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We are all painfully aware of the current low interest rate environment. We are seeing drastic intervention by The Federal Reserve in order to stimulate the economy. This intervention is causing wide divergence amongst classes of fixed income securities. The Fed may control short term interest rates, but it is investors who determine the demand for individual assets. Although Bernanke has announced that the Fed is on hold until 2014, anemic short term rates do not eliminate a potential change in investor preference.

Most investors will debate the state of the United States' economy and expectations about world stock prices. However, most investors will agree that corporate balance sheets, as a whole, are in pretty good shape. While stock prices reflect expectations of future earnings, bond prices represent a claim on company assets and are directly related to the company's financial condition.

In my previous article, Levered Municipal Closed-End Funds: A Cautionary Tale, I detailed my concerns with the aforementioned securities. I continue to believe they are overvalued and merit revisiting in one's portfolio. Many investors of this asset class are income dependent and conservative in nature. Although municipal bonds are rarely the subject of default, there are other risks that persist, specifically interest rate risk. I have decided to recommend a group of closed-end funds that can help protect against a long term municipal bond portfolio price decline. The investments below are risky and should not represent more than 10% of an investor's overall portfolio (less that 1% per holding). I will describe my expectations, each investment strategy and each asset segment.

Although many investors fixate on the yield of fixed income securities, as investors we must focus on the total return. Yield should be combined with price change in order to calculate total return. I have chosen to focus on asset classes that have a potent after-tax yield as well as price appreciation. This portfolio is not designed to replace someone's municipal bond portfolio, but merely compliment it. The investments below are credit sensitive and historically have experienced negative correlation to municipals. Each investment should be carefully researched before determining its inclusion in your portfolio.

There are four main ways to increase the yield of your fixed income portfolio: lengthen the average maturity, reduce the credit quality, invest internationally and increase the leverage. I believe there is a time and place for each of these strategies and have included some recommendations below.

Lengthen the Average Maturity

Although I recommend an underweight to long municipals and treasuries, I believe that preferred stocks are currently undervalued and represent a favorable opportunity. Preferred stocks are fixed income instruments that generally have a fixed coupon and no maturity. Preferred stocks are most often issued by banks, utilities and REITs (not the most favored segments of the market). After a horrible 2008, preferreds have been gaining ground and paying handsome dividends.

Reduce the Credit Quality

The recent flow into fixed income investments considered to be low risk (i.e. treasuries and municipals) has caused prices to rise and yields to fall. By investing in fixed income securities considered risky (lower rated), we are able to collect a higher yield on our invested capital. With securities that contain credit risk, investors must be aware that they may not be paid timely interest payments or receive their principal upon maturity.

As I look across the risk spectrum, there are several categories I feel are being shunned and look attractive on a risk/return basis. Today, I recommend diversifying your fixed income investments implementing several risky categories:

Convertibles - These bonds are issued by companies that give the bond owner the right to convert the bond into shares of company stock. Because of this conversion option, these bonds are typically issued with an interest rate below what the issuer would pay on a normal bond. This gives the issuer a cheaper borrowing rate and the investor upside potential on the company's stock. Because of their hybrid status, convertibles often trade in relation to the stock market.

Floating Rate/Senior Loans - These bonds are often low rated (speculative grade) and have an interest rate that adjusts with changes in LIBOR plus a spread. Many floating rate bonds have floors that allow investors to receive a minimum amount of interest, regardless of LIBOR. Many of the companies that issue these bonds are cyclical and opt to pay higher rates when the economy is good and pay lower rates when the economy is not so good.

High Yield - These bonds are often known as "junk bonds." They are issued by companies that may be experiencing financial difficulties, have a short credit history or have a risky capital structure. In order to access the credit markets, they must entice investors with a yield higher than any other comparable maturity bond. High yield bonds are known to have a higher default rate than investment grade bonds and historically have a high correlation to the stock market. High yield bond performance is closely tied to the economy and often underperforms in periods of falling interest rates

Investing Internationally

The global investment community is continuously shrinking. During the last 10 years, investors have witnessed impressive foreign market expansion. Although the ease in which we buy foreign investments has changed, the risks have not. Foreign investments take on a set of risks not seen in domestic bonds, such as: exchange rate risk, political risk, foreign taxes, liquidity, etc. Although the US Dollar has attracted greater attention, a reversal in investor appetite may occur. If the dollar falls in value, bonds denominated in foreign currencies may appear more desirable and appreciate.

