One of the biggest problems that investors have had for quite some time now is an inability to generate any significant amount of income off of their portfolios. This is a particularly large problem for retirees as they are highly dependent on their portfolios to obtain the money that they need to pay their bills and finance their lifestyles. The reason for this problem is the policies that have been pursued by the Federal Reserve over the past decade or so and unfortunately it does not appear that this situation will be improving anytime soon. There are some ways around this problem though. One of the best solutions is invest in a closed-end fund that specializes in the generation of income. That is because these assets provide investors with a diversified professionally-managed portfolio that can be easily traded. In many cases, these funds can deliver higher yields than most other things on the market due to their ability to use certain strategies that other funds cannot. In this article, we will discuss one of these funds, the Pioneer High Income Fund (NYSE:PHT), which yields 8.89% as of the time of writing. This is admittedly not as high as what some other closed-end funds possess but it is still acceptable in the current environment as we will see later in the article. Thus, let us examine the fund and see if the fund could be right for your portfolio.
The Pioneer High Income Fund differs from many other funds in that it does not have a dedicated web site. According to the fund’s fact sheet, the Pioneer High Income Fund has the stated objective of providing its investors with a high level of current income. The fund has a secondary objective of generating capital appreciation. These are certainly not unusual objectives as most income-focused closed-end funds have a similar objective. As is the case with many fixed-income funds, this one seeks to achieve its objective by investing in below-investment-grade bonds (“junk bonds”) and convertible securities. This is an interesting combination, particularly from the perspective of capital appreciation. This is due to the convertible securities in the fund as these can actually be converted to common stocks once certain conditions are met. Thus, they could have significantly more upside potential than the ordinary speculative-grade bonds that comprise the remainder of the portfolio. With that said though, convertible securities are typically issued by companies that may have trouble obtaining more conventional financing for whatever reason.
The fund’s focus on speculative-grade securities is certainly something that might concern some investors. This is due to the fact that these securities are issued by companies that the market judges to be at relatively high risk of default. As retirees are often concerned with the protection of principal (which makes sense as they cannot easily get more), they will generally be hesitant about the risks that defaults can cause to their principal. One way that fund’s investing in these securities aim to protect against this is by having a substantial number of holdings since this limits the losses that the fund will suffer in the event of a default. This fund uses that strategy as well as it has 358 holdings. Thus, it would take something like a large number of defaults all at once to truly inflict significant losses on the portfolio. This is a rather unlikely event.
The fund’s substantial number of holdings naturally means that even the largest positions in the fund only account for a relatively small proportion of the overall portfolio. Here are the largest positions in the fund:
Source: CEF Connect
As we can clearly see, the largest position in the fund, a 7.7% bond issue from Liberty Mutual Insurance, only accounts for 1.21% of the portfolio. This very small position relative to the entire fund is quite nice to see due to the protection that it provides against idiosyncratic risk. Idiosyncratic, or company-specific, risk is that risk which any asset possesses that is independent of the market in aggregate. This is the risk that we aim to eliminate through diversification but if the asset accounts for too much of the portfolio, then the risk will not be completely eliminated. Thus, the concern is that some event may occur that causes the price of a given asset to decline when the market as a whole does not and it may end up dragging the entire fund down with it if it accounts for too much of the portfolio. In the case of bonds, like this fund invests in, a default of a single large position would have the same effect. As we can see though, there is no position that accounts for a large enough proportion of the portfolio for us to have to worry about this.
Another way to reduce the overall risk of a bond portfolio is by limiting the time until the bond matures. This is because there is a lot more that can happen in thirty years that can cause the issuing company to encounter financial difficulties leading to a default than can happen in five or ten years. As such, it may be somewhat gratifying to see that the fund’s portfolio is primarily invested in primary short-term bonds as opposed to ones with very long-term maturity dates:
Source: CEF Connect
As we can see, the overwhelming majority of the bonds in the company’s portfolio mature in ten years or less. This provides a certain degree of comfort due to the already discussed reason about the things that can happen in a short time period as opposed to a long one. Another reason why it is a good thing though is that bonds with a relatively short time period until maturity are much less sensitive to changes in interest rates than bonds with an extended period of time until maturity. This is something known as bond duration. Basically, when interest rates increase, the price of a bond with a low duration will fall less than the price of a bond with a high duration. As a general rule, the shorter the time period until the bond matures, the lower the bond’s duration. As we will see shortly, interest rates have nowhere to go but up so we generally want to be invested in relatively low duration bonds in order to minimize our risks. That is exactly what this fund appears to be doing.
As noted in the introduction, one of the biggest problems faced by investors today is an inability to generate any significant degree of income off of the assets in their portfolios. This is a particularly big problem for retirees due to their dependence on their portfolios to finance their living expenses. The reason for this problem is the policies that have been pursued by the Federal Reserve over the past several years, specifically its control over the federal funds rate. The federal funds rate is the rate that the nation’s commercial banks charge each other for overnight loans. As we can see here, the central bank cut the federal funds rate to all-time lows in 2007 following the collapse of Lehman Brothers and left it there for more than a decade. The bank did begin to raise the rate during the Trump Administration but it still remained low by historical standards. The outbreak of the coronavirus pandemic changed this and the bank again cut rates to all-time lows where they remain today:
Source: Federal Reserve Bank of St. Louis
As of the time of writing, the federal funds rate stands at 0.09%. This is important because this rate influences the interest rate of everything else in the economy. This is the reason why things such as mortgages currently have such low rates. It is also the reason why savings accounts and certificates of depositing are yielding basically nothing. This has rendered traditional retirement income strategies such as laddering certificates of deposit essentially useless. Retirees have therefore been forced to seek out other options to obtain the income that they need to finance their lifestyles.
