5 Taxable Mortgage Closed-End Funds With High Dividend Yield Enhancement

Includes: BSP, CSP, JMT, SLA
by: George Spritzer, CFA

This is the third article in a series describing closed-end funds that can capture “alpha” or excess return over a benchmark. The first two articles discussed covered call and equity dividend closed-end funds.

In this article, I discuss the taxable mortgage bond sector.

There are two main ways to capture “alpha” from closed-end funds:

1) Discount Capture: This occurs when you buy a closed-end fund at a discount which then narrows. (You can also capture alpha when you buy a closed-end fund at a premium which then widens further but this can be risky if the premium goes away).

2) Dividend Yield Enhancement: With dividend yield enhancement, you are not depending on a change in the discount to net asset value, so this method for capturing “alpha” is also available for longer term buy and hold investors.

Suppose you own a closed-end fund which distributes 10% of net asset value each year and sells at a 20% discount. Assume a net asset value of $100 and a market price of $80. The $10 annual distribution is 12.5% of market price, so you are earning an additional 2.5% in yield enhancement from the discount.

Another metric is the adjusted expense ratio which is the expense ratio minus the dividend yield enhancement. In some cases, this results in a negative adjusted expense ratio.

For the hypothetical example given above, assume a fund expense ratio of 1% a year.

  • Dividend Yield enhancement alpha= 12.5% * 20%= +2.5%
  • Expense Ratio= 1.0%
  • Adjusted Expense Ratio= 1.0 – 2.5= -1.5%

I have compiled a list of four taxable mortgage funds where the sum of the discount and annual distribution rate exceeds 20%. I have also included another fund (NYSE:JMT) which trades at a lower discount to NAV, but has a high distribution rate and has managed to maintain its distributions over the last year.

(NYSE:CSP) is probably the riskiest fund in the group and holds some highly distressed securities. But management has marked down the prices of the worst performing issues to near zero, so there is limited remaining downside risk in these issues.

My annual distribution numbers are different from web sites like cefconnect and Bloomberg which use the trailing 12 months of distributions. Some of these funds have had distribution cuts in the last year. To be more conservative, I annualized the latest monthly dividend when computing an annual distribution rate.

All of the quoted distribution rates benefit from dividend yield enhancement. Two of these funds (NYSE:BSP), (CSP) have negative adjusted expense ratios.

1) American Select Portfolio

  • Ticker: (NYSE:SLA)
  • Expense ratio= 1.08%
  • Discount= 13.12%
  • Annual Distribution Rate (NAV) = 7.09%
  • Annual Distribution Rate (market price) = 8.16%
  • Dividend Yield Enhancement alpha= +1.07%
  • Adjusted Expense Ratio= +0.01%

2) American Strategic Income I

  • Ticker: (NYSE:ASP)
  • Expense Ratio= 1.41%
  • Discount= 13.93%
  • Annual Distribution Rate (NAV) = 7.21%
  • Annual Distribution Rate (market price) = 8.38%
  • Dividend Yield Enhancement alpha= 1.17%
  • Adjusted Expense Ratio= 0.24%

American Strategic Income II

  • Ticker: BSP
  • Expense Ratio= 1.02%
  • Discount= 17.11%
  • Annual Distribution Rate (NAV) = 6.19%
  • Annual Distribution Rate (market price) = 7.46%
  • Dividend Yield Enhancement= 1.27%
  • Adjusted Expense Ratio= -0.25%

American Strategic Income III

  • Ticker: CSP
  • Expense Ratio= 0.97%
  • Discount= 18.34%%
  • Annual Distribution Rate (NAV) = 5.58%
  • Annual Distribution Rate (market price) = 6.82%
  • Dividend Yield Enhancement alpha= 1.24%
  • Adjusted Expense Ratio= -0.27%

Nuveen Mortgage opportunity Term Fund II

  • Ticker: (JMT)
  • Expense Ratio= 1.45%
  • Discount= 3.94%
  • Annual Distribution Rate (NAV) = 9.49%
  • Annual Distribution Rate= 9.88%
  • Dividend Yield Enhancement alpha= 0.39%
  • Adjusted Expense Ratio= 1.06%

Disclosure: I am long CSP.