Subscribers to "Yield Hunting: Alternative Investment Opportunities" got an early look at this material which often produce lower entry price points and higher yield and income.
The second mini-taper tantrum that has been ongoing in the bond markets the last few weeks, and spilling over affecting the equity markets as well, has been created due to a scare about interest rates. For those investors who are fearful of higher rates and been forced out of the bond markets, we offer up a solid option for the yield-seeking investor. The security has a tighter duration but still significant potential for growth and yield.
Duration measures how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. A zero-coupon bond has a duration that matches its maturity. A plain vanilla corporate bond's duration will be less than maturity.
The longer the duration, the higher the interest rate risk. Those higher risks are due to the sensitivity that a longer-dated bond has to changes in interest rates. With interest rates as low as they are, durations have increased all else being equal due to lower cash flows. The formula for assessing what a bond price will do for a certain change in interest rates is to simply multiply the duration by the change in rates. For example, the ten-year treasury has a duration today of about 9.1 years. If rates were to increase 1%, or 100 bps, the bond would fall 9.1%.
The latest scare about higher rates has led to significant selling of long-dated bonds. These include municipals and treasuries, in favor of shorter-dated bonds. While we think the sell-off will be short-lived and not likely be a prolonged decline (the data simply doesn't support it), being defensive could be prudent for those that are more risk averse.
In a closed-end fund update on September 7th to subscribers, we highlighted limited duration as the best ranked sector on a risk-adjusted basis. That is determined by the three-year standard deviation of the NAVs, current yield, and discount of the sector. In other words, we ascertain yield and capital gain potential per unit of risk taken. From the article:
In the above table, we assess the discount of the sector, the distribution yield, along with the 3-year standard deviation of the NAV as the risk proxy. From there, we create our modified Sharpe ratio which assesses the current discount rate coupled with the yield per unit of risk assumed which we then rank. The muni funds are, for the sake of the Sharpe ratio calculation, adjusted to a tax-equivalent yield using a 40% effective rate.
The formula shows that the limited duration sector as being the best risk-return trade off in the CEF universe today. It carries the largest discount to NAV of any group while carrying yields that are comparable or just slightly below the average of the table (7.90%). We have long applied excess cash to the two Eaton Vance Funds (EVV and EVG) and would add to EVV at these levels should you have excess cash today. Additionally, for the more risk averse investors, overweighting EVV is a great way to mitigate some of the risk in the core model.
(Source: Author's Calculation)
We will present an option for investors' consideration:
BlackRock Limited Duration - BLW
The BlackRock Limited Duration Fund (NYSE:BLW) invests in a myriad of sub-sectors of the fixed income markets; very much like a multisector fund. However, the objective is to keep the duration below five years, including the effect of leverage on the portfolio.
(Source: BlackRock website)
The effective duration of the portfolio as of the end of August was 3.32 years with an average maturity to worst of 6.44 years. Management then reduces the duration through interest rate swaps on the portfolio. The portfolio is composed of mainly non-investment grade bonds but very little of the triple-C or worse variety. This allows them to generate decent yields but still keep the duration (interest rate risk) low.
The fund is levered by 28% with a yield to maturity of 7.04% and yield to worst of 6.89%. Portfolio management has been strong with NAV growth on an annual basis over the last five years of 8.2% annual, well above the category average of 5.5%.
Shares trade at an 8.5% discount to NAV (marketplace subscribers got the article when it was at a 9.6% discount), which is below the three and five-year averages of 8.6% and 4.6%, respectively. This is a fund that traded at a 6.5% just a few weeks ago. The spread widening is largely due to the discount blowing out on two tantrum days in September (9th and 13th of the month) when price fell ~4% but the NAV was down just 0.8%.
The chart below shows the since inception premium/discount of the fund. There are three time periods when the discount was wide: in 2005, during the financial crisis, and in the last year. In other words, the current opportunity shows up once every three or four years.
Just like late last year, the opportunity stems from a fear of higher rates. We think the potential for higher rates between now and year-end is now close to or fully priced into the shares. Thus, there is the potential for about 300 bps of upside should the Fed not raise rates in September or December. The current z-scores are very favorable with the 3-month at minus 1.00 and the 6-month at minus 0.4.
The fund recently paid an $0.18 special distribution in July on top of their regular payout of $0.087 per share per month. The distribution is adequately covered with NII at 97.3% as of the end of July. Most importantly, UNII is a positive 8.3 cents, the only fund in the category with positive UNII. On top of that, UNII and earnings trends are positive, which are key predictors of distribution coverage. Again, this is the only fund in the category that shows that dynamic as well.
The current yield is 6.70% but with a relatively low standard deviation of returns. Over the last five years, the NAV's standard deviation has been just 3.5%, in line with the Barclay's US Agg, with over twice the yield. Price standard deviation is much higher at 12.15%, which is a large spread over the NAV volatility. In fact, this fund has one of the highest spreads between price and NAV volatility among the funds we track. That price volatility needs to be framed and understood, but most importantly, taken advantage of.
From a total return perspective, the NAV IPO'd at $17.33 per share in July of 2003. The NAV today is $16.69, for a total cumulative NAV bleed of 3.7%. Of course, that has been during a 13-year period of falling interest rates. If we assume a 0.5% NAV erosion going forward and a long-term discount of 6.5%, then our total return forecast over the next three years is 5.5% annualized. Using a long-term discount of 5% gets us closer to a 6% return per year for the next three years.
For those looking for reduced duration risk but still have the ability to generate some yield, there are four limited duration closed-end funds. Of the four, we like the BlackRock fund even though it has the tightest discount. The fund has a safe distribution, which we think is key to the sector. The discount today is one of the largest with only three such opportunities since the inception of the fund 13 years ago. Not only do we like the discount positioning (implying reversion to the mean) but the defensibility given the low duration. Investors should utilize the price volatility to their advantage and buy on down days when there are irrational sell-offs due to interest rate moves or market order selling.
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Marketplace Service For Those Hunting For Yield
In April 2016, we launched our marketplace service Yield Hunting: Alternative Income Investing dedicated to yield investors who wish to avoid the froth associated with the equity, REIT, and other more volatile areas of the market. We encourage investors to utilize the free two-week trial in order to benefit from our yield opportunities within closed-end funds, business development companies, and other niche areas. We attempt to construct a "low-maintenance portfolio" with a yield in excess of 7% on a tax-equivalent basis with capital gain optionality.
Disclosure: I am/we are long BLW.
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.
Additional disclosure: The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned. The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications or other transactions costs, which may significantly affect the economic consequences of a given strategy. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.