This article was first released to Systematic Income subscribers and free trials on Dec. 19.
Investors often express a desire to "park cash" in the income market for various reasons. This could be because of a need to manage outlays for upcoming lifecycle events or even as ballast in the portfolio.
The balance between yield and risk is up to the individual investor and their own situation. Investors who want to ensure a precise amount of capital to be available at a future date are better off using Treasury securities maturing before the relevant date. Investors with more tolerance for risk can extend their horizon to many other securities.
This particular investment use case can be defined as a need to generate a decent amount of income without taking an excessive amount of risk. In other words, we are looking to maximize yield while keeping market beta at a relatively low level.
The four key criteria for this type of allocation are:
- decent quality (to mitigate potential drawdowns in case of market weakness),
- relatively short maturity (creating less sensitivity to interest rate moves – note that floating-rate securities unlike short-maturity securities can still be sensitive to a fall in short-term rate expectations),
- no closed-end structures (since discounts are much more unpredictable and add another level of price risk) and
- diversification - as always, it's a bad idea to select a single security to play this role
Our first port of call is the baby bond space which features many decent-quality, relatively high-yielding resilient securities. The chart below plots yield (y-axis) and year-to-date total return (y-axis). The year-to-date return is used as a proxy for lower-beta resilient securities. It goes without saying that this is not synonymous with resilience as securities that have held up well this year could just be expensive or lagging the market drawdown for technical reasons. Investors need to be comfortable with each one on fundamental grounds as well. That said, returns of close to zero in a very tough year for income assets is a pretty good start.
In this space, we like the following bonds:
- mREIT Arlington Asset Investment 6.75% 2025 bonds (AIC) trading at a 9.2% yield
- BDC OXSQ 6.5% 2024 bonds (OXSQL) trading at a 7.8% yield
- BDC PhenixFIN 6.125% March-2023 bond (PFXNL) trading at a 6.24% yield
Investors less comfortable with baby bonds or who want greater diversification may want to stick with term ETFs - ETFs that primarily hold securities having a certain maturity profile. The chart below shows a number of term ETFs across different sectors.
For investors with a somewhat higher level of risk appetite, we like the 2025 High Yield (red dots) Corporate ETF (IBHE) with a 7.76% portfolio yield-to-worst after fees. The fund is down 3.4% this year. For a higher-credit quality fund we like the 2024 Investment Grade Corporate Bond ETF (IBDP) having a 4.9% portfolio yield-to-worst after fees. The fund is down 3.8% this year.
A third type of security worth highlighting are floating-rate high-quality funds such as SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN) which holds floating-rate investment-grade corporate bonds or the Janus Henderson AAA CLO ETF (JAAA) which holds AAA-rated CLOs both of which feature underlying yields north of 5%. Both funds are up this year in total return terms.
Takeaways
The broader income investment market looks very attractive for capital allocation with yields that have been higher only infrequently in the last decade. However, that doesn't mean that investors can't find a good use for lower-beta securities. Although these securities don't typically feature the yields of their higher-octane counterparts, they can be useful for managing lifecycle events, taking some risk off or building up a "drier powder" allocation to use if markets stumble next year.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
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