The primary option that retirees have generally chose to pursue is to move their money out of safe bank accounts and into the capital markets in search of any source of yield. This influx of new money into the capital markets is one reason why we have seen such powerful asset appreciation over the past few years. Unfortunately, this appreciation has also suppressed market yields. We can see this by looking at the S&P 500 index (SPY), which currently yields 1.30%. The bond market is not really any better as the iShares Core U.S. Aggregate Bond ETF (AGG) only yields 1.82% as of the time of writing. At these yields, even a $1 million would generate less income than a minimum wage job in the absence of asset appreciation, which is by no means guaranteed.
The Pioneer High Income Fund is able to do better than this due to the nature of the assets that it invests in and its ability to use other strategies to boost the yield of the portfolio beyond that of the underlying securities. The fund yields 8.89% as of the time of writing. While this is somewhat less than many other income funds, it is still enough for our hypothetical $1 million portfolio to generate $88,900 in annual income. This is enough to provide a decent lifestyle in many parts of the country when combined with Social Security.
One of the strategies that the fund uses to enhance its distribution yield is leverage. In short, the fund is borrowing money in order to buy high-yield bonds. As long as the rate that the fund pays on the borrowed money is lower than the yield on the purchased bonds, this strategy works quite well to boost the overall portfolio yield. As we have just seen, interest rates are currently at extremely low levels and when we also consider that the fund can borrow at institutional rates (which are lower than retail rates), this is likely to be the case. Unfortunately, the use of leverage is a double-edged sword since it boosts both gains and losses. As such, we want to ensure that it is not using too much leverage since that would expose us to too much risk. As I pointed out in a previous article, I do not like to see a fund’s leverage above a third as a percentage of assets for this reason. The Pioneer High Income Fund currently has a 30.36% leverage ratio when compared to its assets so it appears to be fulfilling this requirement and maintaining a reasonable balance between risk and return.
One of the biggest reasons why investors purchase shares of closed-end funds is because of the very high distribution yields that they typically pay out. The Pioneer High Income Fund is no exception to this as the fund currently pays out $0.0725 per share monthly ($0.87 per share annually), which gives it an 8.87% yield at the current price. The fund’s payout has varied a bit over the years but the increase in November 2020 was a nice change from the steady declines over time:
Source: CEF Connect
The fund’s long-term history may not be especially appealing to those investors looking for a steady and secure source of income, but its recent increase may be comforting. One thing that may also be comforting is that this distribution is comprised entirely of dividend income with no return of capital component:
Source: Fidelity Investments
The reason that a return of capital distribution may be concerning is that it can be a sign that the fund is returning its investors’ own money back to them. This is obviously not sustainable over any sort of extended period. There are other things that can cause a distribution to be classified as return of capital though such as the distribution of unrealized capital gains. In addition, as I have pointed out in the past, it is possible for these distributions to be misclassified. As such, we do want to analyze exactly how the fund is financing these distributions in order to determine how sustainable they are likely to be.
Unfortunately, we do not have an especially recent report to consult for that purpose. As of the time of writing, the fund’s most recent financial report corresponds to the full-year period ended March 31, 2021. As such, it will not include any information about the fund’s performance over the past several months. Fortunately though, it will still tell us how well the fund weathered through the very challenging market last year. During the full-year period, the fund brought in a total of $26,684,098 in interest and $863,923 in dividends off of the assets in its portfolio. This gives the fund a total income of $27,548,021 during the period. It paid its expenses out of this amount, giving it a total of $23,425,268 available for the shareholders. This was not enough to cover the $24,408,529 that it actually paid out in distributions, although it did get very close. The fund has other ways to get income though such as through capital gains. It generally succeeded at this, achieving an $18,610,050 realized loss, but more than offsetting that with $87,597,081 in gains. Thus, it did manage to bring in more than what it actually paid out during the period and so the distribution appears reasonably secure.
As is always the case, it is critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to generate a suboptimal return off of that asset. In the case of a closed-end fund like the Pioneer High Income Fund, the usual way to value it is by looking at a measure known as net asset value. The net asset value of a fund is the total current market value of all of the fund’s assets minus any outstanding debt. This is the amount that the shareholders would receive if the fund were to immediately shut down and liquidated.
Ideally, we want to acquire shares of a fund when we can get them for a price that is less than net asset value. This is because such a scenario implies that we are getting the fund’s assets for less than they are actually worth. That is unfortunately not the case here. As of September 20, 2021 (the most recent date for which data is available as of the time of writing), the Pioneer High Income Fund had a net asset value of $9.65 per share but the shares actually trade for $9.79 per share. That gives the fund a 1.45% premium to net asset value. While this is a premium, this price is certainly much better than the 11.80% premium that the fund has averaged over the past thirty days. Thus, the fund does appear to be priced somewhat reasonably compared to its average.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.