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Bill Gross On Opportunities In The Closed End Fund Arena

|Includes:FHY, FSD, PIMCO High Income Fund (PHK)

In a recent interview for US News & World Report :

Bill Gross was asked where does he see opportunities for individual investors.
He mentions Muni CEF but does not mention his corporate bond funds.

So where are the investment opportunities for individuals?

"Both from the standpoint of stocks and bonds, an investor wants to go where the growth is. There are countries that should grow faster than Euroland countries, and countries that should grow faster than the United States. They would be the big obvious ones: China and Brazil, and even Mexico.

In terms of the bond market, there are opportunities in what are known as closed-end funds, [which issue a fixed number of shares and] trade like stocks. The magic to them is that many of them are slightly levered: They borrow basically at zero percent or close, and then reinvest back into their asset class. Municipal closed-end funds with bonds that yield typically 4 to 4½ percent can be turned into a 6 to 7 percent tax-free investment on the basis of this borrowing and the mild leverage. Many PIMCO funds, many BlackRock funds, many Vanguard-they're all over the place-you can buy them at 6 percent yield, tax-free, and they provide the opportunity for investors to get those historic 6, 7, 8 percent returns that I said at the beginning were not available through generic types of investments. So I say buy these closed-end funds, because they yield 6 to 7 percent and there's basically the same risk as in the generic universe."


But what I found more interesting in this interview is Bill Gross' take on the "new normal" in bonds.
He said that if he is able to deliver 1%-2% a year above the universe of the Total Return fund it would be acceptable - hence returns of 3-4% a year should be the norm under such conditions.
For the HY universe, maybe 10% could be achieved but the risks are too high there now and thus he is NOT concentrating on this sector now.

I imagine that's on a lot of investors' minds. What should they expect?

"You start with the obvious: The Federal Reserve has lowered short rates to close to zero. The investment-grade bond market, which includes treasuries and corporates and mortgages, all in one big pot, yields 1¾ percent. It's hard to manufacture near double-digit returns from that. It's the metaphorical concept of squeezing juice out of an orange; almost all of the juice has been extracted, so to speak.

So investors looking for a repeat of historical performance are bound to be disappointed, and that's why I wrote several months ago-which caused a ruckus in the market-about the [dying] cult of equity. It was the same thing with the cult of bonds, the "cult" meaning that there was a belief that historical returns could be projected into the future. They can't. They can't for bonds and they can't for stocks either, in my opinion.

The PIMCO Total Return Fund starts with a universe that yields 1¾ percent. If we can outperform the market by 1 to 2 points a year and things stay the same, then investors can get a 3 to 4 percent type of return. But they shouldn't expect a 6 or an 8. A 10 percent return, it's nearly impossible, at least from a generic [investment-grade] type of universe. We can speak to high-yield and we can speak to opportunities elsewhere, but they, of course, involve risk-taking. [Now we are concentrating on] more short- and intermediate-term bonds, mainly mortgages and, in some small percentages, bonds in Italy and Spain."


This re-enforces my notion that at current market conditions the PHK portfolio will be lucky to produce a rate of 8%-10% a year on the positions it holds and thus we see the great reliance on derivative trading to compensate for the "hole" between the earned income and the inflated distribution rate.

2012 has worked well for PHK in that regard based on NAV performance but they cannot and will not be right all the time with derivatives and when the mistakes occur (see 2011 fiascoes), both NAV as well as the distribution rates will be cut badly.

In the meantime, I am very happy to be short PHK while being long alternatives like FHY and FSD (and others too) who trade at discounts to NAV and actually EARN their distributions in pure income from their portfolio without the risk of derivative trading.

Happy Thanksgiving to all!!

Disclosure: I am short PHK.

Stocks: PHK, FHY, FSD