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8% Current Income And Stable Principal From A Portfolio Of Closed-End Funds

Summary This High-Income, Stable-Capital CEF portfolio is designed to generate current income with reasonable tax efficiency. The portfolio’s second, and equally weighted, objective is long-term sustainability of capital. The objectives are addressed by entering positions in quality funds when their discount status is attractive. This article summarizes the final quarter of 2015. High Current Income and Capital Stability from CEFs At the end of 2015’s gut-wrenching third quarter (chart at right) I took note of the sharp declines in closed-end funds and considered that an opportunity was at hand. I proposed a portfolio of CEFs ( A CEF Portfolio For High Current Income With Capital Preservation ) designed to generate high current income with capital sustainability: The Stable-Capital, High Current-Income Portfolio. With the fourth quarter in the books, it’s time to review the results. I’ll not spend time here rehashing the details of the portfolio; interested readers should refer to the article cited above. But I will say that one incentive for building this model grew from my frustration with the performances of ETFs, ETNs and CEFs that offer portfolios of CEFs. As the name implies, the model has three objectives: First is high yields for current income. I’ve targeted 8% for taxable funds and 5% for tax-free municipal bond funds. Any excess is to be reinvested. Second is sustainable principal value. Capital growth is not an explicit objective, but maintaining a sustainable principal while withdrawing income at approximately 7.6% will obviously require periods of capital growth to offset inevitable periods of capital erosion. Third is tax efficiency. I wanted a manageable portfolio, so I limited the selections to 15 funds and equally weighted them. The portfolio is diversified across income asset classes. The funds selected are: Equity (40%) Dow 30 Premium & Dividend Income Fund Inc. (NYSE: DIAX ) Eaton Vance Tax-Managed Global Buy-Write Opportunities Fund (NYSE: ETW ) Eaton Vance Tax-Managed Diversified Equity Income Fund (NYSE: ETY ) Tekla Healthcare Investors (NYSE: HQH ) NASDAQ Premium Income & Growth Fund Inc. (NASDAQ: QQQX ) Columbia Seligman Premium Technology Growth Fund, Inc. (NYSE: STK ) Real Estate (6.7%) Cohen & Steers Total Return Realty Fund Inc. (NYSE: RFI ) Preferreds (13.3%) Flaherty & Crumrine Preferred Securities Income Fund Inc. (NYSE: FFC ) First Trust Intermediate Duration Preferred & Income Fund (NYSE: FPF ) Fixed Income – Taxable (26.7%) Western Asset Mortgage Defined Opportunity Fund Inc. (NYSE: DMO ) PIMCO Strategic Income Fund, Inc. (NYSE: RCS ) AllianzGI Convertible & Income Fund (NYSE: NCV ) PIMCO Dynamic Income Fund (NYSE: PDI ) Fixed Income – Tax-Free Municipal Bond (13.3%) Eaton Vance Municipal Bond Fund (NYSEMKT: EIM ) MFS Municipal Income Trust (NYSE: MFM ) Comparables The comparables I’m using for this portfolio are: Cohen & Steers Closed-End Opp (NYSE: FOF ), an unleveraged closed-end fund of funds with 85 CEFs in its portfolio. PowerShares CEF Income Composite (NYSEARCA: PCEF ), an unleveraged ETF holding 147 closed-end funds. UBS E-TRACS Mthly Pay 2x Closed End ETN (NYSEARCA: CEFL ), an ETN (Exchange Traded Note) indexed to a 2x leveraged portfolio of 30 closed-end funds. YieldShares High Income ETF (NYSEARCA: YYY ), an unleveraged ETF that holds a portfolio of 30 closed-end funds using the same index as CEFL. Fourth Quarter Results Income The first objective is current income, so let’s start with a look at distributions for the funds. Recall that any distributions for the quarter over 2% (8% annualized) for 13 taxable funds and over 1.25% (5% annualized) for two tax-free, muni-bond funds are retained for reinvestment. (click to enlarge) Total distribution was $3430.00, a return of 3.26% for the quarter. The return is enhanced by three funds posting special distributions. PDI added $2.61/share for $608.13; DMO added $1.20/share for $322.80; and RCS added $0.04/share for $32.28. Thus, special distributions put an extra $963.21 or 28.08% to the quarter’s yield. When only the regular distributions are considered, the portfolio paid $2466.79, which exceeds the anticipated $2,372.43 by 4% (see previous article for a discussion of anticipated yields). Distributions for all but three funds met the 8%/5% target. The shortfalls were minimal and were anticipated at the onset: DIAX -$10.60, FPF -$31.10, and QQQX -$14.62. Overall, the 8%/5% target objective was exceeded by $1,428.03, which is available to reinvest. At the quarter’s close, yields for the funds are as shown in this next chart. (click to enlarge) As we see, a few have increased but most now have decreased yield percentages, reflecting changes in market prices. This leads to discussion of the next objective: stability of principal. Price Performance and Capital Stability It was a good quarter for the portfolio. Somewhat surprisingly so, in fact, considering the generally poor performance of equity and fixed-income markets. Here is the market price performance for the portfolio’s funds. (click to enlarge) Only four funds had price declines. For two of these, PDI and DMO, the declines were partially a consequence of their high special distributions. One, FPF, is essentially flat. And one, NCV, is the portfolio’s big loser having given up 4.5%. I added NCV to the portfolio because I felt that it was due for a move up. It had just come off a large dividend cut and moved from a perennial premium to a discount of -15%. The fund was paying a 13.44% yield. I anticipated the discount would be reduced and the fund would stabilize at a somewhat higher valuation to NAV. This has happened; the discount is now -11.2%, but NAV has been falling along with the rest of the high-yield bond market. The fund does, however, continue to pay an exceptional distribution (14.1%). Two funds that have been long-time favorites of mine, STK and HQH, had stunningly good quarters; they’re up 13.8% and 12.1%. I’ve written on both of these several times over the past couple of years, and regular readers are aware of my high regard for both of them. HQH had been unduly beaten down. As the biotech sector dropped mid-year, HQH dropped even further. This is yet another example of the exaggerated panic selling so often seen in closed-end funds. STK was also oversold in response to the summer’s market upheavals in technology. It fell to a -6.2% discount at one point, but was back up to a 2.4% premium when I began this portfolio. Anyone who was quick enough to grab that -6% discount gets my admiration and compliments. Premiums and Discounts Let’s look at the changes in discount/premium status for the funds which provides a bit of an object lesson in CEF investing. (click to enlarge) In large measure I felt that these funds were undervalued and oversold at the end of September. As such they offered especially attractive entry points. As we see here, only one fund (NYSE: DMO ) has not gained value from a favorable move in the discount/premium. Two, FFC and RCS, have grown from moderate-to-modest discounts to substantial premiums. I held both of these at the time I started this exercise. I’ve since sold FFC (and anticipate replacing it with FLC or, perhaps, another preferred share fund) to take advantage of that profit and have been considering doing the same for RCS. RCS is a fund that has run a perennial premium. It dropped to a discount after PIMCO cut distributions on several of its high flyers (not, however, RCS). I felt that RCS’s drop was unwarranted at the time and it quickly turned around. I will likely echo my real-money swap of FFC for another preferred shares fund in this model portfolio once I’ve reviewed the space. It could be FLC here as well, but there are other strong contenders which may be a better fit. Preferred shares are presently a bit of a hot asset class, so everything out there (except FPF which is already in the portfolio) is above its mean discount status. I’ll add here a view of the Z-Scores for the funds from the beginning and end of the quarter because I think it helps to reinforce the emphasis I’ve been putting on moves in discount/premium status relative to mean discount/premiums. (click to enlarge) On the whole, the 29 September Z-scores were indicating reasonable entries for most of the funds. As I noted at the time DMO, EIM, PDI and STK were exceptions, but I wanted those high-quality