Top Trends: Income and ETFs

10/21/2013 10:00 am EST

Focus: FUNDS

David Fabian

Managing Partner, FMD Capital Management

Money manager and income specialist Dave Fabian discusses four important current trends that income-oriented ETF investors need to consider; he also highlights the top funds to take advantage of these opportunities.

Steve Halpern: We're here with Dave Fabian. How are you doing Dave?

Dave Fabian: I'm doing very well, Steve, thanks so much for having me back.

Steve Halpern: Since the last time we spoke, you changed the name of your money management company from Fabian Capital to FMD Capital. Could you update us on the change?

Dave Fabian: Absolutely, we're actually really excited about it. The name change really came about because we're expanding our brand more on a national stage.

We're starting to do quite a bit more institutional research and the like, and we thought it would be better for a lot of our followers and clients to have a little bit of a different name change out there in the marketplace, and of course, along with that we also introduced a new portfolio that we're really excited about for our money management clients.

I focus exclusively on high-yield closed-in funds that's picking up a lot of interest as well. We're really excited about the changes, and at the end of 2013 and 2014 are going to be some really exciting times for both equity and income investors.

Steve Halpern: Congratulations.

Dave Fabian: Thank you so much.

Steve Halpern: You note that you don't subscribe to the theory that all bonds are bad, even in the face of rising interest rates. In fact, you suggest there are always opportunities out there for income investors. Could you expand on that?

Dave Fabian: Absolutely. Well, 2013, you know, has really seen probably the most volatility in the interest rate space since the mid-90s. Really, we've seen a huge spike in interest rates from a low in the 10-year of about 1.65% to over 3% in a period of about four or five months.

Since, though September, the Federal Reserve came out and said that they are not going to taper their asset purchase programs, and so, we saw a big fall in interest rates, which, of course, translates into a rise in bond prices. Really, now what we're seeing is some additional interest starting to come back into the bond market.

There were huge outflows in the early part of the month, of course, funds like PIMCO, and the like, garnered all of these headlines about how they are losing billions of dollars in assets, but really what we're starting to see is money come back into certain areas of the bond market, and there's some really excellent opportunities out there for income investors.

Of course, we don't subscribe to the theory that all bonds are bad, even in the face of some of these rising interest rates, there have been some areas of the bond market that have performed extremely well, so it's really about positioning your portfolio into the areas that are doing well, and letting go of some of the losers and the like.

Steve Halpern: In your latest research report, you outline four high-yield ETF trends that investors need to focus on today, so let's go through them. First, you look at short duration, high-yield bonds, and in particular, you recommend them because of low volatility. Can you tell us a little about that?

Dave Fabian: Absolutely. High-yield has been excellent space for income investors over the last several years. They've put up fantastic returns.

High-yield bonds have had very low default rate, they're a great income stream and of course, what we've been recommending over the last several years is for people to start transitioning their portfolios, specifically in high-yield, from longer duration to shorter duration.

The shorter average duration in an ETF or a mutual fund means that you're going to have less sensitivity to interest rates.

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One of my favorite ETFs in this space is the PIMCO 0-5 year High-Yield Bond ETF (HYS).

It's currently trading very up near the all-time highs, and even in that May timeframe where I talked about where we started to see some of that interest rate volatility, it had very low price depreciation, unlike some of the longer duration ETFs in that space.

Right now, that yield on HYS, the yield is over 4%, and I think that it just represents a much better opportunity than some of the longer duration cousins that it has out there, funds like (HYG) and (JNK), which offer slightly higher yields, but are much more sensitive to interest rate risk so they have much more price volatility in them.

Again, we're recommending that investors move to that shorter duration type of security, which is going to insulate their portfolio more from interest rate risk.

Steve Halpern: You also look at mortgage bonds. Could you tell us how you would play that?

Dave Fabian: Absolutely. Once of the ETFs that we track on our watch list every single day at FMD Capital Management is the iShares MBS ETF (MBB).

That owns only mortgage-backed securities, and one of the things about mortgage-backed securities is it's one of the factors of the bond market is the Fed is actually purchasing, so you have this built in demand that allows you the opportunity to access a very liquid market.

