Author: John Gerard Lewis, Gerard Wealth
Covestor model: Stable High Yield
Disclosure: Long PAA, CMO.
Do high-yield securities frighten you? It’s an understandable reaction. After all, there’s usually some adverse reason that a company offers a bond or stock yield that’s well above the norm.
But would you have the same reaction if the high yield were simply the natural and intended result of a company’s normal business strategy? In other words, if a company’s primary business were to squeeze out optimal dividends, instead of optimal profits, would you be as apprehensive?
There is, in fact, an industry that operates this way, and as demonstrated by a model portfolio that I manage at Covestor.com, investing in its components has been quite rewarding for those of us who have done so over the past three quarters.
The model, 44 percent of which is composed of high-yielding mortgage real estate investment trusts (mREITS), has returned about 10 percent as of May 18 since its inception date of July 7, 2011, while the Standard & Poor’s 500 Index has fallen by 3.6 percent.
The model takes advantage of the double-digit returns offered by selected high-quality mREITs, such as American Capital Agency (AGNC) and Capstead Mortgage (CMO), and pairs them with a 40 percent allocation to short-term bond exchange-traded funds. (mREITs arbitrage short-term and long-term mortgage securities and are required to distribute 90 percent of their profits in dividends.) Comprising the balance of the portfolio is a couple of Build America Bond ETFs and a pipeline master limited partnership.
The idea is to offset any perceived risk of holding a high-yield component with the price stability of the short-term bonds. Whether this “insurance” strategy has worked thus far is largely a moot question, as the high-yield component has, of itself, produced a positive total return.
One might thus argue that the 40% in short-term bonds, with their, sub-2 percent yields, has suppressed the total return of the portfolio. But of course the real purpose is to mitigate damage should the mREITs suffer a decline, in which case the short-term bonds would serve to mitigate the harm.
One could further argue, quite reasonably, that the aforementioned insurance is altogether unnecessary, as the collective volatility of the six mREITs held is actually quite low, with their respective betas all below 0.60.
This means that even the most volatile of them is still 40 percent less so than the overall market. But to abandon the short-term bonds is to abandon the strategy, and good investment discipline dictates that the pro-forma allocation remain intact.
The idea is not to chase yield; rather, it is to balance the pursuit of optimal yield with a given tolerance for risk. Particularly in this model we are endeavoring to achieve market-beating returns while being able to sleep at night.
The low-beta metric for the mREITs serves as a bonus in that regard, as the short-term bonds are the strategic means to calm down total volatility. Together, these form a surprisingly low risk profile, as evidenced by the model’s lowest-risk designation at Covestor.com. It’s rated “1” with the riskiest models being rated “5”. Of course, this risk score is limited to the Covestor universe rather than general market risk metrics.
As with all investments there is some risk, notwithstanding the inherent safeguards, and Covestor’s risk score is only one measure. But with professional guidance, a portfolio with such good, market-transcending performance, at least in the short-term is, to my mind, worth a small management fee.