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Fixed Income Ain’t So ‘Fixed’

Summary Subclasses of Fixed Income has had highly unusual and varied performance over this market decline. Medium & Long Term Treasuries are two of the greatest sources of risk in the Fixed Income subclass. High Yield Corporate debt has not only had positive returns, but is reducing risk. We’ve convinced readers several times through our intuitive visualizations that the market decline currently underway can’t simply be explained by looking at historical norms. The current market dynamics are telling a unique story about the undercurrents of asset behavior. Take for instance, Fixed Income. It’s that canonical asset class that garners the second half of portfolio allocation parlance — 80/20, 70/30, 60/40… In all of these coptic number combinations, the second value indicates the amount an investor should allocate towards Fixed Income in an effort to reduce risk in the portfolio at large. And yet, as an asset class with such a refined mandate of risk reduction, investors have seen highly varied outcomes in the subclasses of Fixed Income over the past two weeks. Below, we use the following Fixed Income subclasses and related tickers for our analysis: Fixed Income Subclass Ticker Short Term Treasuries (1 – 3 Years) SHY Medium Term Treasuries (7 – 10 Years) IEF Long Term Treasuries (20+ Years) TLT US Inflation Protected Securities TIP Investment Grade Corporate Bonds LQD High Yield Corporate Bonds HYG USD Denominated Foreign Fixed Income EMB Local Currency Foreign Fixed Income BWX Cumulate Return Since the Decline Began The first market correction occurred on Friday, the 21st of August. Therefore, the chart below looks at cumulative return of the major sub-classes of Fixed Income from market close on the 20th of August to market close yesterday, the 1st of September. (click to enlarge) In fact, the return of Fixed Income subclasses has been anything but ” fixed” during this market decline. Usually, treasury bonds are the bastion of safety when it comes to market dislocations. For example the 10 year yield dropped to an all-time low of 1.695% during the 2011 September correction. Not this time. From the chart above, you can see the only subclass of treasuries that has not experienced decline is Short Term Treasuries (1 – 3 years). Medium Term Treasuries (7 – 10 years) and Long Term Treasuries (20+ years) have experienced declines of roughly 1/4 of one percent and nearly 3% respectively. For comparative purposes, the iShares Core Aggressive Allocation , ticker, AOA has dropped 4.5% since the correction began. In simpleton terms, the subclass of Long Term Treasuries has experienced a loss 65% as great as an aggressively allocated portfolio… take a minute, because that’s a big deal. Also surprisingly, low credit quality corporate bonds — also known as High Yield — have been one of the greatest sources of risk reduction in the current decline. The often-quoted dogma is that “high yield bonds act like stocks during market decline.” However, High Yield has not only accreted positive return over the past two weeks (albeit marginally), but also hedged risk most effectively (as can be seen in the final chart below). Risk Sources in Fixed Income Subclasses Our prior posts have demonstrated the value of intuitive visualization when considering sources of risk. Specifically, an investor shouldn’t just care about how risky an individual asset is, but should also analyze the risk of an asset using some measure of co-movement. Below we provide both of those measures — Expected Extreme Risk and Contribution to Portfolio Risk — for the Fixed Income subclasses. (click to enlarge) Expected Extreme Loss is calculated using today’s sample estimate of exponentially smoothed volatility to scale historical log returns. Those scaled historical returns are then used to create a non-parametric return distribution, for which we use the 99% CVaR as the Expected Extreme Loss. Note how the expected extreme loss of High Yield debt is only slightly higher than Medium Term Treasuries and Investment Grade Corporate debt. This chart is akin to showing, “if market dynamics were to change (i.e. the structure of covariation were to change), which subclasses might we expect to exhibit the most extreme risk given today’s volatility information.” In our upcoming post, we will go through a more comprehensive description of how we frame risk at Viziphi, and how our tools make those concepts easily accessible to users. However, it suffices to say that investors should not just be thinking about the information available in the market today, but what might happen should we see a shift in the co-movement structure. (click to enlarge) Contribution to Extreme Loss is used by simulating multivariate t-distributions whose volatility and covariance structure are determined using exponentially smoothed sample estimates of today’s information. The investor should take note that the two single greatest sources of risk in the Fixed Income subclass, given today’s market dynamics, are Long Term Treasuries and Medium Term Treasuries, and one of the greatest sources of diversification is High Yield Corporate Debt. If you’re still reading this post, you shouldn’t be… you should be checking your brokerage account to see how much exposure you’ve got to those two subclasses because this is a significant shift from the way that risk has been hedged using Fixed Income in past market environments. Summary Historical anecdote doesn’t suffice in understanding how investor’s portfolios are being impacted by the current market environment. Core tenets of asset allocation — like using Fixed Income to broadly reduce portfolio risk — can fail to provide the most effective guidance to hedging risk in different market environments. Measurements like Contribution to Extreme Loss and Expected Extreme Loss help investors quantify risk in ways to respectively understand how: The current market environment is driving asset subclass risk within the portfolio Aggregate risk could change given a shift in asset co-movement Both measures are vital in constructing a coherent picture of risk and should be leveraged when attempting to make prudent portfolio allocation decisions. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

