Tag Archives: alternative

DMO Is The Best Of The Mortgage Bond Funds And It’s Bargain Priced

Summary DMO is a mortgage bond CEF that outclasses its competition and is well priced after a rough few months. I liked DMO in September. I like it more now. I liked DMO in September. I like it more today. When I last wrote about Western Asset Mortgage Defined Opp (NYSE: DMO ) I considered it to be the best of the mortgage-bond closed-end funds. It was selling at a small premium at the time, something I will generally avoid. But that premium was only 0.2%, so I decided to buy it anyway. It has been tracking down since, but that only makes me like it more. I’ve been watching it closely and am likely to add to my position before the end of the year. At the December 1 close, DMO had moved up smartly on the day (1.6%), but since that mid-September article, the fund is down -4.64% at market price and -2.55% at NAV. Why buy into a falling position? Let’s begin answering that question by having a look at how DMO compares to the entire fixed-income CEF category generally and mortgage-bond funds specifically. DMO vs. Its Categories This first chart shows total returns and distribution yields for DMO, along with median values for mortgage-bond CEFs (n=10) and all fixed-income CEFs (n=111). (click to enlarge) First thing to note here is that the past month and year have not been good to fixed-income CEFs across the board. This has been part of a broad trend for high-yield bonds. The large high-yield bond ETFs, iShares iBoxx $ High Yield Corporate Bond (NYSEARCA: HYG ) and SPDR Barclays High Yield Bond (NYSEARCA: JNK ), and the mortgage-bond ETF, iShares Mortgage Real Estate Capped ETF (NYSEARCA: REM ), are down comparable amounts. It doesn’t take intense scrutiny to see that DMO is beating its categories in all recent performance metrics. In the face of these numbers, I’m not terribly concerned about the dip since September. This is particularly evident if we turn our attention to NAV returns. Not that I like it, mind you, but I do not see it as cause for concern. Where everything else is negative, save REM’s meager 0.18% uptick for the past month, DMO’s NAV is solidly in the green. And NAV is what really counts in my view. But most of us look to a mortgage bond fund for income, not necessarily capital gains, right? DMO is yielding over 10% where the median mortgage-bond and fixed-income CEFs are paying 7.0% and 8.4%, respectively; and the high-yield bond ETFs are yielding near 6%. Only REM is paying more, but it is doing so with a consistent erosion of capital as we see in this price chart. (click to enlarge) Income investors will often give lip service to not caring about total return. If you’re investing in the likes of REM, I can see why you’d want to resort to that justification. You can, if you’re so inclined, look at REM in isolation in the total return chart and maybe feel okay about it. It has, after all, returned 35%, or would have done so had you been reinvesting dividends at no transaction costs. But look at that price chart above it. The 34% loss there is, in fact, a 34% loss of your capital if you invested in REM for current income five years ago. Sure, it’s been paying out a ton, but it’s been your own money in large measure, and you’ve had to pay taxes on it. If you had invested in DMO instead, you would have received 10% or so a year income plus your capital would have grown by 18%. Of course if you reinvested the distributions (again, assuming that magical chart-universe where there is no cost for doing so) you’d have more than three times what you would have had from the high-yield bonds or REM. So, as I said about UBS ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN (NYSEARCA: MORL ) in September, you can get a better yield than DMO, but with DMO you get to keep your money. I’ll not go into MORL again, other than to note that there are a substantial number of Seeking Alpha income-seekers who will sing its praises, praises that are completely unjustified in my opinion. A more complete look at MORL is on my to-do list, so if you’re interested in my take on it, it should be on your screen soon. I hope I’ve at least begun to convince you that DMO is an outstanding performer in the mortgage-bond space. If you need more, there are additional comparative historical performance data (in particular comparisons to the other mortgage bond CEFs and MORL) in the September article to assist in your due diligence. Why do I like it more as of December 1? Well, I did like it even better the day before, but even with the December 1 gain, DMO is much more attractively priced than it was in September when my only hesitation was that it was priced at that small premium coming off an uncharacteristic discounted period. At that time, I thought the trend would continue and the premium would continue to grow, so I felt it was as good an entry as the fund was going to present for a while. Wrong, obviously; it’s even better now. Premium/Discount Dynamics DMO has moved from a small premium to a decent discount, a move accompanied by that modest decrease in NAV (-2.6%). Distribution yield is up 60bps from mid-September as a consequence. While -1.87% is not a particularly deep discount in the CEF universe, it is, in my view, excellent for a fund of this quality. And the discount is moving in the right direction, according to the Z-scores. (click to enlarge) Where the mortgage-bond and fixed-income categories are, despite their lackluster performances, less discounted than their means (positive Z-scores) over the past 3 and 6 months, DMO is solidly in the other direction. The current discount is almost 1½ standard deviations more negative than the three-month mean. As I noted, one does not expect a fund of this quality to be running a deep discount, so that -1.87% looks pretty good to me right now. If you accept that it is a high-quality fund, and you consider Z-scores to at least suggest a direction for mean reversion, DOM looks good here. Distribution Sustainability Finally, a word about the sustainability of the distribution. This is always a consideration in fixed-income CEFs. Many high yielders maintain their yields by returning investor capital. This cannot continue indefinitely and, all too often, such funds will be forced into making drastic distribution cuts that lead to sharp price drops. One indicator of distribution sustainability is UNII, Undistributed Net Investment Income. DOM reported UNII of $0.62/share at the end of September. Its distribution is $0.21/share monthly, so there is little indication of a problem on that front. Summary I continue to like DMO and think it remains one of the best income opportunities. It has faltered lately, but less so than its peers. It is paying an attractive distribution. And there is no indication that the distribution payment is at risk as the fund is holding a quarter’s distributions worth of UNII. I realize that there is a lot of uncertainty and anxiety regarding a changing interest-rate environment, but I do not see a truly disruptive change on the near horizon. I do not anticipate anything like a devastating blow from a 25 to 75 bps raise from the Fed over the next year, which is what I consider as most likely scenario. My one caution is that it is best accommodated in a tax-deferred account because, as with any bond fund, the distributions are ordinary income and receive no favorable tax treatment.

