Opportunities Are Appearing In Leveraged Junk Bond Funds

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Includes: CIF, PGP, PHK, PHT, PTY
by: Matthew Waterman

Summary

While far from the bottom in bond prices, recent quick drops in price might make some short term buys.

I contrast three PIMCO funds that rocketed to the top of my watch list, and 2 others.

Current fund yields, their loss from the 52-week highs, and leverage ratios are given, plus holdings data.

Also a short talk about unleveraged funds and effective hedging with bonds.

PHK Chart

PHK data by YCharts

The bond market has definitely turned on itself.

After seeing a precipitous drop in my own account with the PIMCO High Income Fund (NYSE:PHK), I decided to take a look around at what's going on with some other similar funds out there. The chart above says a lot more about the state of these investments than I'm sure I'll be able to articulate here. However, I'm going to do my best to help you make a decision about whether this is a place you should keep your money. I think that a vicious pullback like this can be an excellent time to buy more.

Let's start with interest rates on treasuries, this will always be the best yardstick to compare against, because U.S. treasuries are considered the safest kind of investment in the world. Now that's safest in terms of paying your principal back, not with regards to outpacing inflation. The following bond data is from the Yahoo! Finance Bond Center:

Maturity Yield 6/22/15 Yield 6/19/2015 Previous Week Previous Month
3 Month 0.00% 0.00% 0.01% 0.01%
6 Month 0.04% 0.03% 0.09% 0.07%
2 Year 0.65% 0.61% 0.70% 0.61%
3 Year 1.05% 0.98% 1.10% 0.99%
5 Year 1.67% 1.56% 1.70% 1.56%
10 Year 2.37% 2.26% 2.35% 2.21%
30 Year 3.16% 3.05% 3.09% 2.98%

Volatility creates opportunities.

If nothing else, what I can say about the bond market right now is that it's volatile. Just as it looked like interest rates were calming down before the weekend, we have a sharp change in rates this morning. And pretty much for the exact same reasons: Continued volatility in Greece and other parts of the Eurozone.

Now pundits (I'm a pundit too, never thought I'd use that word to describe myself!) will try to explain the day to day motion in any given market in terms of what makes the most sense to them. However, the reality is that all kinds of factors influence the motion of prices, and it's really best not to think about it. What you should do instead is focus on what actually is known, and what I can see in that table of interest rates is that over the last month, a spread of just 16 basis points in the 10-year treasury (That's only a 0.16% change) has caused a price drop as high as 23.2% in these funds.

That is an inference that just a 1% hike in treasury rates could knock out 100% of a fund's value. Ummm... no. That's not happening.

So let's look through a few of these funds, and see if there's any safety here.

The ticks I've assembled in the chart at the top are collected from a watchlist I maintain of closed-end bond funds. To start with, we should call a spade a spade. "High Income" means junk bonds. Either bonds with reduced credit ratings, or in some cases somewhat better bonds that were purchased at a discount during some kind of market selloff, such as foreign bonds.

Generally speaking, just because the bonds of a company yield a lot, it doesn't mean that there's a major chance of any given company going out of business. The people who work as managers at these funds are trained in evaluating the safety of a business in terms of how much cash it generates against the amount of debt they owe. The largest risks to us as investors tends to be the amount of leverage used by the fund, and any premium that investors have offered above the Net Asset Value, or the "NAV."

I'm going to start with the aforementioned PIMCO High Income Fund, as it is well known and popular with Seeking Alpha readers. The price at close today was $9.37, down from it's 52-week high of $13.75, a drop of 31.85% so far, and a drop of 17.4% in just the last 30 days!

I had just published another article where I mentioned that fund, here is a recap:

The PIMCO High Income Fund has been selling at a premium to it's net asset value for a pretty long time now. According to the data sheet for this fund, found here, NAV is about $7.53 right now. At that price the fund would yield better than 19%. The leverage on this fund is about 29%. So unleveraged NAV is somewhere around $5.35, yielding around 13.5%. The intrinsic value of this fund should be somewhere in between where we are today at $10.11/share and that unleveraged NAV.

Well, no sooner did that article hit than PHK came down another 7%. A little egg on my face there, but I did go ahead and place an order to buy more. Realistically, I think the worst case scenario is that we go back to NAV, or maybe slightly below that. It's happened before. In 2008 the fund dropped all the way down to $3.92, throwing off an incredible 37% yield. But That was an exceptional time when everyone thought the world was ending, and though we are at the end of a very long bull market in fixed income, this fund will continue on.

What I should address here is that the asset mix has changed since the end of 2014. This fund is composed of close to 54% government bonds now. In the recent past, the fund had also been overdistributing, or paying more out in dividends than it earns. They've made the (Perhaps prudent) choice of shedding credit risk in exchange for safety, but that means less income for the fund too. In spite of this move, the leveraged yield remains high today, but as time passes there is a potential to see that dividend amount reduced, as the NAV will erode if they keep giving out so much cash.

What I expect to happen is that as events unfold in the Eurozone, this fund will swap those government securities for the debts of other countries. For the time being, they are at a premium to NAV of 34.26%. There is certainly risk here of further pullback in the short term, but they hold a little shy of $1.35 billion in bonds and preferred shares. Based on previous annual distributions around $180 million, I believe that the assets they have on hand give them a little over 7 years of wiggle room to figure things out, so I am a buyer on this pullback.

Here are some other closed-end funds to compare against:

Another PIMCO fund here, as birds of a feather flock together. That's the PIMCO Corporate & Income Opportunity Fund (NYSE:PTY). Currently yielding 15.54%, down -25.32% from it's year high. The trailing yield here is based on a special end of year dividend of 65 cents, which has also been paid in the past. Be warned, that payment varies each year. The 2013 end of year dividend was $1.84, for example. These end of year payments are based on investment gains in the fund, which is a return of capital.

