Enhance Retirement Income With CEFs Selling At Bargain Prices

by: John Dowdee

"Be greedy when others are fearful" is sage advice offered by Warren Buffett. This applies today to closed end funds (CEFs) that invest in bonds and preferred stocks. Over the last few years, investors clamoring for yield bid up the price of these CEFs. However, when the Fed began hinting that tapering was on the horizon, interest rates began to rise and the price of fixed income CEFs plummeted. As investors headed toward the exits, the price of these funds fell more than their Net Asset Value (NAV), causing discounts to widen. Some of these funds are currently offering distributions of over 8% without resorting to Return of Capital (ROC). Now, after all the shenanigans in Washington have been resolved, it appears that tapering is off the table for the foreseeable future. Under this scenario, the prices of these discounted CEFs appear to be bargains. As a retiree looking for more income, I analyzed these funds to see how they have performed on a risk-adjusted basis over the past several years. This article presents the results of my analysis.

The 7 closed end funds that I included in my analysis were:

  • Clough Global Opportunities (NYSEMKT:GLO). This go-anywhere fund sells at a discount of 13.7%, which is lower than the 52 week average discount of 12.7%. This is a balanced fund with 78% equities and 22% fixed income, but the allocation can change at the discretion of the managers. It also increases income by employing option strategies. For the stock sector, the largest sector is healthcare at 21% and about 25% of the holdings are non-US securities. The fixed income sector is a mix of long-term government bonds and short-term investments. The fund utilizes a high 47% leverage and has a high expense ratio of 3.4% (which includes about 1% for interest payments). The distribution rate is 8.5%.
  • Wells Fargo Advantage Multi-Sector Income (NYSEMKT:ERC). This fund sells at a discount of 12.5%, which is much lower than its average discount of 7.5%. This is a go-anywhere bond fund that holds 688 securities, 76% from the US and 24% international. The fund invests primarily in high yield corporate bonds and emerging market government bonds but may also venture into mortgage backed securities. It employs 24% leverage and has an expense ratio of 1.2%. The distribution rate is 8.3%.
  • Wells Fargo Income Opportunities (NYSEMKT:EAD). This fund sells for a discount of 7.5%, which is much lower than the average discount of 1.6%. It has 323 holdings, most of which are high yield bonds. However, the fund also invests in loans and preferred stock. The fund employs 24% leverage and has an expense ratio of 1.3%. This distribution rate is a high 9%.
  • Nuveen Quality Preferred Income 2 (NYSE:JPS). This fund sells at a discount of 11.5%, which is much lower than its average discount of 6.1%. This fund holds 227 securities, with about 90% in preferred stock. It invests 100% within the United States. The preferred stock is distributed among industry groups with 32% in insurance and 21% in commercial banks. It employs 30% leverage and has an expense ratio of 1.7%, including interest payments. The distribution rate is 8.0%.
  • Nuveen Preferred Income Opportunities Fund (NYSE:JPC). This fund sells at a discount of 10.6%, which is much lower than the average discount of 6.5%. The fund has 247 holdings, with over 90% in preferred stock, all from U.S. domiciled companies. The preferred stock is focused primarily in insurance, commercial banks, financial services, and REIT industries. It employs 29% leverage and has a 1.7% expense ratio, including interest payments. The distribution rate is 8.5%.
  • Flah&Crum Claymore Preferred Securities (NYSE:FFC). This fund sells at a small discount of 1.5%, which is low when compared to the average premium of 2.3%. This fund has 129 holdings, with over 90% in preferred stock. The preferred stock is primarily from banks (40%) and insurance industries (30%). The fund employs 33% leverage and has an expense ratio of 1.6%, including interest payments. The distribution is a high 9%.
  • Western Asset High Income Fund (NYSE:HIX). This fund sells at a small premium of 1.7%, which is low compared with the average premium of 3.6%. Over the past year, the premium has reached as high as 13.8%. The fund holds 435 securities, with over 90% in high yield bonds. The fund utilizes a relatively low 21% of leverage and has an expense ratio of 1.4%. The distribution rate is a very high 9.4%.

For reference, I also included the following ETFs in the analysis:

  • SPDR S&P 500 (NYSEARCA:SPY). This ETF tracks the S&P 500 equity index and has a yield of 2%.
  • iShares Barclays 20+ Year Treasury Bond (NYSEARCA:TLT). This ETF tracks the performance of long-term treasury bonds and yield about 3%.

To analyze risks and return, 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, these CEFs generated excellent returns but also had relatively high volatilities. 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 SPY. If an asset is above the line, it has a higher Sharpe Ratio than SPY. Conversely, if an asset is below the line, the reward-to-risk is worse than SPY. Similarly, the blue line represents the Sharpe Ratio associated with TLT.

Some interesting observations are apparent from Figure 1. All the CEFs, except ERC, were more volatile than treasuries but also generated substantially higher returns. On a risk-adjusted basis, the CEFs handily beat TLT. Also somewhat surprisingly, many of the CEFs had better risk-adjusted returns than the S&P 500. This was not expected since SPY has been in a strong bull market since 2009. However, this is likely because the look back period started in October, 2008, which included the tail end of the equity bear market.

If we look at the relative performance among the CEFs, GLO and JPS lagged. The other CEFs had very similar risk-adjusted returns with FFC being slightly better than the rest.

Next I wanted to assess how much portfolio diversification I might receive by investing in these high yielding CEFs. To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the selected funds. The results are provided as a correlation matrix in Figure 2. As is evident from the matrix, these CEFs provided relatively good diversification. The CEFs were negatively correlated with long-term treasuries and only moderately correlated with the S&P 500. The correlations among the CEFs were higher but only about 60% to 75%. So my conclusion was that these CEFs would provide a reasonable amount of portfolio diversification.

Figure 2. Correlation matrix over past 5 years

I then looked at the past 3 year period to see if the outperformance had continued. The results are shown in Figure 3. Over the past 3 years, the SPY has been in a rip-roaring bull market and easily outpaced the high yielding CEFs. ERC and EAD had risk-adjusted returns similar to TLT but all the other CEFs had better risk-adjusted returns than long-term treasuries. Among the CEFs, FFC continued to generate excellent performance with JPC close behind, and HIX placing third.

Figure 3. Risk versus Reward over past 3 years

Bottom Line

Over the time periods analyzed, the high yield CEFs have generated risk-adjusted returns better than long-term treasuries. No one knows what the future will hold but based on historical data, I like these assets. Volatility is relatively high, but if you are risk tolerant, you should consider investing in these CEFs.

Disclosure: I am long GLO, ERC, EAD, JPC, JPS, FFC, HIX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.