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The Margin Investor

Yield focused Portfolio Margin Strategies - Bond Funds: Return Analysis

11/1/2012

2 Comments

 
As an investor that weathered the recent financial crises and the tech bust back in 2000, there's something extraordinarily reassuring about dividend focused strategies. Having cash hit your brokerage account every month just feels good. Luckily, it turns out it's made for good investing too.

The Leveraged HYG Strategy - has the risk been worth it?

Our previous two posts discussed how to create a portfolio with a dividend yield of 17% by establishing a leveraged position in HYG – a high yield corporate bond ETF. We used risk analytics to show that the leveraged HYG portfolio comes with about twice the overall risk as an S&P 500 portfolio (i.e. SPY) – not bad considering the dividend yield, though certainly not great either.  

Figure 1 below shows the performance of the 3-to-1 leveraged HYG portfolio over the past two years (assuming dividends are reinvested). The total return on the portfolio is 51%, representing an average return of 1.68% per month. 

Clearly, the returns of HYG have been quite attractive. Both the return from dividends, as well as the returns from capital appreciation have made this portfolio a big winner during the past two years. Undoubtedly, this is a result of the excellent performance of corporate bonds: contracting credit spreads coupled with low default rates. It's been a great time to be a corporate bond investor indeed.
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Figure 1. HYG from Oct 27, 2010 to Oct 26, 2012
Figure 2 shows a number of performance statistics at the daily, weekly and monthly levels. The most notable stat (other than the return) is the Minimum Return experienced in a given month at -17%. Obviously, a large negative return like this is something most investors want to avoid. Some would say it's is an inherent danger of leveraged portfolios. 

Or is it?

Thus we arrive at the crux of the matter: is there a way to reduce the risk of this portfolio without watering down the returns significantly?

The answer of course is "Yes". We'll explore this question in more detail in the next post.

HYG stats
Figure 2. HYG performance stats from Oct 27, 2010 to Oct 26, 2012.
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Yield focused Portfolio Margin Strategies - Bond Funds: Risk Analysis

7/18/2012

4 Comments

 
In the previous post we examined the use of bond ETFs such as the iShares iBoxx HY Corp Bond ETF (ticker: HYG) to create a portfolio with an annualized dividend yield of over 17% net of margin borrowing costs. This involved taking on a leveraged position in HYG. The amount of leverage discussed was 3-to-1 and, as a result, a Portfolio Margin account was recommended.

We concluded the previous post by warning about the risks involved with this type of highly leveraged fixed income ETF position. In today's post, we look at the risk profile of this strategy from a scientific standpoint. The tables below are taken from our risk system which evaluates portfolio risk using a multi-factor risk model. 
risk comparison
Table 1. Risk Comparison for the 3 times leveraged HYG portfolio.
Table 1 above shows the risk of the leveraged HYG portfolio in comparison to the risk of other well known assets. As can be discerned from table 1, the 3 times leveraged HYG portfolio is twice as risky (where risk is measured in terms of volatility of future returns) as the S&P 500 portfolio (ticker: SPY) but has only a little more risk than a portfolio consisting of a Crude Oil ETF (ticker: USO).
Table 2 shows the Portfolio Total Risk and breaks it down into Common Factor Risk and Asset Specific Risk. Common factors are forces that influence a large number of stocks (think of things like yield curve movements and changes in credit spreads). Asset specific forces emanate from risk tied only to this particular ETF (e.g. characteristics of the specific bonds in the ETF's portfolio). 

Total Portfolio Risk
Table 2. Portfolio Risk for the 3 times leveraged HYG portfolio.
On row three of Table 2 we can see that the Portfolio Total Risk is 37.71%. This means that the expected annualized standard deviation of the portfolio's return is 37.71%. 
Risk Decomposition
Table 3. Risk Decomposition for the 3 times leveraged HYG portfolio.
We can also investigate the sources of this risk. Table 3 above displays the Common Factors the Portfolio is exposed to (column 1), the exposure level of the portfolio to these common factors (column 2), and the decomposition of the risk across the common factors (last column). As the table indicates, the majority of the portfolio's risk emanates from the exposure of this fund to the High Yield Credit Spread factor. This is evident by looking at the column on the far right of table 3, which lists this factor's contribution to the overall portfolio risk. The numbers in the last column are additive (i.e. sum to the the Portfolio's Total Risk). Interestingly, the portfolio's exposure to changes in the yield curve actually decrease the portfolio's overall risk since interest rates and credit spreads are negatively correlated.       
So, what can we glean from the above analysis? There are three key takeaways:
  1. The 3 times leveraged HYG portfolio gives you a net dividend yield of over 17%, but comes with the risk of a 2 times leveraged SPY portfolio.
  2. By far and away the biggest source of risk is High Yield Credit Spreads. Therefore, it's imperative that you believe the economic picture is improving. A blow out of credit spreads could slam this portfolio hard.
  3. Our analysis points to ways to hedge out a big chunk of the credit spread risk, while keeping most of the dividend yield. We will explore this in a future article.
4 Comments

Yield focused Portfolio Margin Strategies - Bond Funds

7/6/2012

2 Comments

 
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One of the questions most frequently posed by readers of The Margin Investor is whether (and how) Portfolio Margin can be used to build portfolios on the higher cash flow yielding side; undoubtedly a germane question given the combination of robust yields on dividend paying stocks/corporate bonds, coupled with exceedingly low margin rates.

An attractive approach to constructing a yield focused portfolio is through the judicious use of a high yield corporate bond ETF. A good example of this is iShares iBoxx HY Corp Bond ETF (ticker: HYG) which currently yields around 7%. This ETF tracks the performance of a diversified basket of US corporate non-investment grade bonds. Without further ado, let's walk through an example.    

Fist, assume we have an Interactive Brokers account such that our margin borrowing rate is 1.7%. Under Portfolio Margin, we can leverage this up to 3 to 1 (or more depending on risk appetite) in order to obtain a gross yield of 21%. To calculate the net yield, we minus the IB margin rate cost of 3.4% (1.7% * 2), which results in a net yield of 17.6%. By using leverage, we've converted a 7% yielding portfolio to a portfolio yielding 17.6%. That's 1.47% per month flowing directly into our brokerage account. 
By using leverage, we've converted a 7% yielding portfolio to a portfolio yielding 17.6%. That's 1.47% per month flowing directly into our brokerage account.  
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HYG from June 6, 2010 to June 6, 2012.
What's the catch? Well, there's always a catch. The added yield comes with additional risk. Specifically, the fund is exposed to the following two core risk factors:
  1. Interest Rates - when interest rates go up the fund will lose value. According to my calculations the fund's effective duration to medium term rates is around 7. This means that if the medium term gov interest rates move up around 50 bps (i.e. half a percent), the HYG ETF will go down roughly 3.5%. On our leveraged portfolio, this would be a 10.5% loss. 
  2. Credit Spreads - as corporate credit spreads increase, the HYG ETF will lose value. Of course, the converse is also true. This is essentially a bet that the economy will continue to improve (or at least not deteriorate).

So, the bottom line here is this strategy is only for you if you believe the Fed is committed to continuing its policy of low interest rates and provided you don't expect to see any problems in credit markets. We'll leave it to the reader to decide if this is a prudent strategy. Regardless, this portfolio will pay you handsomely while you wait.

In the next article, we will examine the risk of this portfolio in more detail.
2 Comments

    Author

    Jason Apolee is a contributing editor to The Margin Investor where he focuses on news commentary and evaluating broker offerings.

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