This post is written especially for the Investing for Income section of Seeking Alpha. I do identify strongly with the need for articles with a more long-term perspective, especially for people willing (trying?) to sit around and not trade with the daily rises and falls in their positions, content to collect a comparatively fat dividend each year while being compensated for assuming market/credit and interest rate risk.
Make no mistake, by participating in this (especially the bond side of it) you are becoming part of the "shadow banking system" - loaning out your capital for a high interest and the risk of default - and we all know the problem with that.
Still, while the economy is recovering and companies are even calling in their debts, this may prove to be a very profitable, low risk proposition.
I drew up a table looking at all closed end bond funds ("CEFs") with dividends higher than 10%. These dividends can be surprisingly juicy, going up to 15% at the top end:
click to enlarge images
Using this chart:
- P/B indicates the premium to or discount from NAV that the fund is trading at. As you can see, Pimco High Income Fund (PHK) is trading at a 74% premium, which I will go into later.
- Yellow-highlighted funds have stale-dated NAV reporting - in other words, either an up to date figure is not accessible on their website, or I had to calculate one for the purposes of this table.
- This past month (esp week) has been terrible to bond investors, especially in Putnam Premier Income Trust (PPT), who got absolutely hammered.
- Buy and hold - It looks as though the American Strategic Income Portfolio (BSP) suffers very little variation in price - being up only 0.44% YTD, and only suffering -0.66% while all the other funds bled upwards of three digits in basis points this month. It also has the second highest dividend yield available in the bond CEF universe, which is a nice plus.
- Buy and hedge - This requires a little more sophistication on your part but can be very rewarding from a risk-reward standpoint. Essentially the pure high yield portfolios (thus we omit 8, 9, and 10 from this) are exposed to credit risk and interest rate risk. There is little point in shorting another fund to hedge both these risks out as you would have to pay out about as high a dividend as you would take in. CEFs also don't have options traded on them, so that is out. However, if you believe (as I do) that the recent bloodbath in bond funds is solely due to interest rate risk and that the risk of defaults has not actually increased, then you can hedge against that with little capital down by buying a put option on treasury bonds (or a call on TBT). Sadly the market access (finding a broker who will sell you that option) and knowledge (duration matching) required to do this properly are beyond the scope of most investors, and while I know this is possible in theory I have not done this in practice.
- Speculate - This story comes from personal experience trading the PIMCO High Income Fund (PHK). Go on to their site for this info. At the start of this year (January 2010), PHK traded at $10.85, and received a $0.12 dividend every month. This was a very comfortable 13.3% dividend yield. However, the problem was that its reported NAV was about $7, so the stock was trading at a 55% premium to NAV. In other words, if you bought PHK and somehow managed to break it apart into its component bonds, you could not sell them off for anywhere near the value that you bought it at. Who on earth would make that trade? Everyone from my professor at school to members of my fund whom I spoke to about it gave me the same response - this is market irrationality, the shoe is going to drop at some point.Of course, I bought in. YTD, I have had about a 36.9% return on that, which isn't too shabby. Of course, that doesn't prove anything, but here is my justification (to myself) why it still made sense to buy PHK at a 55% premium to NAV. Observe the chart below.
The proper reasoning for speculators in CEFs. As at January 2010 I could not have known whether the premium to NAV was going to suddenly evaporate. However my analysis was based on the January - December 2009 period. As the markets recovered, and AIG was bailed out (PHK holds substantial amounts of AIG debt as you can see in its holdings), the NAV of the fund recovered as its underlying holdings began to trade at more sane levels.
However, because it was a closed-end fund, in which the underlying holdings could not be redeemed for units of the fund, a curious thing happened - the market price of PHK started trading as a futures bet on the NAV continuing to rise. This made sense if you eyeball the chart and realize that an investor who bought PHK in, say, May 2009, for a substantial premium to NAV, saw this "premium risk" entirely dissipate by the end of the year when NAV itself actually rose to the May 09 market price. Likewise, someone like myself buying at $10 in January 2010 had to have some reasonable expectation that the NAV would be rising from $7 to $10 over the time that I held it.
How could you know NAV would rise that drastically in a short time? While you could expect some "strong security selection" (as they phrase it in their report) to help that NAV figure up it is highly unlikely that that could entirely boost NAV from $7 to $10 within the relatively short period I intended to hold it. Instead, the answer must be in another source of returns, also in their report:
High-yield and investment-grade corporate bonds added significantly to Fund performance, as these securities experienced price appreciation due to the compression of credit spreads during the period."
Aha. The NAV was unduly depressed because investors no longer had the appetite for junk bonds - but this appetite was coming back. In fact, if credit spreads narrowed further, it wasn't crazy to expect NAV to return closer to the ~$15 level it was at from 2004-2007! (Well, $15, minus whatever permanent impairment it had suffered due to actual default and/or premature sales of holdings realizing the paper losses).
This not only made the 55% premium to NAV make sense in January 2010, it actually made PHK look cheap. The only problem was because of the giant mass of securities held by PHK it was essentially impossible to tell how much that "permanent impairment" had been, and how much was "temporary impairment" that we could expect to quickly dissipate. Fortunately, the NAV figure is reported daily on the website, and its positive growth over time allows us to infer that those credit spreads are continuing to narrow. The recent slowdown in the growth of NAV also tells us that we may be hitting the "NAV ceiling" perhaps in mid-2011.
OK, what now? It is all well and good to reflect on a trade that went well, whether or not my underlying thesis was correct, but what do we do going forward? PHK is no longer as attractive a buy as it was in January 2010; referring you back to Figure 1, the NAV is still on an uptrend, but has slowed down significantly, and if my "trading as futures" thesis is correct the market price should plummet 30%-ish once NAV seems to have found a ceiling. Not great in terms of risk/reward.
Are the others like this? The defining characteristic of a fund that has a market price trading as though it was a futures market on its own NAV is that its market price will be at a significant premium to NAV. Besides PHK, only PHT fits this criteria on our list. However, based on an inspection of PHT's fundamental holdings and recent performance, we believe it is exhibiting the same slowdown in growth of NAV, and so is pretty much the same bet (high dividend yield compensating for the risk of an even higher fall in market price).
Conclusion: Just keep this in mind. As yet there do not seem to be any opportunities to speculatively trade any of the CEFs mentioned in this table, but this PHK story will hopefully serve as a future reference in your playbook for the next credit crisis.
- Every potential high yield bond fund investor must read this Seeking Alpha article detailing the pitfalls of distribution cuts and some reasons they may happen. Essentially, if the CEF is paying out more than it is taking in, it's a Ponzi scheme, and like all good Ponzi schemes they will not be able to pay what they promise if this is the case. therefore, reading the income/cashflow statements is critical.
- Contradicting other authors. My "trading as a futures" analysis of PHK's performance runs in direct contradiction to other Seeking Alpha authors such as Joe and George, who have analyzed it assuming a stable NAV. This is a mode of thinking that only applied pre-crisis; post crisis, the NAV clearly moved in strong trends, and therefore the market price would move in anticipation of the NAV. The fact that PIMCO funds exhibited the largest premiums to NAV post crisis was merely a result of their having been strongly invested in financial and municipal debt, thus having suffered the largest temporary cuts to NAV as credit spreads increased.
- Long BSP - its valuation has proven to be extremely stable, and yes it still has a 15% dividend yield.
- You could also go long PHK and PHT if you feel like taking risky trades that may turn out very rewarding in total return terms. (up to your own risk preference)