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A Market Neutral Strategy To Profit From High Yield Bonds

Summary KKR Income Opportunities is a closed end fund that invests in high yield bonds and senior loans. While the 10.6% yield and the 14% discount to NAV may look tempting, some investors are worried about a continuation of the weak trend in this space. In this article I will present a market neutral strategy that can benefit from a compression in NAV discount while hedging a significant portion of the market risk. In a recent post I talked about the KKR Income Opportunities Fund (NYSE: KIO ) and how I found it attractive for income seeking investors. The biggest concern I have on that fund is the risk that weakness in high yield and leveraged loans may persist in 2016. In that case the 10% yield may be partially eroded by a declining NAV or a widening of the discount to NAV. For this reason I decided to dig further into this space and tried to devise a strategy that reduces the market risk while allowing investors to benefit from a reduction in the NAV discount. This strategy may be interesting for sophisticated investors that have access to and are familiar with the pros and cons of shorting. The strategy The strategy I have in mind involves going long KIO and at the same time hedging the position by shorting a combination of two related ETFs: the iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA: HYG ) and the SPDR Blackstone/GSO Senior Loan ETF (NYSEARCA: SRLN ). For more details on KIO I encourage you to read my previous post . Here I am going to give you a quick snapshot on HYG and SRLN before detailing the reason why I believe this strategy could deliver superior risk adjusted returns. HYG is an ETF that gives you exposure to US high yield bonds. It is very well diversified, with more than a thousand securities in the portfolio and a concentration of 4.7% of NAV in the top 10 names. The effective duration of the fund is 4.3 years while the total expense ratio is 0.5%. According to the latest fact sheet the credit rating breakdown is the following: SRLN is an ETF that gives you exposure to leveraged loans. It is less diversified than HYG with a total of 192 securities and has a concentration of 15% of NAV in the top 10 names. The average maturity is a bit less than 5 years but interest rate risk is minimal as loans are generally indexed to Libor. The total expense ratio is 0.7% and the most recent credit breakdown is the following: Analysis of the trade Considering that KIO is a fund that invests in high yield bonds and loans and is trading at approximately 15% discount to NAV I believe one could effectively short a combination of HYG and SRLN at prices close to NAV and go long KIO to take advantage of the mispricing. I would go short $1,500 of HYG + SRLN for each $1,000 in KIO to take into consideration the level of leverage in the KKR fund (a third of the assets are financed through a credit facility). The following analysis shows the NAV performance of $1,000 invested in KIO since the beginning of the year and compares it with the NAV performance of $1,500 invested in HYG +SRLN. The analysis includes the dividends distributed by all the funds. What you can see from the analysis above is that KIO outperformed both HYG and SRLN on a distribution adjusted basis in terms of NAV. I attribute a good part of that outperformance to the significant underweight in the energy sector of the KIO fund. Despite that, the stock performed poorly, down 12% for the year due to an increase in the NAV discount or down 4% after taking into consideration the distributions received. What to expect from the trade As you are short $1.5 for each $1 invested in KIO you are expected to “pay” a dividend cost of approximately 7.5% for your short: 5% is the average yield on HYG and SRLN and that needs to be multiplied by 1.5. This outflow will be more than compensated by a 10.6% dividend in KIO. All things staying the same and excluding tax considerations you net 3% and you are likely left with some spare cash given that you are shorting more than your long investment. In a positive scenario you can expect the NAV discount to reduce over time providing an additional source of profits. In terms of NAV performance you can expect a very similar development for your long and your short: KIO is a bit weaker in terms of average rating but has a lower exposure to the tricky energy sector. Some of you may ask a question: is this a pure arbitrage trade? I want to stress that this is not an arbitrage trade. Underlying securities in the two portfolios are different, sector weightings are different and portfolio concentration is different. However overall performance of the different assets should show a very strong correlation, with the main difference being that you buy a portfolio at a 15% discount and you sell a similar (but not identical) portfolio at par. Your biggest risk exposure lies in the possibility that the discount to NAV widens further in KIO. That should happen only in case of a new sharp drop in the value of the assets. I believe that would represent a great opportunity to cover my short at a profit and double down on KIO at an even cheaper valuation relative to the market value of its underlying assets and I would be more than willing to take that risk.

