), high yield corporates (17.6%), and senior loans (10.2%). He has been proven correct with his early engagement with the theme, as EM bonds are currently one of the best performing credit related fixed-income asset classes in 2014. They have even outperformed domestic high yield securities of similar duration and credit quality. I monitor DSL’s underlying portfolio closely for changes in sector allocation, as it gives me great insight as to areas of the fixed-income market that offer the best risk vs. reward for income and capital appreciation.
DSL currently trades at a 5.35% discount to its NAV, which is slightly above its trailing twelve month discount of 7.66%. Its distribution policy is yielding 8.28% in relation to its market price.
Finally, the newest position we entered into for clients in our CEF income portfolio is the Blackrock Multi Sector Income Fund. BIT’s team of 3 managers is equally contributing their respective specialty of low duration fixed-income, mortgage backed securities, and securitized products. Its heaviest and most differentiated weighting is in securitized products such as asset backed securities (ABSs), collateralized loan obligations (CLOs), and collateralized mortgage obligations (CMOs). With smaller allocations to high yield bonds, bank loans, non-U.S. developed, emerging market, and investment grade credit.
Three characteristics that really drew me to BIT was its deep discount, unique portfolio, and it’s excellent NAV performance post taper announcement. To put it in perspective, the NAV of BIT has done nearly double the performance of PCI and DSL since the September 2013 interest rate high. In addition, BIT’s portfolio, which is leveraged by 42%, could exhibit excellent relative performance in a longer term rising rate environment due to the floating rate nature of many securitized products, and the moderate use of interest rate swaps to offset volatility. As a result, its current effective duration rests at just 3.02 years.
BIT currently trades at an 8.95% discount to its NAV, which is slightly above its trailing twelve month discount of 9.45%. Its distribution policy is yielding 7.73% in relation to its market price.
From my perspective, we aren’t at the precipice of another large interest rate backup; however over time as the economy will undoubtedly improve and QE will come to an end, a secular change is likely to play out. Altering the style and approach to your own portfolio should increase your income stream and lower your interest rate sensitivity. However, I would caution you to be mindful of all three funds’ heavy reliance on credit to achieve their stated objectives. Any credit contraction or spread widening could lead to a swift change in market price.
Each of these funds has appealing characteristics in the manager’s themes or portfolio attributes. In my opinion, all three funds should add a broadly diversified mix and unique facet to your high yield fixed-income portfolio. Like any strategy, developing a plan, then implementing it decisively, will ultimately yield a more successful outcome.
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