funds in here despite those apparently unattractive valuations. Notice too, how frequently the Z-scores predict reversion to mean values. By these indicators, HQH remains an especially attractive opportunity (especially so if, like me, you’re inclined to think biotech is due for a recovery), but little else in the mix is. Indeed, I would not be surprised to see some corrections in the other direction in the coming months. As I noted above, RCS and FFC look ripe for profit taking. The equity option-income funds, DIAX and QQQX, which I also suggested were good buys because of their unjustified under-valuations have moved to highly positive Z-scores as well. The problem with trading out of these funds is that one needs to find a replacement. I’ll be working on that as time allows and as I go through a similar exercise for my own portfolio which shares many of these positions. Performance Summary Fourth quarter performance is summarized in this table. (click to enlarge) As shown, the portfolio is up $5,550.27 (5.5%) on market price. Results for the quarter for some asset-class benchmarks are seen in this chart. (click to enlarge) The portfolio performed well relative to these benchmarks. On price returns it lagged the S&P 500, Russell 3000 index and the Dow Jones REIT index, but it beat corporate and high-yield bonds and preferred stocks. Consider that the 5.5% price return does not include the 3.3% distribution yield, a yield unmatched by any of these benchmarks, and it’s clear that it was a good quarter for the HI-SC portfolio. The next chart summarizes the total returns for combined market price and distribution yields for each fund. (click to enlarge) Only NCV is negative for the combined values. Comparables As noted earlier, there are products that offer exposure to CEFs. I’ve not been a big fan of these, but I know many readers are. Here’s how they stack up for the quarter. Each is based on a $100K investment at the quarter’s start. The table that follows shows percentage return for combined market value and distributions. The chart says it all, in my mind. CEFL, true to its charge and 2x leverage, generated remarkable income. But, true to its ongoing track record, that income has come at a substantial capital cost. It does beat FOF and YYY, as it should with its 2x leverage, but it lags PCEF. The lag is trivial but PCEF is an unleveraged product, so in an up-trending quarter, one would have certainly expected a better showing from CEFL than an essentially even run with the ETF. None of these comes close to the HI-SC returns. I’ll be the first to admit here that the model had an unfair advantage in that it was selected at the beginning of the quarter with valuation as a high priority. But I’d also argue that the model portfolio has a much higher quality of funds than any of the comps here and that is also a consideration. We’ll continue following these funds as I do quarterly updates to see if the outperformance trend continues. Updating the Portfolio As it stands there is $1,428 in excess distribution returns to reinvest. One possibility is to add them to the funds that are the greatest distance from the equal-weighted goal. My typical target for rebalancing a portfolio is more than 10% out of balance. This table shows none at that level, but three over 9% out of balance. If I add a third of the reinvestable capital to each of DMO, PDI and NCV it would bring them closer to equal weighting. A good case can be made for this. DMO and PDI are top-of-their-class funds, but their valuations look pricey at the moment. NCV has, as I noted, been hit hard by the flight from high-yield. Is that due to turn around? I think it might to some extent, but I’m not anticipating a good year for that asset class. And when an asset class falters, the CEFs for that asset class almost invariably exaggerate the declines. The fact that NCV has such a high yield argues in favor of bringing it up to near balance. I also am considering taking some profits and swapping out of some funds. I should have some clarity on that in the coming weeks, so I’ll be holding off on the re-investment until I make those decisions. I’ll update on changes when I make them. If you have suggestions, I’d love to hear your opinions in the comments.

