Are you looking for a fixed income fund for the rising-rate environment ahead? A lot of that interest has gone to floating rate, senior loan funds and there may well still be some interesting buys there. But you may also want to consider a set of funds that hold fixed-income portfolios with an average durations of 1.9 to 3.2 years? Sure, you'll say, but I need to get more than a couple of percent income. Well, these funds are yielding 6.2 to 8.5%.
Let's be clear before we go any further. That kind of yield in short-duration credit will necessarily come with risks. To get there the funds have weighted average credit ratings of BBB- to BB- and 21.8 to 39.1% leverage. One of them is over 40%. One is invested heavily in emerging markets, and several are heavy in mortgage debt. If that's not your cup of tea, read no further, but if you're still with me let's have a look. Before I do, though, let me acknowledge SA member and frequent commenter, berloe, who brought one of these funds to my attention. I had been thinking about emerging market bond funds recently, and was considering writing a piece focused on the Stone Harbor Funds (NYSE:EDF) and (NYSE:EDI), yielding 12-14%, but I thought I start with this quite different fund category first.
The category, fixed-income limited-duration, includes only five funds: Blackrock Limited Duration Income Trust (NYSE:BLW), Eaton Vance Limited Duration Income Fund (NYSEMKT:EVV), Eaton Vance Short Duration Diversified Income Fund (NYSE:EVG), Franklin Limited Duration Income Trust (NYSEMKT:FTF), and Wells Fargo Multi-Sector Income Fund (NYSEMKT:ERC). There may be other funds that would fit but I've not tried to sort that out. If you are aware of funds that fit this category please let us know in the comments.
As these are billed as limited duration funds the appropriate place to start seems to be a look at average portfolio durations.
Portfolio weighted-average credit ratings (from Morningstar) are in the next table.
EVG has a marginally better rated portfolio and ERC's is marginally worse than the others. Data for FTF is not available. Interestingly EVG's portfolio includes 34.4% AAA rated credit and EVV's includes 20.7% AAA.
EVG is more strongly international than the other funds. Its portfolio is 56% invested in US securities and 43% in emerging markets. EVV is 89% US and the others are all 80% domestic. ERC has 9.8% exposure to emerging markets; FTF has 5.7% (all Mexico) and the others have none.
Yields and Discounts
Current discounts and yields for the funds are seen in the next chart. Each is priced at a discount, and market yields range to a high of 8.5% . Each fund pays monthly.
BLW had a distribution cut in Oct 2015 but has added two large special dividends in 2016. EVV cut its distribution 15% in Sept 2016. EVG has been stable since Feb 2009. FTF's distribution has been stable since May, 2014. ERC had a 4.5% cut in July 2016 and a 3.3% cut in Jan 2015.
Putting the discounts into perspective with a look at Z-scores tells us each has been losing discount points over the past year. Z-scores are positive for all five funds for 3, 6 and 12 months.
The funds struggled from 2013 through 2015. Last year they showed a strong recovery, along with the high-yield bond market generally.
EVG has lagged the pack for both five (upper chart) and one (lower) year terms.
Leverage and Fees
Each of the funds is leveraged, from a low of 21.8% to a high of 39.1%. Fees are consistent with closed-end funds generally although the Eaton Vance funds do stand out as charging higher fees than their peers.
Low duration, high-yield bonds have an appeal in the current interest-rate environment. While I do not consider any of these as long-term holds, they have potential as a place to park money with an attractive yield and some degree of insulation from rising interest rates afforded by the low durations. It's worth noting that the funds are all three star rated by Morningstar, except EVG which is a two star rated fund.
For me no one fund stands out. Each has marks in its favor and each has negative points.
BLW is the least discounted and has the second lowest market yield based on its monthly distribution. It has seen significant discount compression in the past quarter as seen in the 3-month Z-score of 2.4 (meaning 2.4 standard deviations above, i.e. less discounted, than the mean discount for the period. At first the sharp loss of discount seems unexpected in the face of the fund's low yields relative to its peers. That low yield is deceptive, however, as the fund added $0.42 per share (4.9 months equivalent) in special distributions in 2016 bringing its true yield to 9.5%.
The two Eaton Vance funds (EVG and EVV) have the lowest average durations but EVG has underperformed the category. And they also carry the highest leverage. EVG's portfolio is more global than that of the other, and its non-domestic holdings are concentrated in emerging markets. This can be seen as entailing more risk, but an argument can be made for emerging market bonds being a good place to look for high-yield at this time. EVG also has the best credit rating on its portfolio which should counter some of the inherent riskiness relative to the rest of the category.
EVV has recently cut its distribution which should make future payouts more secure. At the end of September it had negative UNII to the tune of -$0.1367/share which amounts to two months of distributions at the current rate. Presumably the 15% distribution cut will bring that number into line. The fund has exceptionally high leverage (39.1%) which is likely to get more costly to manage. Its 2016 recovery trailed all but its stablemate, EVG. It does offer the deepest discount and the shortest duration portfolio. Yield is mid-pack at this time.
ERC with the lowest-rated portfolio and the highest duration does offer the highest yield of the category as those two positions might predict. It has a discount at the middle of the category but its Z-scores are on the high end. It does have the best total return performance for 2016 and the second best for the past five years. But, to my way of thinking the longest duration and the lowest rated portfolio push this fund to the edges of the category's appeal. What I like about the category is short duration. That will clearly come with lower yield, so it seems counterintuitive to seek out yield at the cost of giving up what makes the category a timely choice. For that reason ERC is my least favorite of the five funds despite its high yield and strong performance numbers.
FTF is near the other end of the spectrum from ERC. Discount is mid-pack but the Z-scores are the lowest of the category. Those Z-scores suggest somewhat less likelihood of losing value to discount mean-reversion, but this is a difficult point to know how to weigh. The fund did have negative UNII equivalent to 2.6 months distribution as of the end of September 2016. However there was a modest special distribution at the year's end, so it's not clear how meaningful that negative UNII may be. Leverage is modest for the category. Duration is on the long side. It's the longest unadjusted and the second longest leverage-adjusted duration. Here again, I'd reject this fund on the basis of the higher duration for its portfolio.
Short duration is what recommends the category to me. On that basis EVG and EVV look the best. But it's hard to overlook BLW's performance edge which gain looks to be greater than a six-month longer average duration might predict. I'd give the slightest of nods to EVG as the category's best buy, but only the slightest. BLW is a close second. Were it not for those massive Z-scores for BLW I may have reversed the order here.
Finally, to repeat what I said above, I'd watch this one carefully and be ready to move out quickly.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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: I am not an investment professional and this article does not constitute investment advice. I am passing along the results of my research on the subject. Any investor who finds these results intriguing will certainly want to do all due diligence to determine if any security mentioned here is suitable for his or her portfolio.