Small-Cap Stocks Are Ready To Rumble

Summary The backdrop for small-capitalization stocks looks compelling right now. A strong seasonal pattern for the small-cap sector is at hand. Small-caps tend to do most of their business in the US and should benefit from the improving US economy. The first half of December is historically weak performance-wise; mid-December is the time to accumulate. During times of stronger economic growth and rising interest rates, small-capitalization stocks have outperformed their large-cap counterparts. Add to the mix an approaching strong seasonal pattern, and you have the recipe for small-cap outperformance. The small-cap sector of the market will likely post a year-end rally and outperform large-caps over the next six months, if history is any guide. Small-caps have actually trounced large-caps by about 7% this year until they peaked on June 23rd of this year. Since then, large-caps have “turned the tables”, with the S&P 500 ahead by approximately 4% year-to-date. However, it’s time to overweight small-caps in your portfolio as history clearly favors stocks of small companies at this juncture in time. Much has been written over the years confirming the seasonal tendency for small-caps to outperform from January to June. Let’s take a look at a chart, which illustrates the seasonal pattern: (click to enlarge) Source: Jeffrey A. Hirsch, Stock Trader’s Almanac When the line on the chart is descending, large-caps are outperforming small-caps; when the line on the chart is rising, small-caps are moving up faster than large-caps. Based on this strong historical seasonal pattern, it may be prudent to trim your exposure to large-cap stocks and overweight small-caps for the next six months or so. Smaller companies tend to do most of their business within the U.S. and should benefit particularly from the modestly improving U.S. economy. With all the tax-loss harvesting going on this month, mid-December would be an appropriate time to begin buying the sector. There are a few ways to potentially capture the small-cap seasonal phenomenon. The Vanguard Small-Cap ETF (NYSEARCA: VB ) is a solid choice with the lowest expense ratio in the space, at just 0.09%. The SPDR S&P 600 Small Cap ETF (NYSEARCA: SLY ) is limited to just 600 or so small company stocks. The selection universe for this fund includes all U.S. common equities listed on the NYSE, NASDAQ Global Select Market, NASDAQ Select Market and NASDAQ Capital Market with market capitalizations between $250 million and $1.2 billion. The iShares Core S&P SmallCap 600 ETF (NYSEARCA: IJR ) is an ETF which offers inexpensive, superior performance. Its expense ratio is just 0.12%. If you’re looking for a more widely diversified fund spread across sectors and the growth-value spectrum, the iShares Russell 2000 ETF (NYSEARCA: IWM ) fits the bill. It’s the largest ETF in the small-cap sector and carries an expense ratio of 0.20%. Lastly, the PowerShares DWA SmallCap Momentum ETF (NYSEARCA: DWAS ) is an interesting choice. Dorsey Wright & Associates, an internationally recognized firm for its work in tactical asset allocation and technical analysis, selects securities pursuant to its proprietary selection methodology, which is designed to identify securities that demonstrate powerful relative strength characteristics. DWA has an excellent track record and a wide following. Its expense ratio is the highest of the group, coming in at 0.60%. Year-to-date, IJR, DWAS and SLY have performed similarly and all three are outperforming VB by approximately +1.97% and IWM by +2.33%. (click to enlarge) Here is a longer-term chart going back to June of 2012: (click to enlarge) IJR and DWAS, again, have performed similarly and have outperformed VB by +5.86%, SLY by +8.27% and IWM by +8.78%, respectively. IJR has edged out most of the other ETFs over various time periods and combined with its very low expense ratio, makes it a very attractive choice in the small-cap space. Conclusion The outlook for small-cap stocks looks favorable right now. One of the most important factors powering the performance of small-cap stocks is economic growth. Studies involving past rates of return have shown that during times of improving economic conditions and rising interest rates, small-cap stocks tend to outperform large-caps. One possible reason for the strong performance of small-caps relative to large-caps in rising rate environments is that rates tend to go up in response to better economic conditions, which tend to provide a positive backdrop for small-cap companies. We would use the weakness we’re seeing in early December to accumulate small-caps via low-cost ETFs through year-end.

