Enhancing TAA bond returns with fixed income CEFs

This is my last post in the three part series on TAA bond portfolios before I get back to the equity side of things. Today I wanted to look at a way an investor can significantly increase returns in their bond strategies. The TAA strategy I’ll present below uses fixed income closed-end funds, and two factors – value and momentum to generate equity TAA like risk adjusted returns. Let’s dive right in.

First, the strategy uses fixed income CEFs (closed-end funds) that use leverage to increase the yield on fixed income instruments. Also, the closed end fund structure allows access to some hybrid fixed income/equity investments like convertible bonds. If you’re unfamiliar with CEFs, CEF Connect is a great resource for all things CEF. In addition to the leverage, what’s is nice about the closed-end fund structure is that often they trade at discounts to their net asset value (NAV) thereby allowing an investor to get an even better yield. That’s part 1 of the strategy.

Part II is applying value and momentum to the fixed income CEF market. In the CEF world, discount to NAV is a common value metric. But you have to be careful with simple discounts to NAV. Some funds perpetually trade at discounts to NAV while others perpetually trade at premiums to NAV. A better metric for value in this space is discount to average discount over a period of time. For example, if a fund usually trades at a 10% discount to NAV, then if it currently trades at a 5% discount it is trading at a premium and therefore not a value play. Thus, we rank the fixed-income CEF world by current discount to the average discount over the last year. That is our value metric.

In part III, we apply momentum to the strategy. Here you could use various momentum measurements but for this post we’ll just use simple 6 month total returns. Thus we rank by value and momentum and then pick the top 4 CEFs equally weighted. As an example, FAX is one of the top 4 CEFs if we ran the screen today.

Finally, we apply the simple economic risk-on risk-off indicator, SPY-UI, to the strategy to manage drawdowns. Re-balance period is every 4 weeks. Also, some CEFs can be quite illiquid so we need to apply some liquidity minimums so we can make sure the CEFs chosen are readily tradeable. The chart below shows the results of this fixed income TAA strategy from 1999 to today. As usual, I used Porfolio123 was used to implement this strategy.

Pretty good results on an absolute and risk-adjusted basis for a fixed income strategy. Better than stocks and similar to equity based TAA strategies. The addition of the value and momentum factors together outperform either factor on its own by a large margin.

But why use a fancy fixed income strategy to generate equity TAA like returns? The strategy has slightly better risk adjusted performance than many equity TAA strategies but not by much. That is the biggest question with this approach. Seems like a lot of work just to end up with returns similar with equity based TAA strategies. True. But at least in my experience the attractiveness of the fixed income CEF space and strategies like this is behavioral. Many investors, rightly or wrongly, ‘like’ the income generated from these products. For example, the average income form the currently ranked to 4 ETFs in the strategy is about 8%. Having that income stream helps them stick with their investments. For those investors, this automated, risk-managed, factor based approach to choosing fixed income CEFs maybe be worth the extra effort.

That’s all for this post. In short, a quantitative factor based approach to the fixed income CEF space produces some very attractive risk-adjusted returns.