My current asset allocation has about 35% in fixed income/cash, which is about age – 10. Within the passive portion, 40% is fixed income (FI), split between stable value (SV) funds and the total bond market (TBM) 35/5. The interest rate is about 2% for the SV funds in my 401K and an outstanding 3+% in my wife’s 401K. They compare favorable to current bond yields such that I’m considering getting out of TBM altogether. Views on my approach to FI in my passive accounts may vary from mainstream to conservative.
The opposite is true in my active accounts where I use leveraged closed end funds (CEFs) for the FI allocation. In open-end mutual funds, investors transact with the mutual fund company. In closed-end funds, investors buy or sell fund shares with other investors on an exchange. CEFs operate just like an ETF except usually they’re actively managed. ETFs have a fund sponsor who can create/destroy fund units in response to demand so that fund price tracks closely its net asset value (NAV). In contrast, CEFs can have market values that deviate substantially from NAV. Such discount/premium is a key evaluation criterion for CEFs.
One outstanding feature of many CEFs is their high current yield. For example, I own PCI, PDI and PTY in my tax-advantaged accounts. PCI/PDI are multi-sector funds, whereas PTY is a corporate bond fund. All are managed by Pimco. Yields in the trailing 12 months were 12-14%. Double digit yields were made possible by employing leverage, typically around 40% (achieved by issuing lower-yielding preferred shares). Leverage works both ways so you can say my overall approach to FI is a “bar-bell” in terms of risk. CEF management fees are on par with (the more expensive) active mutual funds but obviously the after-fees return is the primary consideration. Pimco funds are known to employ derivatives to hedge interest rate risk which makes them particularly valuable in this environment.
In my taxable account, I also own leveraged muni CEFs, PCQ and PCK, both CA muni funds managed by Pimco (yes I think they are the best in this business). They’re yielding 5.5-6% which is close to double digit pre-tax yields depending on your tax bracket. They dropped quite a bit post election since certain anticipated tax changes will make them less attractive. I’m less worried about these tax changes than the longer term fiscal situation in California. For now they are medium term (~2 years) holds. I will not add to them, but rather will seek opportunities to sell especially if I can create more space in my tax-advantaged accounts.
The backdrop of any FI discussion is of course the direction of interest rates. I believe rates have in fact bottomed. Not all is lost for FI though. Hedging with interest rate derivatives is one approach. For now, MBS (mortgage backed securities) should do quite well as pre-payments stop. Floating rate loans should do quite well, too. In fact, I’ve already picked out a CEF in the latter category for my watch list.
There is far more diversity in FI as I pointed out in Beyond 60/40. A recent post from Newfound Research did an excellent job decomposing risk factors in various FI instruments:
Most individual investors have an FI allocation heavy in treasuries and investment grade corporates which is a lot of rate exposure (see LQD and TLT in the graph). I find it ill-advised giving my outlook on rates. At any rate, individual investors tend not to pay much attention to FI, since they tend to be overweighted in equities anyway. Readers of this blog though should not be surprised by where I stand. I don’t think a TBM index fund works nearly as well as its equity counterpart. One reason being the index is weighted by issuance. That there are non-economic, state actors with heavy footprints is another. Not to mention it doesn’t cover SV funds, CDs, and bank loans if one considers all the FI options available.
Supplementing DGI for Retirement Income
A common criticism for DGI for retirement income is that it requires a higher portfolio value due to current low yields, thus over-saving and longer working years. That is a valid point. The canonical approach for retirement income generation is to withdraw a fixed percentage, e.g. 4% from a $1M portfolio for an initial annual income of $40K. The S&P 500 yields just over 2% today. A 4% yielding portfolio will force one into high yielding but low growth sectors such as utilities, telecoms, and REITs, etc. This naturally increases portfolio risk.
My solution is: supplementing a well-rounded, high quality DGI portfolio with high-yielding CEFs. Let’s do some quick math. Assuming the DGI portfolio yields 2.5% and has a 7% annual growth rate. We can also construct a CEF portfolio with 8% yield and assume no principle growth. Then the combination of $727K in the DGI portfolio and $273K in CEFs will generate $40K initially. The weighted portfolio growth will be 0.727 x 7% > 5%, more than enough to overcome inflation. All of the assumed numbers are quite conservative and can easily be constructed from securities available today.
Readers interested in investing in CEFs should do their due diligence. Two resources I find tremendously helpful are CEFConnect and the MorningStar discussion forum.