PIMCO High Income Fund – Next Stop, NAV

$PHK is a closed-end fund that had historically habitually traded at a large NAV premium, with the irrational bull thesis predicated on an unsustainable dividend. We had correctly predicted a dividend cut would be forthcoming. Now that dividend has been cut, the next stop for $PHK is NAV using $PHT as an analog. Target price of $7.11, represents -18% downside from current $8.62 price. This thesis is very simple. For the reasons articulated in our previous PIMCO High Income Fund (NYSE: PHK ) article , the bull thesis for $PHK trading at a significant premium to NAV was highly misguided as the dividend level was unsustainable. On 9/1/15, Pimco announced the predicted dividend cut in the September dividend announcement , cutting the monthly dividend by 15% to $0.103 from $0.122. $PHK’s stock price has decreased significantly today given the announcement, -8.8% currently to $8.62 from yesterday’s close of $9.45. Investors in $PHK or potential short-sellers may believe that the selling pressure will subside given the observed price action. However, this is misguided, as we have an analog for another high yield closed-end fund that had historically traded at a premium and had its dividend cut. Pioneer High Income Trust (NYSE: PHT ), which launched in Apr-2002 and cut its dividend in Feb-15 to $0.115/month from $0.1375/month (-16% dividend cut). This caused the fund to trade down dramatically from a ~45% premium to a current -1.5% discount to NAV, causing significant capital loss for CEF investors. (click to enlarge) $PHK’s current NAV is $7.11 (see ” Daily Statistics “), meaning that the current $8.62 price still represents a 21% premium to NAV. Now that the “dividend consistency” bull argument for $PHK has been discredited, there is no “NAV premium” floor for the fund and we expect $PHK to follow a very similar trajectory to $PHT, with $PHK ultimately trading to NAV in the near future. Note: In addition, there is adequate borrow for short-sellers. Caveat emptor. Disclosure: I am/we are short PHK. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: The author and/or others he advises holds short a position in PHK at the time of publishing this article. The author may make trades in securities mentioned without notification. The information contained in this article is impersonal and not tailored to the investment needs of any specific person. You should consult with a professional where appropriate. The author shall not be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. The opinions expressed in this article are for informational purposes only and should not be construed as investment advice. The article is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. The research for this article is based on public information that the author considers reliable, but the author does not represent that the research or the article is accurate or complete, and it should not be relied on as such. The views and opinions expressed herein are current as of the date of this article and are subject to change. Any projections, forecasts and estimates contained in this article are necessarily speculative in nature and are based upon certain assumptions. In addition, matters they describe are subject to known (and unknown) risks, uncertainties and other unpredictable factors, many of which are beyond the author’s control. No representations or warranties are made as to the accuracy of such forward-looking assumptions. It can be expected that some or all of such forward-looking assumptions will not materialize or will vary significantly from actual result.

