In the Search for Yield, CEFs Might be Clutch
Despite two rate hikes since December, longer-term bond yields remain near historic lows. At the same time, political gridlock is lowering expectations in some quarters for President Donald Trump’s plans to aggressively stimulate U.S. economic fortunes.
As income-hungry clients keep reaching for yield, some veteran fixed income advisors are leading clients into nontraditional closed-end bond funds.
“The past eight years have been relatively challenging for investors trying to rely on their bond portfolios for income,” says Eric Boughton, a portfolio manager at Deschutes Portfolio Strategies in Lake Oswego, Ore., which manages $1 billion. “Yields have been paltry, to say the least.”
As a group, CEFs are distinct from so-called open-end funds since they don’t constantly create and redeem new shares. In most cases manufacturers issue shares once and that’s it. As a result, evaluating a fund’s performance usually means monitoring market prices to reflect funds trading at lower “net asset” values to the actual securities underlying such broad investment baskets.
With open-end funds still “priced to perfection,” these portfolio managers and chief investment officers say that some bond CEFs are selling at attractive discounts. That means clients can now cushion their portfolios with built-in valuation cushions to help protect against the ravages of inflation over time.
Although discounts aren’t as plump as earlier this year, advisor Boughton is telling investors they still need to consider CEFs as part of their strategic fixed income planning.
Since February 2009 he estimates a typical bond CEF has generated average annual total returns of 14%. By contrast Boughton notes a widely-followed Barclays index of higher quality open-end U.S. bonds has produced on average slightly more than 4% a year.
Post-global credit crisis, he figures an average taxable bond CEF has paid out in cash about 9% annually. Meanwhile, Boughton finds that major open-end indexes of investment-grade taxable bonds he tracks show average yields of 2% to 4% across short, intermediate and long-term U.S. debt markets.
“The search for other options to traditional open-end bond funds is leading us to the closed-end marketplace,” Boughton says.
Jerry Slusiewicz, president of Pacific Financial Planners in Laguna Hills, Calif., is also still finding good relative values in such alternative types of bond funds. “I’m talking to my clients about adding two layers of protection against more volatile markets in coming years,” says the advisor, who manages about $90 million.
Several conservatively managed CEFs he routinely monitors are trading at double-digit discounts to their net asset values and yielding 7% to 9%. These are largely not using leverage, meaning managers aren’t heavily borrowing cash against their funds to boost exposure to different sectors.
It’s a popular hedging strategy often used by CEFs, Slusiewicz notes. “But leverage is a double-edged sword,” he says. “In a strongly positive market, owning more of a security can be a good thing. But if bond prices start dropping and interest rates go higher, you’re going to take a bigger hit.”
Slusiewicz is big on checking the Closed-End Fund Association’s analytics site and its advanced search capabilities to screen for discounts and other data. The online tool sets also let him screen only for CEFs with no leverage. In fixed income, a recent search found non-leveraged funds from the likes of Western Asset, Templeton Investments and Morgan Stanley selling at relatively juicy discounts.
“Prices are still priced to perfection so the risk is still there – these funds trading at double-digit discounts at this point are largely coming out of the junk and emerging markets bond sectors,” Slusiewicz says.
But he finds that over time CEFs can help diversify his clients’ portfolios that might otherwise be heavily leaning to open-end domestic government bond funds.
“The closed-end marketplace is an alternative way to get some exposure to markets that are less correlated to whatever way the U.S. Fed moves with interest rates,” Slusiewicz says.
Len Templeton, an advisor in Chandler, Ariz., is favoring municipal bond CEFs. His independent RIA, which manages about $380 million, works as an income specialist for other advisors and institutions.
Templeton is finding munis that are yielding in the 5% range. By comparison, he notes the open-end Vanguard Intermediate-Term Tax-Exempt Fund is expected to pay around 2.5% over the next 12 months.
“There’s a trade-off using these types of CEFs – you get extra income but they’re going to come with extra volatility,” Templeton says. He refers to such funds as “little income producing factories” that exist in niche markets.
Go with larger funds with ample trading volume and “manageable” bid-ask spreads, Templeton suggests. He also makes sure to only invest in managers with positive “undistributed net investor income.”
Such data is a good way to measure a CEF’s stability in paying dividends, according to Templeton.
“This shows managers who are good at smoothing out distribution streams -- they build a little stockpile so that in more difficult times you don’t have to worry so much about big dividend cuts,” he says.