Even with the recent increase in interest rates, the income stream from treasuries is still only a trickle. To increase income, many retail investors would like to diversify their bond holdings but do not have the requisite knowledge of economic factors to make informed allocations. One strategy is to leave the sector selections to professional money managers. In this regard, Closed End Funds (CEFs) that invest in multiple bond sectors could be a potential solution. To assess the performance of these multi-sector CEFs, I analyzed their associated risks versus rewards over the past several years.
There are 21 closed end funds listed in the multi-sector category on www.cefconnect.com. To reduce the number of candidates, I selected funds based on the following criteria:
- At least 5 years of history
- Distributions of at least 6%
- Premiums less than 5%
- Market Cap greater than $200M
- Average trading volume greater than 100,000 shares per day.
The following 8 CEFs satisfied all of these conditions:
- AGIC Convertible and Income (NCV): This CEF sells at a premium of 2.7%, which is about half the 52 week average premium of 5.5%. This fund has 132 holdings, distributed in high yield bonds (44%) and convertible securities (52%). The convertibles can be either convertible bonds or convertible preferred stock. This fund utilizes a high level (35%) of leverage and has an expense ratio of 1.3%. The fund has a high distribution of 11.8%, which has been achieved without return of capital.
- BlackRock Core Bond (BHK): This CEF sells at a discount of 11% which is much lower than the average discount of 3%. The fund invests in a wide range of fixed income assets. The 585 holdings are distributed among investment grade bonds, asset backed bonds, high yield bonds and Government bonds. Overall, the portfolio has over 75% of its assets in investment grade securities. The fund has a distribution of 7.2%, which does not include return of capital. Effective leverage is 31% and the expense ratio is a relatively low 1%.
- BlackRock Income Opportunity (BNA): This CEF sells at a discount of over 12%, which is much lower than the average discount of 6%. The overall sector composition is similar to the BlackRock Core Bond fund, but the individual selections are different so BNA and BKH are only moderately correlated (about 60% over the past 5 years). BNA has 610 holdings spread among investment grade, asset backed, high yield, and Government bonds. Overall, the portfolio has 75% of its holdings in investment grade securities. The fund distribution is 7.5%, with no return of capital. The fund utilizes 31% leverage and has a low expense ratio of 0.9%.
- Calamos Convertible & High (CHY): This fund sells at a discount of 8.7%, which is below the average discount of 5.7%. The distribution rate is 8.5%, with only occasional return of capital (only one month during the past year). The fund has 267 holdings, with 55% in bonds (with 90% of the bonds in high yield and rest in investment grade bonds). About 40% of its securities are convertibles. The fund employs 27% leverage and has an expense ratio of 1.6%.
- Calamos Convertible Opportunities & Income (CHI): This CEF sells for a discount of 2.2%, which is only slightly below the average discount of 1.5%. The portfolio consists of 267 securities, with about 55% in high yield bonds and 40% in convertibles. The overall sector composition is similar to the CHY, but the individual selections are different so the funds are only moderately correlated (about 70% over the past 5 years). The fund has a relatively high distribution (but had return of capital in 3 months during the past year). The fund utilizes 26% leverage and has an expense ratio of 1.6%.
- Pimco Income Opportunities (PKO): This CEF sells for a discount of 2.7%, which is well below the average premium of 3.9%. The distribution is a relatively high 8.4%, which has been achieved without any return of capital. This fund has 474 holdings that are divided among four primary asset classes: mortgage backed, investment grade corporate, high yield, and Government bonds. This fund utilizes a high 36% leverage and also has a high 2.3% expense ratio.
- Pimco Income Strategy Fund II (PFN): This CEF sells at a small 0.2% premium, which is low when compared with an average premium of over 4%. The fund has a high distribution of 9.5% without any return of capital. The portfolio of 280 holdings is divided over a wide range of investments including corporate bonds (investment grade and high yield), asset backed bonds, municipal bonds, preferred stocks and floating rate debt. The fund also uses derivatives to enhance return and provide risk control. The fund employs a relatively low 21% leverage and has an expense ratio of 1.5%.