Managements Leading Companies Off A Cliff

By Tim Maverick The quickest and surest way for investors to lose money is to invest in companies where the management is, to put it politely, incompetent. Numerous instances exist throughout history. But we’re perhaps seeing the worst example ever, and it’s from the global mining industry . The level of incompetence being displayed is simply astonishing. Chinese Steel Collapse China has the world’s biggest steel industry, producing half of all steel. Crude steel output there soared more than 12-fold between 1990 and 2014. But now, thanks to overcapacity, the Chinese steel industry has shifted into reverse in a big way. Prices have fallen by nearly 30%. Steel rebar prices in China on the Shanghai Futures Exchange are at all-time record lows. Rebar prices are down 30% this year alone. As losses continue to mount for the industry, even Xu Lejiang, Chairman of giant steelmaker Shanghai Baosteel, said that the industry’s output will collapse by a fifth in the not-too-distant future. Forecasts are for a drop in production of at least 23 million metric tons (mmt) over the next year. The China Iron and Steel Association is in general agreement. It says that output probably permanently peaked in 2014 at 823 mmt. In effect, we’ve seen peak steel. Iron Ore Dreams That’s bad news for the major iron ore miners – Vale S.A. (NYSE: VALE ), Rio Tinto PLC (NYSE: RIO ), and BHP Billiton (NYSE: BHP ). China will cut back on its imports of iron ore, a key ingredient in steelmaking. The evidence is already there. The Baltic Dry Index, which includes ships that carry ore, hit its all-time low on November 20 at 498. Iron ore itself hit an all-time low – spot pricing began in 2008 – about a week ago at $43.40 per metric ton. Logic would dictate the miners cut back production. So does Economics 101. But the managements at the big three continue to live in a fairy tale. They continue clinging to their forecast – that Chinese steel output will rise 20% over the next decade – like drowning men to a life preserver. In fact, Rio Tinto still forecasts that annual Chinese steel production will hit a billion tons by the end of the decade. So the three blind mice (iron ore miners) continue raising output, using a scorched earth policy to eliminate the competition. In fact, next year, Vale will open the world’s largest iron ore mine (Serra Sul in Brazil). And the iron ore sector isn’t alone. Other mining segments – including copper, zinc, and nickel – continue to produce as if there’s no tomorrow. How to Spot the Bottom Eventually, the long nightmare for shareholders in mining companies will end. So how do you spot the signs that a bottom is coming and brighter days are ahead? Output cuts will help. But if Company A cuts its production, the dreamers at one of the big three miners will simply raise their output even more. A true signal will be the removal of one of these totally incompetent management teams. That should start the ball rolling towards real change. I then expect the big miner that made the change to finally say “uncle.” And I don’t mean just deciding to finally cut back on output. I mean throwing in the towel completely, walking away from a segment like iron ore, and permanently shutting down production. If a permanent shutdown doesn’t occur, miners will be in the same boat as shale oil producers. As soon as the price blips up a few dollars, a flood of supply hits the market. A commodities version of Sisyphus, if you will. That may happen sooner rather than later. In iron ore, for example, the price is quickly approaching the break-even level for some of the big miners. This is despite falling freight, oil, and currencies helping to lower miners’ costs. Until the permanent shuttering of mines occurs, the sector will remain in its downward spiral. Original Post