Rate Hike Leads To Bond Funds’ Biggest Withdrawals: 3 Funds To Sell

Time and again we at the Zacks Mutual Fund Commentary section warned investors about the possibility of bond fund exodus once the U.S. Federal Reserve pulls the trigger on rate hike. This turned out to be true last week when bond mutual funds and exchange-traded funds saw a record wave of withdrawals. Bond market funds saw the largest redemptions since 1992, when Lipper started tracking the flows. Remember, a low interest rate environment is favorable for investments in bond funds. This stems from the fact that the market value of a bond is inversely proportional to interest rates. Thus, the rush to pull out money from bond funds was pretty obvious. The U.S. corporate bond market is particularly at risk, as the central bank’s rate hike will lead to significantly higher borrowing costs for the lowest-rated companies. Corporate bond prices have also seen significant volatility, as investors find trading in and out of big positions next to impossible without affecting their prices. The Exodus from Bond Markets Apprehensions over the stability of the bond market compelled investors to pull out $15.4 billion from taxable bond funds for the week ending Dec 16. High-yield junk bond funds saw an outflow of $3.8 billion during the week. This was the largest outflow since Aug 2014. Another record wave of redemptions left investment-grade bond funds lose out $5.1 billion. This was the biggest outflow since Lipper started recording data in 1992. Alongside, yields on investment grade and junk bonds shot up to their highest level since 2012, according to data from Bank of America Merrill Lynch. Tom Roseen, head of research services for Lipper, said: “They were getting out of the way of the Fed.” He also acknowledged the recent closure of bond mutual funds and picked on the Third Avenue fund. He commented: “People are focused on the Third Avenue fund taking it on the chin.” New York-based Third Avenue Management had announced that it was closing the high-yield bond mutual fund Third Avenue Focused Credit Fund (MUTF: TFCVX ), but its investors will not get their money for “up to a year or more.” The move to block redemptions from a Stone Lion credit fund was also playing on investors’ minds. According to Morningstar data, high-yield bond funds were the biggest losers over the last one week among other Taxable Bond Funds. The high-yield bond funds lost 3.5% in the one-week period and its year-to-date loss is now at 4.8%. Corporate bond funds lost 0.5% over the one-week period and the year-to-date loss stands at 1.2%. Corporate Bond Funds in Trouble According to UBS, an astounding $1 trillion of U.S. corporate bonds and loans that are rated below investment grade may be in danger. A UBS strategist commented: “It is our humble belief that the consensus at the Fed does not fully understand the magnitude of the problems in corporate credit markets and the unintended consequences of their policy actions.” According to Bank of America Merrill Lynch indices, price of U.S. company debts rated “CCC” had dropped to the lowest level since 2013. Subsequently, the average yield soared to a six-year high. Meanwhile, Moody’s noted that the list of companies rated B3 or lower with a negative outlook increased 5% in November to 239. This was a 37% year-on-year increase. What Increases the Risk for Bond Funds? A rise in rates may lead to bond exodus; consequently, the lack of liquidity may compel investors to sell the asset class at a significant discount. There is a growing concern that a massive exit from bonds may freeze the markets, as the number of sellers may not match the number of buyers. Redemption of bonds would increase the sell-off and fund managers would then have to sell the less liquid assets to match investors’ cash demands. However, if a mutual fund or an ETF holds illiquid bonds, the price swings will be rapid and would create a vicious cycle as price drops will again intensify selling pressure. The liquidity risk is of high concern. For bonds, sovereign government bonds are said to be the most liquid. On the other hand, corporate bonds are to suffer the most. New regulations and capital requirements have compelled Wall Street banks to cut their inventories. This has made the buy-and-sell activity of corporate bonds in the secondary market more difficult. The drop in inventories following fresh regulations has created a gap in the number of buyers and sellers. Thus, bond fund managers are now less prone to holding a large chunk of bonds in fear of any possible rout. The Securities and Exchange Commission had proposed a rule earlier this year that mutual fund companies must disclose how vulnerable their bond portfolios are to rate hikes. This was among SEC’s first moves to address concerns that the first rate hike in about seven years may spark a rapid sell-off in bond funds, resulting in steep losses. 3 High-Yield Bond Funds to Avoid Increasing concerns over bond funds will only intensify as the central bank opts for a gradual hike in rates. Thus, investors looking for safer avenues should exit from certain high-risk high-yield bond mutual funds. Below we highlight 3 mutual funds from the High Yield bond fund category that carry a Zacks Mutual Fund Rank #4 (Sell) or Zacks Mutual Fund Rank #5 (Strong Sell), as we expect the funds to underperform their peers in the future. