- Inflation is high and rising.
- Inflation hedge funds perform particularly well during recessions.
- WIW is a strong inflation hedge CEF, offers investors a fully covered 6.9% distribution yield, and trades with a large 6.5% discount to NAV.
- An overview of the fund follows.
- This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »
I've recently covered several inflation hedge ETFs, which allow investors to easily hedge and profit from rising inflation. These have all been ETFs, as CEFs generally focus on more standard, higher-yielding securities, but I was able to find one inflation hedge CEF: the Western Asset/Claymore Inflation-Linked Opportunities & Income Fund (WIW). WIW focuses on U.S. Treasury Inflation-Protected Securities, or TIPS, which are extremely safe securities and indexed to inflation, a solid combination. The fund outperforms when inflation is high and rising, as is presently the case, but underperforms when inflation is low.
WIW's effectiveness as an inflation hedge, safe holdings, large 6.5% discount to NAV, and strong 6.9% distribution yield, make the fund a buy. As should be clear, the fund is mostly appropriate for investors concerned about rising inflation.
WIW focuses on U.S. Treasury Inflation-Protected Securities, or TIPS. The fund's expected performance is strongly dependent on the characteristics of these securities, so let's start by analyzing TIPS.
Treasuries, including TIPS, are the safest assets in the world, as they are backed by the full faith and credit of the U.S. government. Treasuries can help diversify and de-risk an investor's portfolio, especially if paired with higher-risk equities. On the other hand, Treasuries offer extremely low yields, generally below 2%, and almost no possibility of long-term capital gains.
TIPS, unlikely normal Treasuries, offer investors a bit more than these paltry yields. TIPS are protected against inflation, as their value and coupon rate payments are indexed to the CPI, an inflation index, for positive values of said index. In simple terms, TIPS returns are roughly equal to their yields plus inflation.
Let's explain the above with a quick example.
Say you invest $1,000 in TIPS at a 1% yield, equivalent to an interest payment of $10 per year.
If inflation increases to 7%, roughly where it is today, so would the value of your investment and interest. Your investment would increase in value from $1,000 to $1,070, while your interest payment would increase from $10 to $17.
Total returns would be equal to $70 plus $7, effectively equivalent to inflation plus interest rate (7% + 1%).
Realized TIPS returns for the past year have been close, slightly lower, than the above.
Higher rates of inflation would lead to greater gains and vice versa.
Deflation, on the other hand, has no effect on the value of your investment, interest, or shareholder returns/losses.
If inflation decreases to -10%, your investment will retain its $1,000 value, and your interest payment would remain at $10. This holds true for all rates of deflation.
Currently, inflation stands at a 6.8% annualized rate, while TIPS yield negative 1%. As such, as things currently stand, investors should expect these securities to return about 5.8% moving forward, assuming inflation and rates remain constant. Realized returns will almost certainly markedly differ from this simple calculation, as inflation is constantly in flux. Higher inflation rates should lead to higher returns, and vice versa. At current prices and yields, TIPS should have extremely low returns if inflation were to normalize.
As WIW focuses on TIPS, most of the analysis above applies to the fund as above. With this in mind, let's now have a look at the fund itself.
- Sponsor: Franklin Templeton
- Distribution Yield: 6.6%
- Discount to NAV: 6.5%
- Management Fee: 0.65%
- Total Returns 10Y NAV: 3.4%
WIW is an actively-managed, leveraged CEF focusing on TIPS. WIW's investment thesis rests on the fund's:
- Effectiveness as an inflation hedge, particularly beneficial during periods of high and rising inflation
- Safe holdings, which reduce portfolio risk and volatility
- Strong 6.9% distribution yield, a significant, clear benefit for shareholders
- Large 6.5% discount to NAV, which boosts potential capital gains and distribution yields
The above combine to create a strong fund and investment opportunity, and one which is particularly well-suited for investors concerned about rising inflation. Let's have a look at each of the points above.
Effectiveness as an inflation hedge
WIW focuses on TIPS, with smaller investments in other low-risk fixed-income asset classes, mostly investment grade corporate bonds and emerging market debt. Asset allocations are as follows.
(Source: WIW Corporate Website)
As can be seen above, WIW focuses on inflation-linked securities, mostly TIPS, with these accounting for just under 80% of the value of the fund. As the fund focuses so strongly on TIPS, it offers investors a very similar level of inflation protection and expected performance as these securities. Expect WIW to perform exceedingly well during periods of rising inflation, as has been the case since mid-2020. WIW has outperformed bonds in general as well as all relevant bond sub-asset classes during said time period, as expected.
WIW is almost certain to outperform as long as inflation remains elevated, which is a distinct possibility. I actually lean towards inflation being transitory, due to reduced fiscal stimulus and improved supply chains, but I've been (mostly) wrong so far, and I know lots of investors disagree. For investors concerned about rising inflation, WIW seems like a natural, strong investment opportunity.
WIW's focuses on TIPS which are, as mentioned previously, securities issued by the U.S. Federal Government, the largest, most credit-worthy institution in the world. Treasuries are the safest asset class in the world, which makes WIW a relatively safe fund, and investment opportunity. WIW performed reasonably well during 1Q2020, the onset of the coronavirus pandemic, but somewhat worse than expected. Losses were small, but persisted for months, which was not the case for comparatively safe bond indexes.
