A Trend-Following Approach to the Fixed Income Quagmire

Bond investors can consider a dynamic trend-following approach in managing fixed income exposure in today’s market.

In the recent webcast, Getting Smart About Income, Sean O’Hara, President, Pacer ETFs, argued that fixed income investors face increased challenges in maximizing yields while minimizing risks. Consequently, many are taking on more credit risk to find yield, extending duration to find yield, and looking toward low yields that do not justify the extra risk.

In the U.S. fixed income market, 57% of debt has a yield to maturity of less than 2%, 18% has a yield to maturity of less than 1%, and no bonds have a yield to maturity of greater than 5%. Additionally, roughly 86% of the $60 trillion global bond market traded has yields no higher than 2%. In comparison, nearly 75% of bonds traded with yields above 5% in the late 1990s.

Alternatively, the trend-following Pacer TrendPilot US Bond ETF (PTBD) provides dynamic market exposure to help investors quickly hedge risks when markets turn volatile or focus on yields when markets are calm. The strategy follows strict guidelines with three indicators, including a high yield indicator, a 50/50 indicator, and a T-bill indicator.

The goal is to minimize potential drawdowns during broad market sell-offs. Additionally, the portfolio can generate higher yields without aggressive risk-taking.

O’Hara argued that investors should focus on quality value companies to filter out “value traps.” The price-to-book ratio remains a key input to all major value indices. O’Hara noted that from 1960 to 1989, the cheapest 20% of stocks based on P/B significantly outperformed the most expensive 20%. However, from 1990 through 2020, the relative performance of the cheapest P/B stocks was much more muted. More recently, the P/B has ceased to be as effective as the economy shifts toward intangible investments that are not captured immediately.

Consequently, O’Hara argued that traditional book value makes less sense in an economy driven by intangibles such as patents, licensing agreements, proprietary data, brand value, and network effects. Instead, companies’ value and ability to generate free cash flow is mostly a result of their intangible assets.

Alternatively, O’Hara believed that measures of free cash generation are likely to provide a truer valuation comparison between firms. More free cash flow is tied to the intangible assets mentioned.

Companies with high free cash flow and high dividends have historically exhibited lower drawdowns during periods of market volatility. Furthermore, companies with high cash flows are better positioned to grow and maintain dividends.

For example, the Pacer US Cash Cows 100 ETF (NYSEArca: COWZ) and Pacer US Small Cap Cash Cows 100 ETF (BATS: CALF) both implement free cash flow yield screens to narrow their investing universes.

Free cash flow is the cash left over after a company has paid expenses, interest, taxes, and long-term investments. It is used to buy back stocks, pay dividends, or participate in mergers and acquisitions. The ability to generate a high free cash flow yield indicates that a company is producing more cash than it needs to run the business, which can then be invested in growth opportunities.

“Looking at free cash flow in relation to enterprise value puts companies on more equal footing and presents a more comparable picture of valuation,” O’Hara added.

“Using free cash flow yield to measure the sustainability of a company may produce potentially higher returns and more attractive upside/downside capture overtime.”

Financial advisors who are interested in learning more about income strategies can watch the webcast here on demand.