Source Capital: Big Change Is Coming At This Closed-End Fund

SOR has a long and solid history. But the long-time portfolio manager has retired. The portfolio remake in the wake of his retirement changes everything. Source Capital (NYSE: SOR ) is one of the old timers in the closed-end fund, or CEF, world. Over the long haul it’s done pretty well, using a focused portfolio to opportunistically invest in small- and mid-cap companies with high returns on equity. But now that the manager is has retired, throw that history out. Source Capital’s advisor, FPA Group, is changing everything . Out with the old Source Capital’s now-retired manager was Eric Ende. He had been with FPA since 1984 and worked closely with the fund’s previous manager. He took over the fund in 1996 and basically kept running the fund the same way it had been run previously. But Ende has now retired. SOR data by YCharts Unlike the last manager transition, which was nearly 20 years ago, there’s no smooth hand off planned. FPA is taking an entirely new approach with the fund. That’s big news that current investors shouldn’t ignore. For starters, the fund will shift from an all-equity portfolio to a balanced portfolio that mixes stocks and bonds. Stocks will vary from 50% to 70% of assets and bonds will live in the range of 30% to 50%. This, in and of itself, isn’t a bad thing. But it is a vast change from the previous all-stock focus and shareholders need to be aware of the remake. Moreover, Source will no longer be keyed in on small- and mid-cap stocks. Over the next year or so the closed-end fund will be shifted to a globally diversified large-cap focus. Again, not a bad thing, per se, but a big change from what the fund had been doing for decades. There’s also a not-so subtle shift from what was more of a growth bias to a value approach that’s going to be part of this transition. There’s a couple of take aways here. The first is that the closed-end fund’s historical performance isn’t a useful guide anymore. That performance was built on an investment approach that no longer exists. So, for all intents and purposes, Source Capital should be looked at as a new fund. Second, the changes taking place will have a major impact on shareholders financially. For example, FPA expects 100% of the fund to turnover next year. Thus, every stock holding is set to be sold as it resets the portfolio to a new baseline. That will increase trading costs, but, more important, will lead to as much as $39 a share in distributions in 2016, according to FPA. Source Capital’s NAV was recently around $76 a share, so this is a really big event. And expect every penny to be taxable. Source is also going to initiate a stock repurchase program with the aim of reducing the closed-end fund’s discount to it net asset value. That discount is only around 10% right now, so it’s not a huge discrepancy. In fact, a 10% discount is the trigger for the buyback and about the average discount over the trailing three years. So this probably won’t be a big change. But combined with the portfolio remake and expected capital gains distributions, this has the potential to further shrink Source Capital over time. That could lead to higher expenses as there’s fewer assets over which to spread the costs of running the fund-which will now be run by a team of five managers. What should you do? If you’ve owned Source Capital for years, you need to rethink your commitment to the fund. It is no longer the same animal. Moreover, there’s no track record to go on anymore for this CEF and the next year is going to be one of material portfolio change. That, in turn, will lead to a large tax bill. If you like the idea of owning a balanced CEF, you might want to give the new approach some time to prove itself. But don’t look at the next year or so as the start of the new approach-the management team will need around a year to get the fund repositioned. You’ll need to sit through the transition and then start examining performance, perhaps using January 2017 as a “start” date for tracking the new approach. In other words, for a year or so, there’s no way to really know what you own here. If you don’t like the new approach or don’t want to sit through the portfolio makeover, then you might want to sell sooner rather than later. In the end, this is a big change and if you don’t buy in to it for any reason, you should get out. Yes, that could have significant tax implications for your portfolio, but the makeover is going to lead to a tax hit anyway.