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but the likely future success of the fund. These funds have negative returns year-to-date and over the last 1-year period. The 3-year annualized return is also in the red. The minimum initial investment is within $5000. Northeast Investors Trust (MUTF: NTHEX ) focuses on investing in marketable securities of prominent firms. NTHEX primarily purchases debt securities rated below investment grade by any of the two major ratings firms. Northeast Investors Trust currently carries a Zacks Mutual Fund Rank #5. Over year-to-date and 1-year periods, NTHEX has lost 17.8% and 17.7%, respectively, and has a negative 3-year annualized return of 4.2%. Annual expense ratio of 1.09% is higher than the category average of 1.06%. NTHEX’s 85.59% of assets is allocated to bonds. Franklin High Income A (MUTF: FHAIX ) invests mostly in lower-rated debt securities that provide high yield. These lower-rated securities include bonds, debentures, convertible securities and other debt securities. The fund seeks a high level of current income. Franklin High Income A currently carries a Zacks Mutual Fund Rank #5. Over year-to-date and 1-year periods, FHAIX has lost 11.8% and 10.9%, respectively, and has a negative 3-year annualized return of 1.9%. Annual expense ratio of 0.76% is lower than the category average of 1.06%. Consulting Group High Yield Investments (MUTF: THYUX ) seeks a high level of current income by investing in below investment grade debt securities. THYUX focuses on investing most of its assets in domestic junk bonds. THYUX may utilize 20% of its assets to purchase high yield bonds of issuers located in emerging or developed economies. Average portfolio duration of THYUX is from two to six years. Consulting Group High Yield Investments currently carries a Zacks Mutual Fund Rank #4. Over year-to-date and 1-year periods, THYUX has lost 8.4% and 7.6%, respectively, and has a negative 3-year annualized return of 0.4%. Annual expense ratio of 0.74% is lower than the category average of 1.06%. Original post

High Yield Carnage And Closed End Funds

Summary High yield bonds are suffering a liquidity crisis that is causing NAVs to fall. Due to their nature, CEFs are less susceptible to a liquidity crisis than bond mutual funds, but they are impacted by the high redemptions elsewhere in the bond market. When the time is right, there will be wonderful buying opportunities in the high yield CEF universe, but that time is not quite yet. With Carl Icahn warning about a “keg of dynamite” in the high yield market and Third Avenue liquidating a high yield bond fund, the so-called “junk bond” market is living up to its name. While markets are victim to volatility every once in a while, the problems in high yield are worrisome for a couple of reasons. Firstly, the high yield market never really recovered from the taper tantrum of 2013, meaning the bad run for high yield has now lasted almost three years: (click to enlarge) Secondly, with a ZIRP environment where retirees are desperate for income, many have been fooled into buying into the high yield market at the wrong time. Many fears around high yield bonds focus on the impact of a rising interest rate environment, but a much greater threat is behind Icahn’s red flag: liquidity. A Quick Introduction to Bond Trading With so much media focus on the stock market, many people translate what they know and learn about equities to the credit markets. This is a huge mistake for several reasons, but right now the mistake revolves around trading. Common stocks trade trillions of times in a day, but bonds do not. In fact, many bonds will not be traded for days, or even months . This is especially true for the high yield market, where investors often hold to maturity to collect the yield. The implications of this are significant. Without frequent trading, a fund that needs to sell its holdings to fulfill redemption demands could suddenly be faced with the worst dilemma you can have in any business: needing to sell immediately with no buyers in sight. When this happens, prices crater. Without the liquidity of stocks or even U.S. Treasuries, high yield bonds are susceptible to a massive decline in values, which is why we have seen the decline in value for these funds accelerate recently. Part of this is because more people are selling out of high yield mutual funds, which is requiring the funds to sell to give investors back their cash. In doing so, they are driving prices down, and the trend is likely to continue. Why CEFs are a Good Thing The timing to buy into high yield is not good; as Icahn rightly says, the devastation is likely to continue. There is still money in high yield funds that is likely to come out, and there are still continued fears about rising defaults in energy that are impacting the credit markets more broadly. But when the time to buy into high yield is right, CEFs may be a better alternative than mutual funds for yourself and the market as a whole. If