Friday, April 20, 2007

More fixed-income closed-end funds

As they say, demographics is destiny. One big theme I have tried to keep in mind is the aging Western population and the need for quality fixed income securities. In this vain, I wrote a while ago about closed-end muni bond funds. Today I’ll discuss some other classes of high yield closed-end funds and highlight, as I always do, several personal holdings.

Equity income
This class of closed-end funds invests primarily in high yielding stocks or preferred stocks. Some funds may hold a minority of corporate bonds as well. Yield to common shares may be further boosted by using leverage (similar to muni bond funds but through preferred shares). My favorite in this category is the Evergreen Utilities & High Income Fund (ERH) which sports a 2006 return of 65%. Its main holdings are in the utility and telecommunication services sector. Both Yahoo Finance and ETFconnect show a yield of 8+% based on a monthly dividend of $0.20, but that is not the whole story. ERH has given special annual dividends for the past two years, e.g. $1.398 for 2006, that significantly increases its overall yield. I also like its country diversification: 47% of the fund is invested outside of the US. The utility sector has demonstrated tremendous strength lately and ERH out performed XLU in the past year. There is one draw back however: the fund currently trades at a premium of 13.8%.

An aside on closed-end fund premium/discount
Although not an iron-clad rule, I avoid buying closed-end funds at a premium. I’ve had to relax this rule somewhat recently as this link shows the overall discount for all closed-end funds has disappeared (again). I have some doubts of the utility of this indicator since the correlation to S&P is almost non-existent.

Global bond funds
As the name suggests, these funds invest in global fixed income securities. Leverage may be employed as well. In terms of risk profile, there is a full spectrum ranging from AAA rated sovereign debt from developed countries to foreign corporate debt to emerging market bonds. The instruments may be denominated in US$ or some other currency which may be a plus in this falling dollar environment. An example is the Aberdeen Asia-Pacific Income Fund (FAX, yield 6.4%) that has 50% in Australian government debt. AllianceBernstein Income Fund (ACG, yield 7.2%) is another name. It has a small amount of foreign exposure, a more stable price and a higher yield. For now I’m avoiding concentrated bets on emerging market debt because I do not feel the the risks sufficiently compensated by returns.

Option buy/write
Roger Nusbaum has been writing about this funds which generate a steady income from option premium. The simplest example of such a strategy is would be a covered call. Obviously, there are far more sophisticated variations. According to Mebane Faber, hedge funds employing this strategy are among the most consistent performers. My choice here is the Eaton Vance Tax-Managed Global Buy-Write Opportunities Fund (ETW, yield 9%). There are other funds with higher yields, but at larger premia than the 0.8% found in ETW.

A covered call offers little protection against a serious market down turn. These funds may be more sophisticated than that but this is something to be kept in mind. I also like ETW because of its international exposure (10.4% Japan, 11.7% UK, 24.2% other).

Floating Rate Loan Participation
This is an interesting category that’s currently missing from my portfolio. Jeff Saut mentioned floating rate loan participation closed-end funds (FCT in particular) in last week’s missive. These funds pool together various floating rate debt instruments. The point is that the dividends from these funds adjust upwards with increasing treasury yield thus providing a welcome negative correlation with other fixed income plays. Another example in this category is the PIMCO Floating Rate Strategy Fund (PFN, 8.9% yield, 4% premium). The chart below shows that they are negatively correlated with TLT, the long bond ETF. Moreover, they are expected to be poorly correlated with equities.

ETFconnect is the place to do research on closed-end funds. If there is one class of funds I’m avoiding right now, it’s anything having to do with mortgage backed securities. An example is the Hyperion Total Return Fund (HTR, 8% yield, 1.2% premium). I would also avoid anything having to do with credit default swaps (CDS).

There are a large variety of closed-end funds with yields in the high single digit range and above. Some of them provide equity exposure while other are uncorrelated with equities or negatively correlated with bonds. They are riskier than treasury ETFs, but for those willing to take the risk and needing yield the options are there.

Disclosure: Of the names mentioned, I currently own ERH, FAX, ACG and ETW.