What's different about this fund vs. the "High Income" fund is twofold: 1. It's selling right at the NAV price, and 2. The investment strategy is different. The High Income fund will invest in bonds of lower credit grading, while this fund will invest in opportunistic environments, but preferring higher degrees of safety on its holdings. In contrast to that, the fund has a higher amount of leverage in play, about 34%.

Where this fund starts to really diverge in terms of risk is that it owns about 27% of it's portfolio in non-agency mortgage backed securities. Do you remember when I talked about this problem in my "Anatomy of a Market Crash" article? I was using a hypothetical example in the article, but this is the real deal. Just like so many mREITs that I've been negative on, this fund used leveraged funds to buy non-guaranteed mortgage-backed bonds. I can't argue that buying those bonds is opportunistic, but it's a degree of risk that could end up burning the fund if credit ratings were adjusted.

So I think that's why there's no premium here. People are seeing what's happening to mREITs and thinking that a similar issue could develop. Outside of that, effective maturity years and durations are pretty much equal to the High Income fund. This is a difficult call in terms of "the worst that could happen." The NAV yield is higher on PHK, but more leverage is at work here. If nothing goes wrong, there's a higher potential for return.

If there were a serious problem with mortgage backed bonds however, this fund could be easily knocked down by 30% in price or more. But for the high current yield, I would say that the risk is offset for now.

One last PIMCO fund to look at here, and then I'll move to some other companies. We have the PIMCO Global StocksPLUS & Income Fund (NYSE:PGP). This fund has had the largest drop in share price off the 52-week high, down -40.9%. The current yield is 13.82% and sells at a premium to NAV of about 37.85%.

The name of this fund is a little bit misleading, because there aren't really any shares of stocks on their balance sheet. What they do have are a lot of futures contracts and numerous kinds of financial derivatives. Those derivatives take up more than 40% of the entire portfolio. This fund also holds around 24% of it's NAV in non-agency mortgage backed securities, and is the highest leveraged of all three of the PIMCO funds I've discussed here at 36%. I'm going to go ahead and say stay away from this one, it's got too much up in the air to make a call on.

Alright, moving on to something that's not PIMCO.

We have the Pioneer High Income Trust (NYSE:PHT). Down -37.75% from it's 52-week high, yielding 11.98%. Leverage on this fund is 31.8% per their last monthly data sheet, found here.

What I like about this fund is that it's easy to understand, and the carrying assets are not so much in government assets. This is also the first fund I've covered here that is trading at a discount to net asset value, about -5%. About 70% of this fund's assets will mature in less than 5 years, which makes them more comparable to a shorter-term bond fund.

The downside here is that like PHK, this fund has also been overdistributing, and has had to cut it's dividend payment this year. A whopping 59% of it's assets are rated grade B or lower, which puts them in line to be hurt by treasury rates increasing, because people will pay less for riskier bonds as the safer ones yield more.

If you use the relative yield offered on a 5-year treasury as your yardstick here instead of the 10-year like I've done with the other funds, then there is a more attractive incentive here. If the price on this fund comes down a little bit more, and puts it's yield in line with the funds above, then I would be a buyer. For now, I'm going to have to say wait and see.

Last on my list is the MFS Intermediate High Income Fund (NYSE:CIF). Down -10.10%, yielding 8.43%, leverage is about 34%. I like this fund, this is the only one out of the group that actually increased it's dividend payments this year. That's primarily due to a new managed distribution policy, where they are aiming to pay out an annual yield of 9.5% based on the monthly NAV. You can read more about that change here.

The fund also sells at a modest discount to NAV, about -11%. It does have certain problems in common with the Pioneer fund, namely that there aren't any government securities on the balance sheet, so credit risk will compete with treasuries again, and the maturity is slightly longer, 6.62 years. They have the longest effective duration I've seen here so far, at 5.76 years, which does give them some options about how to proceed should opportunities become available.

Of the junk bond funds I've talked about here, this is probably the safest, as the dividend will be rapidly adjusted to accommodate drops in the NAV. Should U.S. Treasury rates stay low for a long time, then this fund will most likely outperform. We seem to be hearing from more sources that low interest rates are expected to be the norm for several years out. If you are not a fan of volatility, then this fund is probably the best choice here.

Unleveraged choices for comparison sake:

SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK): Down -7.08% from it's 52-week high, yields 5.33%. The fund has seen steadily declining dividends, which is in line with opportunities that exist in new issues. Since it's based on an index, it's the only way to be sure that you are protected from management errors.

Vanguard Total Bond Market ETF (NASDAQ:BND): Down -3.7% from it's 52-week high, currently yielding 2.8%, based on a year end special dividend of 38 cents per share. This is NOT a junk bond fund, it's only here to illustrate the difference in what you can get for yield against the riskier options above. You get a little bit of everything in this fund, but it maintains credit ratings above junk status. I use this fund to round out my allocation in fixed income.

In closing:

Nothing is perfect. There are no investments in the marketplace that can completely protect you from market pricing. And it's possible that I have been completely off the mark in thinking that short-term fluctuations have created opportunity. It could be that buying here only leads to greater losses. Since bonds do not produce anything other than interest payments, there is no growth in earnings to depend on.

Manage your position sizes. Have a plan going in to decide ahead of time how much you are willing to risk. For me that's only 5% of my assets in high yielders. And not more than 20% in bonds total. If those percentages get out of line, I buy or sell stocks as needed to correct them. That's what the point of fixed income is, to act as a hedge against stock volatility.

I hope you found something useful here, if nothing else, some ideas to look at down the road. Thanks for reading.

Disclosure: I am/we are long PHK.

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.