- TCW Strategic Income (TSI): This CEF sells at a discount of 8.6%, which is low compared with the average discount of 1.7%. The distribution rate is 7.4%, which is achieved without return of capital. This fund has 280 holdings, consisting of primarily asset backed bonds (83%) and corporate bonds (14%). The fund utilizes only a small amount of leverage (6.6%) and has a relatively low expense ratio of 1.2%.
For comparison with treasuries, I also included the following ETFs in the analysis:
- iShares Barclays 7 to 10 Year Treasury (IEF): This ETF tracks the performance of intermediate term treasury bonds and yields 1.7%.
- iShares Barclays 20+ Year Treasury Bond (TLT): This ETF tracks the performance of long term treasury bonds and yields 2.9%.
To analyze risks and returns, I used the Smartfolio 3 program over the past 5 years. The results are shown in Figure 1, which plots the rate of return in excess of the risk free rate of return (called Excess Mu on the charts) against the historical volatility.
Figure 1. Risk versus reward over past 5 years
As is evident from the figure, multi-sector bond CEFs generated returns greater than treasuries but also had much higher volatility. Were the returns commensurate with the increased risk? To answer this question, I calculated the Sharpe Ratio.
The Sharpe Ratio is a metric developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with long-term treasuries. If an asset is above the line, it has a higher Sharpe Ratio than TLT. Conversely, if an asset is below the line, the reward-to-risk is worse than TLT.
Some interesting observations are apparent from Figure 1. Most of the multi-sector CEFs were close to the "red line", which means that they had similar risk-adjusted returns as treasuries. However, PKO and TSI were two notable exceptions. These two CEFs provide much higher returns than the other multi-sector funds and did so without a substantial increase in risk. Therefore, on a risk-adjusted basis, Pimco Income Opportunities and TCW Strategic Income were by far the best performers.
NCV was the most volatile of the funds analyzed, likely because of its high leverage and convertible bonds. Although the risk-adjusted return from NCV was similar to other CEFs, potential investors should assess if they can withstand the bumpy ride. The lowest volatility funds were BHK and BNA. These BlackRock CEFs had relatively low absolute returns, but their risk-adjusted performance had a similar Sharpe Ratio as most of the other funds.
I next looked at the past 3 year period to see if the performance had changed. The results are shown in Figure 2.
Figure 2. Risk versus reward over past 3 years
As you might expect, the volatilities during the past 3 years were much smaller than those over the 5 year period, since the 3 year look back period did not include the volatile 2008 and 2009 years. The returns from the multi-sector funds were still quite good and most of the CEFs handily beat treasuries. TSI and PKO remained at the top of the pack in terms of relative performance (but the absolute values of the returns were smaller than during the 5 year period). NCV was still the most volatile but over the past 3 years the risk-adjusted return was better than all the other CEFs except for TSI and PKO. Similar to the 5 year results, BNA and BHK were the least volatile of the multi-sector funds with risk-adjusted performance in line with treasuries but less than the other CEFs.
The investment landscape became even murkier in the more recent past. Since early this year, the fear of rising rates has taken its toll on many CEFs, including the multi-sector funds. To get a more near-term view, I ran the analysis from the beginning of 2012 to the present, a little over 1.5 years. This data is presented in Figure 3.
Figure 3. Risk versus reward since January 2012
The last 1.5 years have not been kind to treasuries, with IEF and TLT falling into negative return territory. BNA and BHK have performed better than treasuries by posting slightly positive returns. The other multi-sector CEFs have continued to perform well, with returns much higher than TLT but about the same volatility. The best risk-adjusted returns were booked by CHI and TSI but NCV, PFN, and PKO were not far behind.
In summary, multi-sector CEFs provided investors with excellent risk-adjusted income over all the time frames analyzed. The recent turmoil in the fixed income space has resulted in most of these funds selling at discounts well below their respective averages. I believe this could be a buying opportunity for retirees looking for income. Overall, TSI and PKO had the best risk-adjusted performance but other funds may be more appropriate depending on objectives and risk tolerance. No one knows what the future will hold but retirees looking for income should give multi-sector CEFs serious considerations.