The way that we typically like to play this sector is through a more actively managed fund. One of the funds that we own for our clients is the DoubleLine Total Return Fund (US:DBLTX), which is managed by Jeffrey Gundlach, who does an excellent job of his research and security selection, as well as risk management, that you don't get in a passively managed ETF.

Mortgage bonds have really come back off of their lows. They are trading above their 200-day moving average, so we think that they're still going to be a very high demand for mortgage bonds in the future.

Again, you have to say short in duration, you have to pick an actively managed fund that we believe is going to outperform over the long term, so mortgage bonds are definitely an area that we're sticking with for the time being.

Steve Halpern: You also talk about trends developing and municipals and emerging markets, yet, you also say that you are ready to jump in and buy these yet. Could you explain to our listeners your outlook there?

Dave Fabian: Absolutely. Earlier in the year we really shed our exposure to munis and emerging market bonds for a couple of reasons.

Municipals for one thing, have garnered a lot of headlines lately about default in the cities like Detroit, and of course there's many cities in California that are under a great deal of duress with their budgets and things, so there's been a lot of outflows in muni bond ETF and they've really gotten hit hard.

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Emerging markets are sort of the same way, risking a lot of underperformance with emerging market bonds, and even emerging market equities and currencies as well, so the whole emerging market space is really underperformed over the last 12 months or so.

What we've seen is both funds actually fall quite a bit during this interest rate volatility, and, of course, when the Fed announced their no-taper decision in September, they snapped back very strongly.

One of things that most of the ETFs in this space is they have a duration of over seven years, so there's going to be more sensitivity in price, and what we're recommending is that anybody that owns muni or emerging market ETFs or mutual funds, that they use sort of this snap back that we've seen over the last six to eight weeks here as an opportunity to be able to sell down some of those holdings.

We think that any rally should be sold and repositioned to other areas of the market like I had mentioned, things that are still doing well, like high-yield, mortgage-backed securities and the like.

Steve Halpern: Finally, the area you talk about in your latest research report is convertible bonds, and that's something that you say you've taken at least a small position in, so tell us about that area.

Dave Fabian: Yeah, convertible bonds are extremely unique. I think they made a very stealth move so far this year, because a lot of people don't know about them. Really, what a convertible bond is, it kind of offers a unique characteristic of both equity and fixed income.

It is a fixed income holding, but you actually have the opportunity to convert it to equity at a certain strike price. It's almost like a high-yield bond, in the fact that it's going to move more like a stock, but also offer a coupon like a fixed income instrument as well.

We've seen big in-flows into convertible bonds this year. One of the only ETFs in this space is the SPDR Convertible Bond ETF (CWB), trading very near its highs right now.

It's had a 14% total return year-to-date. Again, it's an area of the bond market that hasn't had very much volatility, but it's been extremely resilient during this interest rate period. What I'm recommending is that investors look to this space.

Right now they are trading very near the highs, so I prefer to buy it on a little bit of pullback, but I think that space is going to continue to do very well as long as the economy stays on track.

If stocks start to slip, this area might get pulled down a lot with it as well, but right now it's put up very nice numbers, it's still well above its 200-day moving average price trend, so we like convertible bonds as well, and CWB is one area of the market to access this.

Steve Halpern: Now I also note one of the funds that you've recommended is Osterweis Strategic Income and you note that they do have some positions in convertibles, so is that something that people should consider now?

Dave Fabian: Absolutely. The great thing about Osterweis, we own this for our clients in our Strategic Income Portfolio.

It's primarily made up of those short-duration high-yield bonds that I talked about, but it also has a slight, I believe it's about 15% of their portfolio that uses convertible bonds as well.

The ticker symbol for Osterweis is (US:OSTFX); it is an actively managed mutual fund. Their group did a fantastic job again with analysis, security selection, risk management; it's a very concentrated portfolio.

It really gives you areas, as I talked about, both in the short duration, high-yield, and the convertible bond market, so you're getting a little bit of access to both of those positions and sectors of the market that we think are going to perform very well moving forward.

Steve Halpern: Once again, congratulations on the new fund and the changes in your management company, and we look forward to talking again.

Dave Fabian: Thank you so much Steve, have a great day.

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