2014: The Case For 'Reverse Rotation' Into Bond CEFs

by: Arsene Lupin

I'll start with a confession of bias. I subscribe to the theory that red-blooded investors such as yours truly go for stocks, and that bonds are best left to the portfolio of one's mother-in-law. But changing times require re-examining one's axioms. Given the euphoria around stocks and the gloom around bonds, now is a good time for said re-examination. And my conclusion is, on a relative valuation, basis bonds offer not only a better risk-reward, but possibly a better absolute reward. I would hasten to point out that I am talking specifically about closed end bond funds, where you are playing both the income and the end-of-year NAV discounts. Below are some of my arguments for the bond stock reverse rotation.

How Euphoric Are We? The answer, according the Citigroup's Tobias Levkovich, is high, but with the potential to get to excessive. Nevertheless, he notes that readings at this level (see figure below) indicate the market may retreat with an 83% historical probability of losses in the next 12 months. So if you are adept at spotting greater fools, you can certainly play stocks, but risk-reward is not on your side.

We are on the wrong side of growth. The same Zero Hedge article alluded to in the point above also points to a normalized earnings chart. This chart (below) shows that EPS growth is trending in the wrong direction, and cannot justify the elevated P/E of the current market in the months that follow.

Bond Closed End Funds Trading with Doomsday Discounts. As pointed out by multiple sources, such as the figure below and this article from Forbes, bonds have been vilified beyond what they deserve. On a relative valuation basis, as well as a historical discount basis, they are well worth the look.

(click to enlarge)

Bonds are the Turbo-Charged Tricycle. Bond Closed-End Funds give you a three-pronged vehicle for total returns - dividend, the lifting of steep year-end discounts, and the upside from a potential scenario of an earnings recession. A recent Barron's article offers a collation of investment choices from various hedge fund sources. The Barron's article makes a case for all manner of income vehicles (including Preferred Stocks) but specifically calls out Municipal Bonds as worthy of a look.

In summation, investing in optical networks, robotics and social media is more fun, and more worthy of conversation at cocktail parties. But if you go with bonds, you might skip the party altogether and fund that island vacation that sounds vastly more enticing in any case. As always, do your own homework, and pay close attention to valuation and discounts before pulling the trigger.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.