Author Archives: Scalper1

Junk Bond CEFs Yielding 9% And Poised To Benefit From Rising Interest Rates (Part 1)

Summary In the high yield bond carnage, there is a group of funds that has gone oversold despite their insulation from rising interest rates. These funds do not borrow money to invest, so rising interest rates will not negatively impact their net investment income (NII). There remains risk to these funds’ NAV from further declines in the bond market, but dividends are safe for all but one fund. Junk bond markets have gone through a panic and are now in a lull, although many expect more turbulence with future interest rate hikes hurting both the value of issued debts and the borrowing costs of levered closed-end funds. There is a small group of non-levered CEFs that invest in junk bonds but do not use leverage, thereby insulating themselves from higher borrowing costs that will narrow spreads and impact their net investment income in much the way that earnings are hindered by mREITs and BDCs who depend on a spread between low borrowing costs and high investment income from debts. (click to enlarge) Source: Google Finance, SEC Edgar Instead, these funds focus on the high yield market and pass on net investment income to shareholders without borrowing to boost returns. Despite that, these funds’ distribution yields are familiar to investors of levered CEFs, ranging from 4.5% to 12.28%. These funds are: the MFS Special Value Trust (NYSE: MFV ), the Putnam High Income Securities Fund (NYSE: PCF ), the Western Asset High Income Opportunity Fund (NYSE: HIO ), the Western Asset High Yield Fund (NYSE: HYI ), and the Western Asset Managed High Income Fund (NYSE: MHY ). Despite their lower risk profile, these funds have suffered declines similar to levered CEFs, with double-digit declines in the past year across the board, and most losses incurred in the last six months: (click to enlarge) Source: Google Finance With the exception of MFV, these funds were relatively strong performers and were outperforming many levered CEFs thanks to their lower risk profile until the summer. Then as yields rose sharply for high yield debt and default rates continued to rise, these funds joined the junk sell-off to reach their 52-week lows. Source: Moody’s The increase in yields is in part a result of higher defaults and credit downgrades across the market, and has also caused NAVs for these funds to fall alongside all other junk bond funds. This dynamic means that these funds’ current discount to NAV is in fact close to its highest discount in the last year, despite being near 52-week lows: (click to enlarge) Source: CEFA’s Universe Data Is the Risk There? There remains a risk that, if yields rise and bond values fall, the NAV of these funds will decline. However, there is not a commensurate risk of NII declines for two reasons. Firstly, higher borrowing costs are a non-issue for these funds. For funds that are 40% levered or more, higher borrowing costs could damage their ability to make a profit from borrowing to buy junk bonds. What’s more, funds that will need to de-lever because of fears of declining NAVs will be forced to sell off when values are plummeting, causing a similar dynamic that resulted in the shuttering of bond funds like Third Avenue’s . This is a non-issue for these non-levered CEFs. Without borrowing costs or redemptions an issue, they do not need to sell issues unless their NII-to-distribution coverage falls below 100%, which is currently not the case in any of these funds except for MFV. (I will discuss NII coverage of these funds in a future article). With the exception of MFV, this is a rare group of funds which investors can purchase without fears of declining NAVs resulting in distribution cuts. With a sustainable yield of around 9%, these funds are worth considering as an option for immediate and reliable income. Avoid MFV The only fund of this group that is under-earning its distributions is MFV. This is in part due to a recent change in its investment strategy that allows it to focus more on equities in addition to debt: The fund currently has an investment policy that MFS normally will invest the fund’s assets primarily in debt instruments. Effective on December 9, 2015, that policy will be changed to provide that MFS normally invests a majority of the fund’s assets in debt instruments. The change allows the portfolio management team greater flexibility to increase the fund’s exposure to equity securities. There are no other changes to the way the fund is being managed. The good news about this shift is that it will allow the fund to avoid the turbulence of the high yield market with greater flexibility to diversify into equities. The bad news is that this will negatively impact the fund’s immediate income and make it more dependent on capital gains-and active trading-to maintain payouts. Currently, the fund has devoted a third of its assets into equities, limiting its income producing opportunity: (click to enlarge) At the same time, the fund’s equity allocations are slightly skewed towards financial services companies; an ironic decision, considering these companies will benefit the most from rising interest rates: (click to enlarge) It is unclear why the fund’s management has decided on this shift and chosen what very may well be near the bottom of the junk bond market to do so; a decision to shift towards equities earlier in 2015 would have demonstrated much more foresight. So Which to Choose? In part 2 of this series I will discuss the credit quality and income durability of the other funds, but suffice to say for now each currently has NII in excess of its distributions, with coverage ranging from 107% to 128%: (click to enlarge) The relatively low yield on PCF, combined with its high distribution coverage, means that it is unlikely to cut dividends in the short term as it did in 2012, 2013, and 2014, but it also makes the fund’s income stream relatively low compared to HIO HYI, and MHY. In the cases of these funds, distribution coverage is currently solid, making any of these a worthwhile addition to a diversified high yield income portfolio.