The Guggenheim S&P 500 Equal Weight Utilities ETF: Utilitarianism

An alternatives to a traditional government bond holding. Utilities offer steady, consistent returns and are largely immune to the business cycle. This equal weight utilities fund is biased towards low dividend risk, yet has a respectable return. The world of investing has changed much over the past five years due to the financial crises of 2008 and its subsequent recession. The realization that investing may never be the same is a growing one, particular when it comes to income. As it stands now, even if central banks are able to normalize policy, it still may be years before government bond yields normalize, and that’s under the assumption that all advanced economies will continue to grow uniformly. Recent economic reversals in newly emerged economies, particularly the “BRICS” along with the collapse in commodity prices and the astonishing overproduction of crude petroleum have all weighed on high quality assets yields. High quality government securities have been pressed to their limits. Furthermore, cross market technology, institutional trading, pension fund demands and ‘carry asset’ strategies have created much higher volatility in the once mundane government bond market. The point of the matter is that the individual investor may be saving for retirement in a completely new world. The strategy of holding long term government bonds as a portfolio cornerstone has become an ‘old world’ concept. Utilities assets may be one replacement solution for government bond holdings. There are several to choose from, and one of the top yielding in the class is the Guggenheim S&P 500 Equal Weight Utilities ETF (NYSEARCA: RYU ) . According to Guggenheim, the fund “… Seeks to replicate as closely as possible, before fees and expenses, the performance of the S&P 500 Equal Weight Index Telecommunication Services & Utilities. ..” A word about the ‘equal weight’ S&P Index: according to S&P, the equal weight S&P 500 index is an alternative version of its renowned S&P 500 market cap weighted index. In the equal weight index each S&P 500 member constitutes 20 basis points of the S&P 500 index with a quarterly rebalancing in order to prevent excessive turnover. The S&P 500 equal weight Telecommunications and Utility Index is merely a subset of the equal weight S&P 500 index. Since the fund is based on ‘equal weightings’, it seems superfluous to analyze the top ten holdings. Instead, since the objective here is dividend risk assessment it would be more useful to analyze the potential risk to regular distributions. This may be achieved by comparing a company’s payout ratio to the dividend. Since a payout ratio is defined to be the proportion of earnings paid out as dividends, the lower the payout ratio the less likely the dividend will be reduced and conversely, the higher the payout ratio, the more likely a dividend may be reduced. The fund has 34 holdings and an average dividend yield of 4.0571%. The average payout ratio is 73.62%. (This is less than the S&P 500 market cap weighted payout ratio of almost 85). Five of the holdings have payout ratios of over 100%; 21 of the 34 holdings are below the average payout ratio; 11 are above; 2 have non applicable payout ratios; 14 of the holdings are above the fund’s average yield, and 20 are below the fund’s average yield. Hence, the fund is biased towards the ability of the holding to continue to pay or increase dividends. The chart below summarizes the payout ratio (in blue) and the yield (in red). (click to enlarge) (Data from Reuters and Guggenheim) The 10 lowest payout ratios average out to 44.39% with an average yield of 3.563%. There are no Telecom Service companies in the fund with a payout ratio low enough to place it in the ten lowest of the fund. (Data from Reuters and Guggenheim) The 10 holdings with the lowest payout ratio are summarized in the table below. Company Type Price/Earnings (TTM) Price/Cash Flow Price/Book Divided Yield Payout Ratio AES Corp (NYSE: AES ) Independent Power and Renewable 9.70 3.24 2.14 3.31% 23.43% Edison International (NYSE: EIX ) Electric Utility 12.60 5.52 1.72 2.80% 33.70% PPL Corp (NYSE: PPL ) Electric Utility 10.84 6.49 2.11 4.81% 38.81% Dominion Resources (NYSE: D ) Multi-Utility 24.29 12.25 3.40 3.65% 41.43% Scana Corp (NYSE: SCG ) Multi-Utility 10.29 6.69 1.44 4.04% 43.98% Nextera Energy (NYSE: NEE ) Electric Utility 15.56 8.11 2.16 3.02% 45.61% Sempra Energy (NYSE: SRE ) Multi-Utility 17.77 9.24 2.07 2.88% 48.80% Public Service Enterprise (NYSE: PEG ) Multi-Utility 11.13 6.56 1.61 3.85% 52.13% Eversource Energy (NYSE: ES ) Electric Utility 16.76 9.80 1.50 3.46% 55.99% Exelon Corp (NYSE: EXC ) Electric Utility 11.59 4.20 1.15 3.95% 56.51% (Data from Reuters and Guggenheim) There are, as one might expect, different types of Utility Companies. Diversified Telecommunications includes entertainment, mobile, internet and voice services; Electric Utilities are, as the name implies, electricity providers although some, Duke Energy for instance, provide natural gas as well; Independent Power and Renewables generate power through renewable resources like wind and solar and also install residential and business solar systems; Multi-Utilities provide natural gas, electricity, storage facilities and pipeline delivery. (Data from Reuters and Guggenheim) For a few detailed examples: AES is global, providing services to Chile, Columbia, Argentina, Brazil, Central America, the Caribbean, Europe and Asia. AES generates renewable power from solar, wind, hydro, bio mass and landfill gas. Scana Corporation, classified by the Guggenheim fund as ‘Multi-Utility’ provides natural gas as well as fiber-optic and telecomm services. Dominion Resources distributes natural gas, electricity, natural gas storage, LNG transportation and risk management services. It also has an equity stake in a joint venture with Caiman Energy called Blue Racer , a Marcellus Shale natural gas processing company; neither are publically owned companies. NiSource Inc (NYSE: NI ) is a holding company providing services through 13 subsidiaries for gas, electric and pipeline as well as a financing service. Many of these companies also hedge or trade derivative contracts. The point being that for utility funds with only a few holdings, it’s worth examining the descriptions or company profiles of the holdings to fully understand the depth of the individual holdings. (click to enlarge) Lastly, the fund has a reasonably long history, incepted in November of 2006. Its expense ratio is reasonable at 0.40%. Its total net assets are over $112,487,000 distributed over 34 holdings with a cash reserve. The average daily volume is 186,066 shares per day and there are 1.6 million outstanding shares. It currently trades at a slight discount, $-0.08 per share to NAV. The fund has paid a total of $17.80 in quarterly dividends since inception. Hence, the fund provides a reasonable yield in today’s low yield environment, low volatility with a beta of 0.87 and reasonable liquidity. Should the global economy contract because of a readjustment in the Chinese economy, and the U.S. economy remains reasonably strong with depressed commodity prices, a utility fund such as the Guggenheim S&P 500 Equal Weight Utilities ETF would do well generating good returns with relative safety for some time to come. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Additional disclosure: CFDs, spreadbetting and FX can result in losses exceeding your initial deposit. They are not suitable for everyone, so please ensure you understand the risks. Seek independent financial advice if necessary. Nothing in this article should be considered a personal recommendation. It does not account for your personal circumstances or appetite for risk.