Investor Letter - October 2022
Defense is Still the Best Offense: A Sequel to our Year End
The last 9.5 months certainly have been challenging, but I do believe all of you are down less than the various benchmarks as of 10/15/22 year to date:
Index YTD Gain/(Loss)
S&P 500 (26.0%)
Nasdaq Composite (36.0%)
iShares Core U.S. Aggregate Bond ETF (AGG (19.2%)
iShares High Yield Corporate Bond ETF (HYG) (17.3%)
TRC actual performance year-to-date through October 15, 2022: (17.6%) *
Performance of various benchmarks (11/1/2020-10/15/2022- roughly 2 years)
Index Gain/(Loss)
S&P 500 (0.1%)
Nasdaq Composite (0.1%)
iShares Core U.S. Aggregate Bond ETF (AGG) (20.0%)
iShares High Yield Corporate Bond ETF (HYG) (14.8%)
iShares National Muni Bond ETF (MUB) (11.6%)
Invesco Preferred ETF (PGX) (21.9%)
TRC actual performance from November 1,2020 to October 15, 2022: +14.2%*
So being “less bad” is not that bad. Nevertheless, it pains me to be negative for anyone this year.
Both the bond and stock markets have had almost record declines in the last 9.5 months given the rise of inflation, the Russia/Ukraine war, China’s economic struggles, the UK’s geopolitical issues, and now a Federal Reserve which no longer “has your back” as an investor, but cares only about lowering inflation to that coveted 2% level (currently north of 7%).
The main topic on many investors’ minds these days is market volatility and how to address it. The cumulative impact of inflation, interest-rate hikes, and geopolitical uncertainty has weighed on bonds and pushed stocks into the bear market territory.
To break down each of these issues and how I as a truly independent advisor can think outside the conventional boxes (for example the conventional 60/40 stock/bond split portfolio with the S&P 500 and US Government bonds, which had the worst performance on record, I recently posted several missives on our website, www.tabularasanow.com) I encourage you to look at them to learn more about how we are positioning portfolios in this “Brave New World Markets” to borrow from Aldous Huxley. They are entitled:
Geopolitical Tensions - how we are positioning portfolios
Rising interest rates and 30-year high inflation- how we are pivoting
The Value of an Independent Investment Advisor that can think outside the box
Liquid, Liquid, Liquid - the benefits of Closed-End Funds versus Mutual Funds, Private Hedge Funds and Private Alternatives
The good news is that all of you are holding the most cash and cash alternatives with “toehold (i.e. small) positions into 70 - 100 closed-end funds as I anticipated some of this (see TRC’s November, December, and February letters) but despite my caution and playing defense with cash and cash alternatives as an asset class, the “safest” part of the bond market of US Treasuries have lost over 50% in the last two years!
Notably, the 2-year US Treasury is now yielding 4.25% from less than 1% a year ago; and the 10-year treasury is getting close to 4% from less than 2% a year ago – so had you put all your money in the “safest” part of the market to earn a safe return in exchange for a small but almost “riskless” investment, you would be down 50% plus!
Remember with fixed income/debt investments as interest rates rise bond prices generally go down.
What is TCR doing now to address all these headwinds and concerns?
First, I am buying slowly the most senior secured loans and higher yielding shorter-term bonds with less duration. Second, I have been taking occasional equity hedges (short equity indices) for those with the appropriate risk profile. Third, I am being patient but opportunistic.
I am only investing when I find something really compelling as there are many high-yielding opportunities with yields ranging from 8% - 15% and paying monthly distributions allowing for considerable compounding of your money with monthly reinvesting in those closed-end funds.
Without getting too geeky, duration is loosely defined as how much a bond moves relative to a move in US treasuries or notes of similar maturity. I am adding more ETFs that do not use leverage to play investment-grade corporate bonds and loans as well. As I made clear when we started, closed-end funds (CEFs) use leverage which magnifies both the ups and downs.
Nevertheless, the largest advantages of closed-end funds are that they are liquid, (i.e.) readily tradeable like stocks, and now are offering the largest NAV (net asset value) discounts of about 10% - 20%. Mutual funds generally do not allow trading of their funds and once you sell you are out and basically not invited back in. By adding more treasuries through ETF (exchange-traded funds) we are adding further diversification and ballast to our portfolios to create a real return plus the potential for upside by buying bonds at a discount to par which we are creating by buying closed-end funds in each of the following income categories:
We have lightened up and almost fully liquidated our allocation to REITs, Convertible Bonds, Business Development Companies and High-Dividend stocks because of their junior capital structure positioning and equity hybrid risk in the face of both rising rates and the strong possibility of a recession next year (if we are not in one already). All of you are on automatic reinvestment of monthly distributions which is an offset to the decline of the CEF price, in that you get more shares purchased at a lower price if the price is lower at end of month. Several of you have inquired why we own so many different CEFs in each category and why this is better than mutual funds that own the same things despite their “titles”, (i.e., all mutual funds whether called “growth”, “value”, “domestic” or “international” and even Warren Buffet owns Apple).
By creating as many different income streams from as many issuers as possible we diversify away from default risk which is the main way to lose from a bond or fixed income investment (i.e., non-payment of interest and default on payment). While most investors think mutual funds provide great diversification, they tend to own the same securities which rarely has ever been the case with debt-related CEFs. Moreover, as is the case with our municipal bond allocations for those with taxable accounts, by owning many different managers of closed-end funds the zigs and zags of each tend to offset one another.
Most of Wall Street is now going “bearish” and recommending “high dividend” stocks to defend against the upcoming recession in 2023 which is now “the house call” at most large Investment Banks (Citi, BofA, Goldman Sachs, Morgan Stanley, Credit Suisse). I noted the possibility of major headwinds last November and went defensive which partly explains our outperformance.
But what is the “safety” of a stock dividend versus a corporate bond or senior secured loan interest payment?
Bonds have indentures which are binding contract that provides detailed information on terms, clauses, and covenants.; Corporate loans have covenants which are financial contracts stating the limits at which the borrower can further borrow. Hence, a restrictive covenant usually limits and prohibits the amount issuers can pay in stock dividends. Dividends, on the other hand, are completely discretionary and can be taken away at any time by the management team of a public company (note ENRON, and PGE).
We are finding more CEFs are lowering their leverage from the maximum of 35% to 20% or less to reduce the negative effect of using leverage against a depreciating set of debt securities. This is lowering the risk of owning them while paying the most interest in many years with NAV discounts as high as 20%.
To further capture the benefit of our relative outperformance and risk-adjusted returns (i.e. getting the highest return with the least amount of risk), I would encourage you to consider putting some of your hard-earned IRA money with TRC to obtain these high prospective yields and total returns (now 7% - 15% depending on your risk profile) without the tax consequences of managing a portfolio of mainly CEFs and some ETFs which require some active management and trading of positions.
As always, the greatest compliment you could provide back to me would be a casual referral such that I could introduce TRC’s income-focused investment approach to those that may want it versus how they are invested now or as a compliment to their existing portfolio.
Best,
Sebastian