Fixed Income Strategy:

I own a basket of fixed income securities that are publicly traded on the New York Stock Exchange. The securities include

Ticker                          Company                                Current Yield

AINV                            Apollo                                      18.9%

ARCC                           Ares                                         11.05%

BXMT                          Blackstone Mortgage              10.69%

CLNC                            Colony                                     18.4%

FSK/FSKR                     KKR                                          4.21% (will be increased)

GBDC                           Golub Capital                          9.8%

IEP                               Icahn Enterprises                    16.56%

MFA                             MFA Financial                         REIT (dividend suspended)

NLY                              Annaly Capital                         13.97%

NNA                             Navios Maritime                     29.93%

OCSI                            Oaktree Strategic                    8.09%

OCSL                            Oaktree Specialty                    8.6%

PTY                              Pimco                                      10.02%

TCPC                            Blackrock                                 16.04%

TRCD                           THL Credit                               22.26%

WPG                            Washington Prime                  REIT (dividend suspended)

This portfolio is a combination of different credits with different degrees of speculation (MFA and Washington Prime are almost pure speculation, versus Apollo, Ares, Blackstone, and Oaktree, which represent fundamental mispricing of solid to excellent credit quality.

These securities currently yield between 8% and 20%, and, depending on how you construct the allocations within a portfolio and average yield of about 15%. This mispricing is because the market always sells off fixed income securities excessively during a correction, as we have experienced since March. These securities have not recovered fully. But, in March, I was able to buy them when yields were over 20%, and some over 40%, so those securities have appreciated significantly in price as interest rates have come down. But, with typical yields still between 6% and 8% of similar credit qualities, we can see that there is probably room still for significant capital gain as well as above-market current interest rate returns. We will have this capital gain versus interest rate trade-off, which will work to our favor.

Reinvestment Strategy:

The income from these fixed income securities – most of the payments are on a monthly basis – are invested in a combination of equities or reinvested back in the fixed income securities, as well as a smaller portion used for speculation.  Specifically, the strategy is:

  • One-third of the cash income is invested in speculative securities, such as derivatives that are puts and calls either on the market (the S&P 500) or specific securities that are especially volatile.
    • Examples of these can be credit default swaps (CDS), derivatives tied to 10-year Treasury securities, or calls and puts tied to specific stocks, whether large-cap equities with more predictable price trajectories or more volatile and less predictable companies, especially technology and biotechnology companies – issues that the market loves one day and hates the next.
    • These are high-risk investments with potentially large returns, but these can also go to zero.
      • Since we have only used one-third of the profits, we can withstand a total loss on these investments without impacting our capital, or incurring any capital loss. We are using the “house money” for risky investments. This can generate significant returns while incurring no risk to our capital.
      • This is a very attractive risk-adjusted return.
  • Two-thirds of the profits are either reinvested back into the fixed income securities portfolio or invested in equity securities with attractive long-term prospects.
    • Examples of these stocks include technology, biotechnology, pharmaceutical, and stable consumer companies.
      • examples include NVDA, AMD, QCOM, GILD, AMAT, V, AVGO, MA, MO, SNP, etc.

The Investment Valuation Floor – The Fed Put

The government is providing a backstop for all government-backed securities. The Fed is also going to be extremely active in the markets, buying not only fixed-income securities but also stock index funds. They are working very hard to keep the market aloft and preventing it from cratering (they still may not be successful). This is an election year and this administration will do everything it can to make sure things look as good as possible through November.

  • I understand there is riskiness, but I expect economic activity and fed support to continue to increase. Even if we have an increase in coronavirus cases, people will remain optimistic – justifiably or not.
  • There will be extreme volatility. Economic activity will waiver, increase suddenly, pull back, and the pattern will continue for some time to come.
  • Market volatility is our friend because we have a stable source of cash flow that protects our capital base. On top of that, the speculative strategy will profit from volatility while the equity investment strategy will play for the long term – it is a multi-year long-term perspective.

Although there are a handful of investments where confidence in the five-year curve is justified, and now is a great time to make these long-term investments, it is still very unpredictable.

  • The short- and long-term state of the economy, how this massive amount of debt gets repaid, how we reopen businesses, etc. is unknown, volatile, and any attempt to predict seems fruitless.
  • But, understanding how to adjust for risk, accept, and ultimately take advantage of volatility, will be powerful. Along with a long-term perspective, this will be the most effective investment strategy.

Interest Rates

We have extremely low-interest rates, and central banks are incentivized to keep those rates extremely low so that this immense amount of government spending can be financed at those low rates. But, can we really keep interest rates below a GDP growth rate – which is what would be required to have any real effect on this new, massive borrowing? It happened after World War II, but I just don’t know anymore…

Money…and Velocity?

The Fed is printing more money. We’re going to see a lot of capital injected into the global economy. But the presence of money is not the important factor. It’s the velocity of money – how people are spending it and is that money chasing after other goods. That will drive inflation. We didn’t see it in the past even though we had a massive capital injection. Deflation and recession are much bigger concerns. Inflation is not on the horizon.

The Fed’s enhanced bond-buying, which includes high-yield bonds and other fixed-income securities is unprecedented and has boosted the value of debt portfolios. However, these portfolios (mostly just above or just below investment grade) still yield attractive disproportionate risk-adjusted returns.

  • We’ve seen this before, especially during the financial crisis. Fixed income securities of lower credit quality get sold off to an extreme (Fidelity’s high-yield portfolio, HYG, was yielding 50% in January 2009).
  • These fixed-income securities, especially exchange-traded securities contained in the portfolio above, continue to be interesting.
  • Economic recovery will occur, but probably over an extended timeframe, and things certainly will not snap back anytime soon.
  • Security mispricing will remain an opportunity.
  • The leveraged debt portfolio described above has benefited disproportionately, and these names will continue to benefit disproportionately.

One More Thing…

The Fed and Treasury have struck a unique and interesting economic stimulus agreement.

  • The Fed can lend to businesses through special-purpose vehicles with essentially an equity contribution from Treasury.
  • Approximately $450 billion has been allocated to Treasury in the $2 trillion stimulus package.
  • Treasury will use that as the equity contribution to special-purpose vehicles that the Fed will use to lend $4 trillion or more to the economy – large and small businesses, and other industries with well-honed lobbyists.
  • The Fed is not allowed to lend money unless it is government-guaranteed debt. But exceptions are made for special purpose vehicles and Treasury will put up the equity.
    • So, the stimulus package is actually much larger than the headline and it will really be driven by the actions of the Fed.
    • The overall risk-adjusted return will be positively impacted by this program, as well.
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