well managed, CEFs do not face the redemption issue that mutual funds do. Because their total number of shares is fixed upon IPO, investors don’t “redeem” their holdings for cash-they sell their stake in the fund to someone else. This means that there can be a steep decline in the market price of CEFs that will not force the CEF to sell bonds. The only time the fund needs to sell bonds is to pay dividends (if its net investment income is less than its distributions) or to free up capital to lower leverage. A well-managed CEF can avoid both by cutting dividends (as we saw many high yield funds do in the last two years) and by lowering leverage (again, a tactic gaining popularity in these funds). This doesn’t mean CEFs are insulated from the bond market carnage; since they are trading in the same market, they are suffering alongside everyone else. But this suffering can take many forms: it can mean that the NAV of its holdings declines, but if the fund holds the bond to maturity, it will get its already invested capital. If the fund doesn’t need to sell the bond prematurely to pay dividends or lower leverage, it can weather the storm of a collapsing high yield market. I believe this is partly why the Pimco High Income Fund (NYSE: PHK ) made its unprecedented dividend cut a few months ago. Predicting a need for cash on hand and a need to stay as far out of the high yield market as the fund’s mandate will allow, it has lowered leverage and lowered distributions to effectively lower its liabilities and liquidity needs. This is prudent, and affirms my confidence in management if not in the wisdom of buying PHK right now. Other funds have made similarly wise decisions, as I discuss below. Picking through the Carnage So where does that leave us now? Several high income CEFs are down massively and will be well positioned to buy when the liquidity crisis in the market is over. But which to choose? (click to enlarge) A comparison of eight funds with relatively similar mandates and investment strategies reveals a lot of similarities and some telling differences. Most significantly, the Deutsche High Income Opportunities Fund (NYSE: DHG ) and the Deutsche High Income Trust (NYSE: KHI ) have the best performance of the group-ironic, since DeutscheBank (NYSE: DB ) has had an awful year. But “best” in this case means a negative total return YTD including dividends and an erosion of 10% of capital on average. The worst performer, the Pioneer High Income Trust (NYSE: PHT ), is down over 46% YTD and is at its lowest point in the last year. A dividend cut in February, which now seems like an extremely prudent decision given the liquidity needs of the high yield market throughout the year, is mostly to blame, and has resulted in the stock trading at a discount to NAV consistently throughout the year. In contrast to this is PHK, which is down 32% YTD but is the only fund to trade at a premium. Just a few weeks ago, however, that premium was as high as 30% just a few weeks ago, which is what caused me to sell the fund . A Group of Peers Looking at the others, we see comparable discounts to NAV among the Invesco High Income Trust II (NYSE: VLT ), the Dreyfus High Yield Strategies Fund (NYSE: DHF ), and the Credit Suisse High Yield Bond Fund (NASDAQ: CHY ). Worse than these is the First Trust Strategic High Income Fund II (NYSE: FHY ), a thinly traded fund that has also performed worse than the others. In addition to a reverse split in 2011, FHY cut its dividend earlier this year. Even more distressingly, the fund failed to see its NAV recover after 2008, although many other funds were able to recover against their lowest point in the dark days of 2009: Combined with First Trust’s small size and thus relatively limited buying power in bond markets, these distressing signals indicate this is not a fund to buy on the dip. The Standout Of the rest, DHF is one of the strongest contenders for a variety of reasons. For one, its dividend cut came in the middle of February and it has not cut in 2015. I interpret this as an indication of the managers’ prescience; simply put, they saw the liquidity crisis before others. Additionally, the fund’s effective duration of 3.72 years is extremely short for the high yield CEF universe and only 5.67% of its portfolio is in energy: (click to enlarge) Finally, to cover dividends, DHF will need to earn a 10.88% yield on its portfolio since it is trading at a discount. This is easy to do even in a ZIRP environment, and is getting easier now that junk bond yields are rising: (click to enlarge) A high yield fund starting today could get that yield with only 20% leverage–much lower than the level many bond CEFs maintain. Leverage is my main concern with DHF, however; at over 30%, it is excessive in this cratering high yield market, which is why I am not buying DHF now and will not for a while. However, when the time is right this fund may be one of the best options in the high yield market, although if the premiums shrink and discounts grow for other historical strong performers like PHK and PHT, they may become attractive too. For now, however, I am fully out of the high yield market and will likely remain so for several months.