From what I've seen, WIW's losses were somewhat higher than expected due to the fund's investment grade / emerging market debt investments, negative alpha, and, perhaps, issues with liquidity and diversification. Prices for some securities went haywire during 1Q2020, which negatively impacted some funds, especially those focusing on more niche securities like WIW.
Finally, WIW is a leveraged fund, with an effective leverage ratio of 1.31x, about average for a CEF. Leverage means more assets which means more income, capital gains and returns, but also higher risk, volatility, and, possibly, losses during downturns. Leverage is almost always behind CEFs underperforming, but I'm not sure that this was the case for WIW during 1Q2020. WIW focuses on TIPS which, being treasuries, perform reasonably well during downturns. Buying a ton of TIPS with leverage should not lead to significant losses during downturns, because TIPS generally don't go down during downturns.
In my opinion, WIW's safe holdings, low losses during 1Q2020, and use of leverage combine to create a reasonably safe, low-risk fund. Unleveraged treasury/TIP index funds are definitely safer, but WIW is reasonably safe too, in my opinion at least.
Strong 6.9% Distribution Yield
WIW currently sports a 6.9% distribution yield. It is a strong yield on an absolute basis, and much higher than that of bonds in general, all relevant bond sub-asset classes, and equities.
The fund's distribution is also fully covered by underlying generation of income, as per management data.
(Source: WIW Corporate Website)
WIW's recent distributions consist of a monthly $0.0485 distribution, equivalent to 4.4% annualized yield, and a special $0.50 special distribution, equivalent to a 3.8% yield, in December (ex-div date of the 22nd). WIW's distribution policy is a bit odd, but consistent with the payoff profile of its underlying holdings. TIP yields and returns are dependent on inflation, inflation was particularly high during 2021, and so the fund used these excess funds to pay a massive special distribution at the end of the year. WIW preferred to pay off most of its excess income as a special distribution because, well, because 2021 was a special year. Distributions were also hiked by a massive 56%, but starting from a very low basis.
Massive distribution hikes and special distributions almost always come at the expense of NAVs, but that is definitely not the case for WIW. The fund has seen rising NAVs for years, and growth has been quite a bit higher than that of its peers, including TIPS indexes.
Extremely few funds offer strong, fully-funded, and growing 6.9% distribution yields, but WIW does, and with growing NAVs to boot. Although the combination seems implausibly strong, do remember that this is an inflation hedge fund, and inflation has skyrocketed these past few years. Investors should expect similar results if inflation remains elevated, significantly worse results if inflation were to moderate.
Large 6.5% Discount to NAV
WIW currently trades with a 6.5% discount to NAV. It is a reasonably large discount to NAV, although somewhat lower than it has been in the past.
WIW's discount to NAV is a benefit for the fund and its shareholders for two key reasons.
First, discounts to NAV can always narrow, leading to capital gains for shareholders. As the fund does not currently trade with a historically above-average discount this seems unlikely, but it is always a possibility.
Second, discounts to NAV lower share prices which, indirectly, boost distribution yields. Due to this, discounts to NAV lead to slightly stronger long-term total shareholder returns even if discounts don't narrow. As an example, and as can be seen above, the fund's discount barely moved from early 2017 to today, and yet the fund posted comparatively strong price returns during said time period. Price returns were higher than NAV returns, as the fund's shareholders received higher distributions by buying at NAV.
WIW Performance Analysis
Finally, I wanted to have a quick look at the fund's performance.
WIW has performed quite well these past three years, in which inflation has been quite high. Long-term performance is much weaker, as inflation was much lower in the past. As mentioned previously, this is an inflation hedge fund, and so overall performance is strongly dependent on inflation rates. The fund's performance throughout the years is clear proof of this.
WIW's price returns are also slightly higher than its NAV returns, due to (slightly) narrowing discounts, and due to the distribution yield increases that discounts entail.
Finally, the fund has slightly outperformed TIPS indexes, almost exclusively due to leverage.
WIW's performance seems reasonably good, although nothing out of the ordinary.
(Source: Seeking Alpha - chart by author)
WIW's effectiveness as an inflation hedge, safe holdings, large 6.5% discount to NAV, and strong 6.9% distribution yield, make the fund a buy.
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This article was written by
Juan de la Hoz has worked as a fixed income trader, financial analyst, operations analyst, and as an economics professor. He has experience analyzing, trading, and negotiating fixed-income securities, including bonds, money markets, and interbank trade financing, across markets and currencies. He focuses on dividend, bond, and income funds, with a strong focus on ETFs.
Juan is a contributor to the investing group CEF/ETF Income Laboratory which is led by Stanford Chemist. Features of the service include: managed income portfolios (targeting safe and reliable ~8% yields) making use of high-yield opportunities in the CEF and ETF fund space. These are geared toward both active and passive investors of all experience levels. The vast majority of CEF/ETF Income Laboratory holdings are also monthly-payers, for faster compounding and steady income streams. Other features include 24/7 chat, and trade alerts. Learn More.
Analyst’s 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.
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