Leverage

Utilizing leverage is a quick and simple way to increase the yield of any investment. Investors have the ability to borrow funds, using their portfolio as collateral to buy additional securities. Portfolio managers often borrow 40% of their invested capital to buy more securities. As long as the interest received by the investments exceeds the rate of borrowing, the residual interest is paid to the investor. Investors must also consider the effect leverage has on price movements. Leverage causes fund prices to move with greater intensity than unlevered funds. A fund that is leveraged 40% would return 1.4% for every price move of 1%. This occurs on the upside and the downside. Leverage should only be utilized by investors who understand the risks and are prepared to accept the consequences. I prefer using leverage to take advantage of underpriced securities, increasing the expected appreciation and yield.

I have selected some securities that utilize the four strategies detailed above. I have chosen to focus on closed-end funds, as they present a tremendous opportunity. Many of the asset classes previously discussed are unloved and trading at attractive valuations. Many closed-end funds holding these securities are also trading at discounts to NAV. I believe that this basket of securities will appreciate while providing a handsome yield. Many of these investments are leveraged and hold low rated, speculative securities. There is significant risk in holding any one of these securities; however I believe these securities have return potential that fairly compensates investors for the risks taken.

Ticker

Fund Name

Closing Price

NAV

Leverage

Distr. Rate

Prem/ Disc

Mkt Cap

Avg Credit Qual

True Yield

After Tax @25%

Taxable Income-Preferreds

JHP

Nuveen Quality Preferred Inc 3

$8.24

$8.12

27.98%

7.57%

1.48%

$195M

BBB+

7.57%

5.68%

PSF

Cohen & Steers Select Pref&Inc

$23.66

$23.36

31.52%

8.72%

1.28%

$284M

7.94%

5.95%

Taxable Income-Convertible

AVK

Advent Claymore Conv & Income

$16.16

$17.41

38.95%

6.97%

-7.18%

$381M

6.34%

4.76%

Taxable Income-Senior Loan

JFR

Nuveen Floating Rate Income

$11.42

$11.59

20.43%

7.20%

-1.47%

$550M

BB-

7.20%

5.40%

PPR

ING Prime Rate Trust

$5.51

$5.72

30.24%

6.32%

-3.67%

$811M

6.32%

4.74%

Taxable Income-High Yield

DHG

DWS High Income Opportunities

$14.54

$15.36

9.08%

-5.34%

$245M

9.08%

6.81%

FSD

First Trust High Inc Long/Shrt

$16.68

$17.82

23.25%

9.60%

-6.40%

$601M

BB-

9.60%

7.20%

Non-US/Other-Global Income

GDO

Western Asset Glb Corp Def Opp

$18.92

$18.99

21.63%

8.09%

-0.37%

$288M

BBB

8.09%

6.07%

FAM

First Trust/Aberdeen Global

$16.65

$17.35

24.53%

9.37%

-4.03%

$289M

A-

7.28%

5.46%

Taxable Income-Multi-Sector (Contain many of the strategies above)

BPP

BlackRock Credit Alloc III

$10.97

$12.05

29.47%

6.95%

-8.96%

$203M

BBB

6.95%

5.21%

PSY

BlackRock Credit Alloc II

$10.27

$11.26

31.68%

7.13%

-8.79%

$419M

BBB

7.13%

5.35%

Simple Average

27.52%

7.86%

-5.13%

$421M

7.55%

5.67%

*Reported from CEFConnect.com, after market close 1/26/2012

**True yield = Distribution rate X (1-Return of Capital)

Source: 4 Strategies For Increasing Yield And 11 CEFs That Will Help You Profit