Closed-End Income Funds: How To Benefit From Rising Treasury Yields

Includes: BFZ, EMD, MSD, NCA, SBW
by: Jason Merriam

There is a lot going on in the credit markets these days and the back-up in U.S. and Global bond yields is not exclusive to an "improving" economy. U.S. Treasury yields were up some 25 basis points this past week while the S&P 500 rose only 2%.

You would expect equities to rally higher if there was an asset allocation swap out of "safety" and into "risk". Yet NYSE trading volume is at multi-year lows, which suggests that the stock market may have been propped up partially by company stock buybacks.

Veteran trader and CNBC commentator Art Cashin offered one theory as to why bond yields were rising: China's trade deficit. He thinks fewer dollars for China could mean fewer dollars to buy bonds. Another possible reason for rising Treasury yields is due to banks selling Treasuries following the Fed stress tests. Many banks are eager to return capital to shareholders in the form of dividends.

Regardless of why Treasuries sold off, its effect has been felt in municipal and taxable fixed income closed-end funds. Below are a few ideas in each sector we find attractive on these pull-backs.

Muni CEF's: Two muni funds we own are Blackrock CA Municipal Income (NYSE:BFZ) and Nuveen CA Muni Value (NYSE:NCA). Both funds now trade at a discount to NAV, pay monthly distributions with current yields of 6.22% and 4.90%, respectively.

The rout in CA muni funds this past week were also exacerbated by news about the potential bankruptcy of Stockton CA and by CalPERS (CA's public employees retirement system) announcement that it was lowering the assumptions for its investment rate of returns.

However, both of these CEF's have good long-term track records, tenured managers and diversified sector holdings. Credit quality runs AA to A and each offers handsome taxable equivalent yields for investors in higher income tax brackets. BFZ employs leverage, NCA does not.

Taxable CEF's: For investors wanting to hedge their bets on the US credit markets, MS Emerging Markets Debt (NYSE:MSD), Western Assets Emerging Markets Income (NYSE:EMD) and Western Asset Worldwide Income (NYSE:SBW) could add some juice to your income streams.

One common appeal of each of these funds is their exposure to Mexico and peso denominated bonds.

Mexico, like Canada, is an important trading partner to the U.S., and if the U.S. does well, so will Mexico.

The average weighting to Mexico for all three funds is approximately 7% of assets.

  • SBW pays monthly, 6.57% current yield and a -7.62% discount to NAV.

  • MSD pays quarterly, 5.05% current yield and a -9.55% discount to NAV.

  • EMD also pays quarterly, 6.49% current yield and trades at a -4.02% discount to NAV.

Credit quality in these three funds average BBB (investment grade) and none pay returns-of-capital in the distributions. MSD uses some leverage but it is less than 6% of total assets.

Summary: The Federal Reserve has maintained interest rates at historically low levels for several years now.

Rates will rise eventually, but with rates still so low, it will take several hundred basis points of rate hikes to effectively push money out of bonds and into stocks or CD's.

Until corporate profit cycles indicate sequential year over year earnings growth, we don't see overnight rates surging any time soon. Inflation is another factor, but not a big problem yet.

Although chatter about "Greece" and euro sovereign debt issues have subsided somewhat, headline risk will likely keep a spotlight on credit markets near-term. It's an election year here in the States and there are also the usual geopolitical suspects honing their rhetorical spiels.

The rise in rates this past week was significant and traders will be focused on the bond market for clues to see if higher rates are here to stay.

However, for investors who are looking to put some cash to work, these closed-end fund ideas might be worth looking into.

Disclosure: I am long BFZ, NCA.

Additional disclosure: Municipal closed-end funds mentioned in this article are state-specific to CA.

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