Do Income Investors Have Anywhere To Hide?

by Michael Fabian | May 28, 2013 10:06 am

The fixed-income strategy that has been “working” over the past several months is elongating duration when the 10-year Treasury Yield hits 2%, then simply riding down the curve when rates near 1.5%. Portfolio managers that have gritted their teeth, trusted the Fed, and used this channel to their advantage have been handsomely rewarded. Now that the 10-year Treasury rate is back at the upper end of its trading range, will history repeat itself, or will the rising rate believers finally have their day in the sun?

With both bonds and equities starting to reintroduce volatility, where can a conservative income investor “hide out” and wait for better opportunities?

I’m always reminded of the fact that when individual investors and institutions make changes to their portfolios, the money from those transactions has to end up somewhere. So in taking a look at the investment landscape, I attempt to rule out places that don’t fit the objective of most income portfolios.

• A bank near you? Highly unlikely with CD and savings rates so low. Who cashes in their income portfolio and transfers funds to a bank anyway? It doesn’t make any sense when you are getting zero return on your capital. Even cash in a brokerage account can offer a nice short-term respite to seek out other opportunities, but is hardly a long-term solution.
• Gold? No yield, riddled with volatility, alongside a strong dollar and the potential for the tapering of QE. I don’t believe gold is in the primary interest of most income investors, but it could be a great long-term investment for a small portion of your portfolio as a hedge against inflation.
• More Treasuries? Somewhat likely, but equities would really have to present a lot more volatility. Much to the chagrin of the “this time is different” crowd, let me assure you that it is not. If equities reverse course and a trend change occurs, treasuries will ultimately benefit.
• Fixed Coupon Spread Product? Collateralized Mortgage Obligations, Municipal Bonds, Corporate Bonds, Asset Backed Securities, etc. A move into spread assets once some dislocations begin to present themselves is likely, however investors would need to be assured that another recession or spread widening event isn’t right around the corner. I think that assurance exists in light of the recent “Fed Speak,” so I’m encouraged this could be a viable possibility.
• More Stocks? I think it really depends on the timing. A conservative income investor who can dollar cost average in during a correction can really come out on top. I also think it depends on your current asset allocation, if you only have 20% stocks, a strategic shift like this would be a great fit.

It is not my intention to generalize each asset class as good or bad, since any changes you make to your portfolio will subsequently depend on your current asset allocation and long-term goals. There are three themes that I recommend you start implementing now to get ahead of the curve:

Step one. Shorten your fixed-income duration [1]to the credit quality of your liking. This is especially important if the 10-year Treasury rate breaks above its most recent high. If you have already absorbed the brunt of the move higher by not shortening your duration at the most recent channel low, watch carefully to see if a breakout materializes. If it does, rates could begin to gain upside momentum as fear sets in, and the next level of resistance is approximately 2.4%.

For example, if you have a large allocation to high yield fixed-coupon bonds like the iShares High Yield Corporate Bond ETF (HYG[2]), consider transitioning to the PowerShares Senior Loan Portfolio (BKLN[3]). You won’t be changing your credit quality or cash flow much, but you will be drastically shortening your duration. Another example could include trading out of the higher duration iShares iBoxx Investment Grade Corporate Bond ETF (LQD[4]) for the iShares Floating Rate Note Fund (FLOT[5]). Investors interested in the intricacies of floating rate notes can read my recent article entitled, Keeping your Portfolio Afloat in Senior Loans[6].

Step Two. Evaluate your risk in equities. If inside you know that you are a conservative investor, but have jumped on the equity bandwagon a bit late, there is still time to make a change. Remember, a small loss is always better than a big loss. It would be a better move to make changes now, rather than carry the stress of watching your portfolio decline until you ultimately make an ill timed mistake by changing your allocation near a market low. Investors interested in the way I have made changes to my own portfolio in the past can read my recent article entitled, Consider Making Additional Changes To Your Income Allocations[7].

An example might include reducing holdings in more volatile positions like the iShares International Select Dividend ETF (IDV[8]) or the Global X SuperDividend ETF (SDIV[9]), while hanging onto high quality positions like the iShares Dividend Select Index (DVY[10]) or the iShares High Dividend Equity Fund (HDV[11]).

Step Three. Ready your next moves. Prepare your watchlist in bonds and stocks and the levels in which they would be attractive enough for purchase. Prepare your cash hoard so that you have enough available to make meaningful portfolio changes that will enhance your future returns. You can also review and develop your risk management plan[12] in the event you don’t feel compelled to make changes now.

Whether this small blip evolves into a larger correction in stocks or bonds is still an unknown, so I caution investors not to make overzealous changes to their portfolio. However, performing some due diligence now, and making well thought out changes over time is what will ultimately yield the most favorable outcome.

Michael Fabian is currently the Chief Investment Officer and Managing Partner of Fabian Capital Management. To get more investor insights from Fabian Capital visit their blog here[13] or click here to download[14] their latest special report, The Strategic Approach to Income Investing.

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