Strong Fundamentals The Name Of The Game For Southern Company

Summary SO’s fundamentals strongly backed by its hefty capital investment plan. The company is utilizing available growth opportunities in the U.S. utility sector to keep earnings growing. SO is actively expanding its renewable energy generation portfolio. The stock is a good investment prospect for long-term income-seeking investors. Utility companies have a defensive business model because of consistent demand and regulated business exposure, which make revenues and cash flows highly certain. In the recent past, utility companies are incurring capital expenditures, which have been weighing on their earnings and cash flows. Utility companies are making capital expenditures to strengthen their power generation infrastructure to keep up with the gradually increasing electricity demand and keeping up with the changing environmental regulation. According to the EIA, electricity demand in the U.S. residential area will increase by 2.1% in the second half of 2015. The report also confirms 1.3% and 1.2% rises in commercial and industrial sales of U.S. utility companies in 2016. The bright outlook of the U.S. utility industry makes me bullish about Southern Company (NYSE: SO ), which is one of the largest utility companies in the U.S. The company serves both regulated and competitive markets across the U.S. SO is making its way in the U.S. utility industry by regularly investing heavily in expansion and the development of its renewable regulated asset base. Also, the stock maintains its attractiveness for income-hunting investors, as SO offers a yield of 4.8%. However, on the valuation front, anticipated production cost overruns at Kemper is making it trade at a discount to peers, which I think provides a good entry point for long-term investors. The company has been reporting healthy financial numbers, due to the strong backing of its large regulated asset base. The company registered an EPS of $1.17 in 3Q2015, an increase of $0.25 per share from EPS of the previous year’s same quarter. And for the nine months ending September 30th, the company’s EPS was $2.30, as compared to an EPS of $1.88 reported in the same period a year ago. The earnings growth momentum of SO is expected to remain strong in 4Q’15, which as per management’s estimates, will yield it a year-end EPS of $2.88 per share, at the high end of the previously given annual EPS guidance range of $2.76 to $2.88. I consider the company’s capital investment plan for the creation of a strong renewable energy generation base as a key driver of its future earnings growth. Recently, SO has announced that it will invest $2.3 billion this year, higher than its previous expectations of $1.4 billion. Although there are additional projects under consideration for 2016, its management still expects to spend around $1.3 billion during the year. Year to date in 2015, the company has announced around 12 new renewable energy-related projects, which will add 1,000MW capacity towards its existing renewable portfolio’s current capacity of 1,600MW. SO has been actively acquiring solar facilities to grow its portfolio of renewable energy generation. The company continued to develop itself as a solar success story by acquiring the 300MW Solar Gen2 and the 300MW Desert Stateline projects from First Solar (NASDAQ: FSLR ). The acquisition being in line with SO’s business strategy of expanding wholesale business in targeted markets through the acquisition and construction of new units, will bode well for SO’s earnings growth in the long run. Moreover, the company is right on track to become the second largest gas utility in the U.S. by merging with AGL Resources (NYSE: GAS ). The merger is waiting for regulatory approval, expected in the second half of 2016, after seeking a nod from AGL’s shareholders. Upside of this merger rests in strengthening SO’s status as the regional powerhouse in southern U.S. Moreover, given the size of GAS, I believe the probable GAS-SO merger will boost overall earnings growth of the company by approximately 4% to 5%. More importantly, SO’s future earnings growth will be driven by the settlement of its Vogtle nuclear power plant. By keeping the nuclear power plants schedule on time, in-service dates of two nuclear power plants are expected to be 2019 and 2020. Actually, customer rate impact for Vogtle unit 3 and unit 4 is expected to remain in the previously predicted range of 6% to 8% , which will affect the company’s future earnings and free cash flow growth positively. Speaking of its clean coal power plant ‘Kemper’, which has been repeatedly delayed in the past few quarters, has resulted in stock valuation contraction. The stock is trading at a forward P/E of 15.34x , in contrast to the utility industry’s forward P/E of 18.85x . The management expects that the project will be operational from the first half of 2016, but in early October, the Mississippi Public Utilities staff analyzed the Kemper project and said that there is hardly a 30% chance that the project will be completed by December 2016. Given the fact that the company’s management has estimated a $25 to $30 million incremental cost, if the project is delayed in the second half of 2016, I believe the Kemper project will remain an overhang on the stock price in the near term. However, once the project is completed, it will augur well for the stock valuation. Furthermore, SO has an attractive capital repayment plan, strongly backed by its cash flows. In the current low interest environment, its current dividend yield of 4.80% , with its strong free cash flow growth potentials, is well headed to ensuring a safe and sustainable future of income investors, and casts an impressive outlook of the stock. Summation The company has strong business fundamentals, which are strongly backed by its hefty capital investment plan. In its attempts to keep its earnings growing, SO is utilizing the available growth opportunities in the U.S. utility sector. And for this, the company is actively expanding its renewable energy generation portfolio, which being regulated, offers huge earnings growth potentials. Owing to the strong growth potentials of SO’s ongoing renewable energy generation projects, I expect to see uninterrupted growth on its earnings and cash flows in the long term, which I think will help its shareholders to be satisfied by consistently increasing dividends. Therefore, I think the stock is a good investment prospect for long-term income-seeking investors.