3 Closed-End Income Ideas to Boost Cash-Flow Yields

Includes: ESD, FCT, FEO
by: Jason Merriam
With so much volatility in commodities, currencies, equities and many other asset classes, income investors find themselves caught in the crosshairs these days.
On one side you have a central bank (Fed) determined to keep interest rates low by printing its own money to buy back its own paper (Treasuries and agency debt). Unfortunately, the Fed is doing this because there are few bullets left in the holster and leveraging their balance sheet is just about the only live ammunition they have left.
The Fed’s disposition will likely continue this way at least for the near-term as will most other industrial nations (i.e. G7), a result of the global monetary intervention necessitated by the tragic earthquake in Japan.
On the other side, are inflated asset prices (equities and commodities) which resulted from the aforementioned “printing” action of the Fed. Easy monetary policy in itself is not necessarily a bad thing. However, a protracted loose money policy following an earlier affliction of “The Easy AL” syndrome won’t necessarily end-well either.
In the long-run, a debased currency will be far less desirable than say short-term efforts to boost exports, etc. There’s some irony too, as these recent attempts at “stimulus”, created more capital gains than jobs, one of the supposed primary objectives of QE’s 1-2 and possibly 3 if it manifests in legislation or needed to balance intervention efforts such as has been orchestrated to help Japan.
Meanwhile, retirees and pensioners face a potential hemorrhage to their purchasing power either by mandate or the reality of more sound assumptions and benefit rationalizations.
Ultimately this could potentially include recipients of Social Security, state funded pensions, all the way down the food chain to the small private enterprise faced with underfunded plan obligations of its employees. It really is a jungle out there.
This is where the usefulness of income oriented closed-end funds can be a potential savior to the income investor. For more than a decade, income and equity CEF’s have been a staple in our portfolio allocations and definitely pulled their weight over the years.
CEF’s were for many years obscured by ambiguity and considered less desirable to the more well-known and larger capitalized open end mutual funds. Part of the ambiguity stems from the fact that it was difficult for the average investor to get their hands around these baskets of assets.
That nearly all CEF’s come to market as an IPO with a fixed number of shares didn’t sound far fetched, but because they were selling for less than what they came to market for, many average investors were left feeling skeptical. Why would anybody pay less for the net-asset-value of a security when a similar security or component security was trading at a higher price? To many, this just was not right!
However, savvy investors have long sought CEF opportunities for exactly that reason. For years, CEF’s were one of the best-kept investment secrets. Ten or fifteen years ago we would not be having this discussion for the simple reason of not wanting to spill the gruel about these marvelous but misunderstood investments. The question we would ask is who in their right mind wouldn’t want to pick up an asset for eighty-eight cents on the dollar when they would have to pay a full dollar elsewhere?
Thus, it does not require an abacus to figure that buying an asset or bundle of assets for less than you would pay if you replicated the bundle or security at market prices, is a good thing. Indeed, it can be remarkably profitable if you pick your spots carefully.
Nowadays the CEF market has mushroomed, and there is a fund or baskets-of-securities in every shape, size, flavor and color. And, retail investors are seeing the light.
We constantly scan the CEF universe for new ideas and the first steps of our selection process are quite basic. Here's our general rule of thumb:
  • Look for funds selling at a discount to net-asset-value
  • Avoid funds with excessive baseline expense ratios (unless discount justifies it)
  • Avoid highly leveraged funds (remember auction rate preferred problems?)
  • Pay attention to market liquidity--ook for CEF’s with good volume and avoid thinly traded funds
  • Look for broad portfolio diversification within the stated objective and asset class
  • Steer clear of funds with less than $100 million in (unlevered) assets
  • Look for managers with established track records
Next, we compare portfolio characteristics; distribution history, credit quality and duration. For example, if seeking a global income fund which focuses on government bonds, avoid overlapping portfolios or heavy concentration of same country obligations.
Are distributions paid from income and capital gains or from return-of-capital? Is credit quality balanced or weighted to a particular rating? If it is a high yield bond fund, look at average maturity. High yield bonds maturing in 2-4 years will be hard for a manger to replicate or swap into at favorable prices in this market and investors will want to get paid for the risk taken.
Here are a few income-style CEF’s we might be interested in if needing to replace other funds in our portfolios:
Western Asset Emerging Markets Debt (NYSE:ESD): current yield of 7.02% with discount of -7.93% to NAV. Select diversification to Russia, Mexico (Pemex), Brazil and Australian resources. Drawbacks: exposure to Venezuela and Turkey.
ESD But, ESD pays monthly and distributions are 100% income.

We like that it is unlevered, has an average 12 year maturity and weighted towards low-end of investment grade; and seasoned managers.
First Trust / Aberdeen Emerging (NYSE:FEO): Current yield 6.84% with a -7.31% discount to NAV. Good mix of equity, government bonds, and corporate paper with exposure to South Africa, Indonesia, Korea (Samsung), Brazil (Petrobras) and Mexico. Drawback: Exposure to Argentina, Turkey and Venezuela FEO
FEO carries 4.70% structural leverage, reasonable expense ratio, pays quarterly and you get a good manager in Max Wolman.
First Trust Senior Floating Rate II (NYSE:FCT): current yield 5.51% with a +0.14% premium to NAV.
Our last selection is a senior loan portfolio consisting largely of secured corporate bank loans. Obviously the big attraction to senior loans is that they are usually secured by collateral (often operating assets) and in the event of default, hold higher creditor preference than bonds, preferred shares and common stock.
The problem with variable rate senior loan funds in the past several years is that as rates declined so did distributions and yield. However, we view these types of assets as a sort of proxy for interest rates.
These types of vehicles have been around for years, though largely sought after by institutional investors. In mid 2008 about the time of the collapse in the auction rate preferred market, (which have also been around for many years), credit markets were deeply distressed.
Consequently, the average bid for leveraged loans also tanked, sending loan prices to 75 cents on the dollar or the average historic leverage loan recovery rate (1995-2007). Unfortunately, this dragged on and by Sept. of 2008 spreads between discounts and NAV FCTwere the widest in almost 50 years.
However, since this past October we have noticed a gradual upward trend in distributions.

This signals a potential firming of credit prices and a tightening of discount spreads.

Whether or not the Fed raises overnight rates anytime soon, the markets appear to be pre-empting their move.
With FCT, you get broad industry diversification and default rates which are well off the average 10.8% peak seen in November of 2009.
Caveats: FCT carries a higher than average expense ratio of 2.43% and 30% leverage. Credit quality is predominantly BB. However, the prospects of rising variable rates and investor demand for these securities, would in our view offset the absent discount and expense ratio.

With any CEF, there are unique risks not typical of an equity, preferred class share, bond or mutual fund. We like them as a mutual fund substitute because they can be bought and sold like a stock and without limitations to the time held.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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