Opportunities to Increase Income in Your Fixed Income Portfolio

We believe an excellent investment opportunity currently exists in the Natural Resources and Energy (such as gold and oil) markets.

The Divergence

The Equity markets have rallied significantly since the financial crisis in 2008-2009, but Commodity markets have not performed well during this same period. The chart on the right shows the performance divergence of these two indices for the last 9 years. Equities (the white line) have soared to all-time highs, but Commodities (the orange line) are still languishing at levels near the lows reached during the financial crisis. The unemployment rate is now at 4.1% which is solidly below the long-term average of 5.8%, and the economies of the world are starting to gain traction. This should lead to some inflationary pressures caused by rising wages and an increase in commodity prices due to an increase in demand. Our research also shows that inflation is a late cycle phenomenon. As a result, we expect these 2 markets to converge in the future, with Commodities outperforming Equities for the next few years.

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Diversification: Correlation to Tax-Free Bond Portfolios

The table below shows a correlation matrix for the last 3 years of various asset classes and securities. The Muni Index is not highly correlated with equities or commodities. The highest correlation is between Oil and the Commodity Index with a correlation of 0.866.   A correlation of -1.0 indicates perfect inverse correlation while a correlation of 1.0 indicates perfect positive correlation and that they should move in the same direction. A correlation of 0.0 means there is no correlation between the two. Since Oil has such a high correlation to Commodities, we have been searching through high yielding, Energy Closed End Funds for ways to add to our Commodity exposure. Adding commodity exposure to our portfolios would help diversify our portfolios and may act as a possible hedge against rising inflation. The two Closed End Funds included in the chart below, FMO and GGN, are both highly correlated to the Commodity Price Index and do not have meaningful correlations to the Muni Index. Both CEF’s currently have dividend yields of more than 10.0% and are relatively cheap historically.

Article 7 - Recession Chart 2.JPG

The chart below shows the high correlation of the nearby crude contract and the Commodity Index.

Article 7 - Recession Chart 3.JPG

Current Energy Value Sector: Master Limited Partnerships (MLP’s)

We believe CEF’s consisting of MLP’s currently offer excellent value as an income producing addition to our fixed income portfolios. They are a very depressed sector due to very negative market sentiment. They have been depressed because of weakness in the oil sector, fears that tax reform might adversely affect them, and years of underperformance which made them a tax loss selling candidate through the end of last year. We believe these fears have been overblown. Tax reform had a positive impact on the sector, and now that we are in 2018, year-end tax loss selling is no longer an issue.

Investors that can handle the increased volatility of CEF’s may benefit from adding 10%-20% exposure to their fixed income portfolios of these high yielding income securities. They not only add an income boost to the portfolio, but they can also act as a possible hedge against rising interest rates due to inflation caused by increased commodity prices.