December 14, 2017
6 Questions on the Income Strategy
What are your current thoughts on the economy, in particular the fixed income markets?
I would go out on a limb here and characterize the current macroeconomic environment as fantastic. As of the first week of December, the New York Fed’s Nowcast is projecting Q4 real GDP growth at 3.9%, which is up from an estimate at the beginning of the quarter of 2.7%. If we do get a Q4 print north of 3%, it will be the first time since 2004 of three consecutive prints north of 3%. While there’s nothing magical about 3%, if you look at the real GDP quarterly growth patterns over the past decade or so, you’ll see one strong quarter, one weak quarter – there has not been a level of consistency until this year. Now we’re seeing accelerating real GDP growth.
The recent corporate tax reform has helped the momentum continue. The best place to see this is in the markets, which are forward-looking discounting mechanisms, and they’re moving higher with very low volatility.
I recently sent to the team a Bank of England working paper called “Eight Centuries of the Risk-Free Rate,” which is all about bond market reversals. One of the paper’s interesting takeaways was that the global risk-free rate hit its eight-century low in July of 2016. Now since that time, rates are up about 100 basis points and appear to be rising, and the US Aggregate Bond Index has provided negative real returns since then.
The U.S. Treasury curve has been flattening for really most of the year and the spreads between long-term and short-term maturities have narrowed to decade lows. What’s your take on the flattening yield curve?
It’s something we watch very closely. Today, we are much less worried about the flatter yield curve than we were in 2015 and 2016, as we think the reason for today’s flattening curve is different than it was back in the third quarter of 2015. In the Income Strategy’s 3Q15 letter, we wrote about our concerns the Fed may raise rates too quickly and too soon. One of the reasons we came to that conclusion was after looking at the inflation break-even rate, which is an indication of the market’s expectation for inflation in coming years, calculated as the difference between the nominal bond yield and Treasury Inflation-Protected Securities (TIPS). At the end of 2015 and going into 2016, the market’s expectations for future inflation over the next decade were plummeting. It hit 1.2%, which at the time was the lowest level in 15 years outside of the financial crisis. This indicated to us that the market thought the Fed may be too aggressive given the state of the economy.
Today, however, the ten-year inflation break-even rate is 1.9%, which is nearing the Fed’s target of 2%. The Fed has been very data-dependent, which I think is why the market is less pessimistic. The bigger question is probably whether 2% is the right target or whether they could raise it. The Fed has done a very good job and it’s tough to criticize them.
One other important point is that the two- to ten-year spread was generally at the current level or lower between 1995 and 2000, which was a great time to be in equities.
Why are rising-rate environments typically bad for fixed income managers?
Higher-yielding income strategies with a substantial fixed income component also have a fixed coupon rate. Which means that when rates rise, the price of the security has to fall to compensate the holder for the higher level of yield they can find elsewhere. Income-generating equities have the advantage that they fluctuate with a growing economy.
In the current environment, I think asset classes that are perceived as safest, like government bonds, are probably the most risky. The Bank of England paper on the risk-free rate over 800 years discusses the current macro environment versus the U.S. macro environment between 1965 and 1970 when inflation in the U.S. went from 1% to 6.5%, which is an increase of six fold after seven years when inflation failed to get above 2%. The driver then was not food and energy, but unemployment falling to 3.6%. So here we are with the current employment rate just north of 4% and coming down; I think it’s something people need to be thinking about.
Investors forget that you can actually lose real money in bonds. In the late 1960s, bond prices dropped 36%. If my comments earlier about an accelerating economy continue to be true, bonds are generally not where we want to be in the Strategy.
How is the Strategy positioned? What do you like? What are you avoiding?
In the Income Strategy, we really have the latitude to invest in almost anything that kicks off income, which in and of itself makes it unique. It is currently concentrated in about 40 names, with approximately 70% in equities, 18% in bonds, and 12% in preferreds.
Rising-rate environments tend to correspond with good performance from value names and smaller cap names, which is much of what we own. We also focus on underfollowed or out-of-favor areas of the market. For instance, we have a ~10% allocation to business development companies (BDCs), which do nothing but make loans to small- and medium-sized business. They only get taxed once if they pay on 90% of that interest income that’s kicked off by those loans to shareholders in the form of the dividend.
The space has historically had a very high share of retail ownership, upwards of 70%, which is the mirror image of what you see with most equities. Because regulators require mutual funds to disclose BDC employees’ salaries as though those fees were being charged by the mutual fund, it elevates the perceived expense ratio of the funds and causes a lot of institutions to not invest in them. We like the competitive setup there, and we like investing in spaces that are not followed.
We also own publicly traded partnerships (PTPs), which are about 21%, REITs (real estate investment trusts) and mortgage REITs are about 16%, and the more unique common equities are 23% of the Strategy.
What we don’t own are the things that typical income strategies own: utilities, staples, and other bond proxies, which we think right now are overvalued.
Are you mostly focused on securities with just the highest yields across these asset classes, or is there more to your approach? Do you think the yield is sustainable?
Overall, our goal is to outperform our dividend yield, meaning that if we’re starting with a portfolio yielding about 7%, and the names we’re buying are actually undervalued, you may see some capital appreciation if we’re right as those securities close the gap to what we think is their intrinsic value.
When we’re looking for investment ideas, the highest yielding securities certainly get our attention. We tend to start with securities that have a current yield above the yield-to-worst on the high yield index, which is currently 5.7%. We are also looking for companies trading below their intrinsic business value. The higher the yield, the less growth we need to expect from the earnings stream to justify the purchase. So if we’re buying something with a 10% yield and the valuation’s reasonable, we have to believe the income will not ever get cut.
If it’s a lower yielding security, we need to see more growth, because we want that total return to be above the high yield index as yield-to-worst plus costs. If you just screen for equities yielding north of 6% with at least $250 million in market cap, that turns up 1,600 equity-like securities, and there are many times that number of bonds available, but we only own 40 total positions. Our goal is to be highly concentrated in the companies in which we have the highest conviction.
Right now the Strategy has a current yield of 7.94% (as of 9/30/17), and yes, we do believe it is sustainable for the foreseeable future. It will bounce around from quarter to quarter, because we own variable-rate payers, like alternative asset managers. We may not know exactly what they will pay out quarter-to-quarter, but we believe it is highly likely that they will distribute almost all of it to investors.
The Strategy was up 18.61% (net of fees)1 for the one-year period ending 9/30/17. Is it a good time to invest?
We believe yes. Our current problem is not that there isn’t anything to buy, in fact it’s the opposite. We’re focused on generating sustainable long-term returns through market cycles. Our job as portfolio managers is to make sure the Strategy includes what we believe are the best opportunities to achieve our objective regardless of market conditions. We’re also the largest investors in the Strategy, so we’re motivated by the same goals as our investors.
1For important additional information on Income Strategy performance, please click on the Income Strategy GIPS Composite Disclosure. This additional information applies to such performance for all time periods. Past performance is no guarantee of future results.
Investment Risks: All investments are subject to risk, including possible loss of principal.
The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.
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