Treating The SPDR Dow Jones Industrial Average ETF Like Any Other Investment

Summary The fund holds several dividend champions, but the yield on the index and the ETF are still a bit weak. The sector allocation is fairly aggressive even though the individual companies should be safer than the rest of the sector they represent. Concerns about the strong dollar and rising domestic rates make me prefer a more defensive sector allocation. DIA has an interesting allocation strategy that made a great deal of sense prior to the invention of computers. The SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ) is an ETF that is often referenced in stock trackers or in articles referencing the entire economy. However, there seems to be little analysis focused on the real ETF despite having over $10 billion in assets under management. I intend to treat DIA like any other equity ETF in this analysis and look at the fund as an investment rather than as a proxy for parts of the economy. Quick Facts The expense ratio is a mere .17%. That isn’t absurdly high for domestic equity, but it is higher than I would have expected for a very large ETF with a remarkably simple allocation strategy. Holdings I put together the following chart to demonstrate the weight of the top 10 holdings: (click to enlarge) The underlying holdings don’t bother me. 3M (NYSE: MMM ) is a great dividend champion and has an exceptionally diversified product line which includes so many brands and household items that there are probably several items created by 3M within a few feet of you. The portfolio is filled with established dividend champions. Okay, Apple (NASDAQ: AAPL ) won’t be confused with a dividend champion any time soon but for the sheer size of the company it would be strange for DIA to exclude them from the group. Sectors (click to enlarge) The sector exposure feels fairly aggressive to me with the top weightings coming from the industrial sector and consumer discretionary. You may notice that health care and consumer staples each appear to be underweight with utilities coming in at a solid 0%. These are three relatively defensive sectors that I would want to be overweighting when the P/E ratios across the market are getting fairly high. With a strong U.S. Dollar weakening exports and driving down expectations for sales and earnings in the domestic economy and an expectation for higher short term rates coming, it feels like an aggressive sector allocation. On the other hand, if I was going to run such an aggressive sector allocation I would want to be overweighting the companies with a long history and a solid dividend. The individual companies look like some of the safer allocations for their respective sectors. Energy That energy allocation is fairly light. I’ll grant that the sector has done very poorly, but I still like having exposure to the larger companies in the sector like Exxon Mobil (NYSE: XOM ). Exxon Mobil and Chevron (NYSE: CVX ) are the two oil exposures here and I like both of them for the long term despite the potential for more pressure on prices in the short term. Strategy It would be absurd to talk about the ETF directly without bringing up the allocation strategy. The Dow Jones Industrial Average is oldest continuing U.S. market index with over 100 years of index history. It simply holds an equal number of shares in each of the 30 companies within the index. The method is a little strange since many ETFs would simply use a market cap weighting. Instead, the weightings are fairly arbitrary as a function of share prices which results in overweighting anything with a high share price and underweighting anything with a low share price. Dividend Yield If we’re going to contemplate DIA as a normal ETF investment, then it is natural to incorporate the dividend yield. The fund dividend yield is 2.31% while the underlying index has a dividend yield of 2.53%. Conclusion The SPDR Dow Jones Industrial Average ETF tracks the oldest continuing index in the United States. The expense ratio isn’t very high, but it is higher than I would expect for the incredibly simple allocation strategy. The simple strategy, which made great sense prior to computers, results in a fairly interesting sector weighting. I find the underlying companies to be less dangerous than the sectors they represent, but as an investment I would prefer something more defensive sector allocations given my concerns about the potential for the market to suffer some setbacks in a challenging macroeconomic environment.