Over the last several weeks, my interactions with income-focused investors have revealed a tremendous interest in alternative – not common stock shares – higher yield investment types. The alphabet soup of investment types includes closed-end funds (CEFs), where I like to dig for high-yield opportunities. CEFs are a target-rich environment for yield, with over 300 listed funds sporting yields of 6% or higher.
A closed-end fund is an investment company that works very much like a mutual fund. The closed-end part comes from the fact that a new fund issues shares just once with an IPO and then the fund manager has an initial amount of capital to invest that is not affected by investors buying or redeeming shares. Once issued, CEF shares trade on the stock exchanges, and the fund management company is not involved in the buying and selling by investors. CEFs have more latitude in the selection of asset classes and investment strategies compared to mutual funds. These funds can – an often do – use a moderate level of leverage, and this type of fund can use managed distribution strategies to pay steady monthly or quarterly dividends to investors.
The net asset value of a fund (NAV) is the total value of securities owned by the fund divided by the number of shares. The NAV would be what each share is worth if the fund were liquidated and the cash distributed to share owners. CEFs typically calculate NAV once a day after the markets close, much like mutual funds. With shares trading on the exchanges, the market prices of CEF shares can trade at a premium or discount to the NAV. Currently taxable funds are priced ranging from a 40% discount to a 65% premium to NAV.
The investment returns from individual CEFs have ranged from very good to horrible. The numerous possible investment strategies, plus just some poor investment choices and management means that the income seeking investor needs to employ more than a basic level of due diligence when selecting high-yield CEFs for investment.
To get started, you should screen funds to find ones trading at a higher than average discount, paying an attractive and stable dividend yield and have generated positive returns to investors over a period of years. Then you’ll need to dig into the investment strategy to find some funds that should be winners from an attractive yield and provide a total return bump if the discount narrows or even turns positive.
Using this approach below are three CEFs that popped out during my research.
- BlackRock Credit Allocation Income Trust (NYSE: BTZ) currently trades at a 12% discount to NAV with a 7% dividend yield. The BTZ portfolio is over 90% composed of corporate bonds and preferred shares. The fund has produced an average 9.34% NAV return over the last three years. Annual expenses of 1.13% are low for a CEF. This fund tends to trade at close to a double digit discount to NAV, but offers above average price stability. Dividends are paid monthly.
- Cohen & Steers REIT and Preferred Income Fund (NYSE: RNP) has shares priced at a 13.9% discount to NAV and yields 6.8%. The REIT focus of this fund should make the NAV less susceptible to a price drop if interest rates increase. RNP has never reduced the dividend in 11 years of existence. The NAV average annual return for the last three years has been 13.4%. A compression of the discount to low single digits would add 10% to the future return.
- Legg Mason BW Global Income Opportunities Fund Inc. (NYSE: BWG) trades at a 13.4% discount and sports a dividend yield of 8.31%. This two-year old fund focuses on high-quality bonds from around the world and has produced a 12.4% NAV average annual return since inception. Monthly dividend payments should help with market share price stability, and any shrinking of the discount will boost the total return.
With CEFs, discounts will widen when the market turns against the specific asset class – corporate bonds, REITs, global bonds – and narrow when the outlook is positive. The result can be market price volatility while the NAV stays more stable. Use share price drops as buying opportunities and consider selling some or all of a position if the discount narrows close to zero or turns into a premium.