The developed world continues the deleveraging process made necessary by the bursting of the credit bubble some five-years ago. Deleveraging produces deflation and there is scant evidence to suggest our world is anything but deflationary. This is also the view of central bankers. Notwithstanding the Fed’s decision to taper its asset purchases, the policy of zero short-term interest rates and liquidity pumping will be with us for quite a while.
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This easy money view, combined with a 15% decline in bond prices this year and the history of interest rates after similar periods of deleveraging, made us reassess our “just-say-no to bonds” strategy (see “Bonds Look Like Sure Losers With Rates This Low.”)
While we continue to significantly underweight bonds, we have recently made an allocation to bonds in the form of closed-end bond funds for the first time since December 2008 and I own shares in all 3 of the taxable funds mentioned below.
The decline in long-term bond prices as measured by the iShares Barclays 20+ Year Treasury (TLT) ETF as a proxy, represents a big plunge for an asset class presumed to be “safe.” This has demoralized many bond market participants and has created a seasonal opportunity in closed-end bond funds, which have a fixed number of shares and trade like stocks.
Unlike open-end funds, CEFs represent a fixed pool of capital. The amount of money being managed is not expanded or contracted by fund managers to match flows from investors. This means the price you pay for the fund can be higher, or lower, than the value of the fund’s underlying investments.
Earlier this year, CEF investors were paying something like $1.04-$1.05 for a dollar’s worth of bond assets. Why pay a premium? The bond market had been rising for ages and people were hungry for yield.
Today, you can buy a dollar’s worth of these same bond assets for 85-87 cents on the dollar. Why the discount? These are retail products and they are being abandoned in droves by disgruntled investors. If you paid $25 for a “safe investment” that is now worth $20, and it is tax-loss harvesting season, exiting is often the knee-jerk response.
Many of these funds are managed by top institutional managers. They are run as institutional portfolios and typically use leverage and derivatives. Few can replicate their strategies and pricing power. We like them for investors seeking income, or as a diversification tool, because the yields are juicy. Taxable CEFs yield in the 8.5% range and tax-free ones yield roughly 6%. Right now they can be bought at a 10-15% discount to underlying value. History suggests a 5-7% discount is more “normal” and it would not be surprising to see the discount shrink once tax-selling pressure abates in the new year.
Apart from the discount, there are other considerations with CEFs: duration, earnings rate, amount of borrowings and the quality of the bond managers.
Duration measures the interest rate risk inherent in the portfolio. We want to own funds with a duration that is lower than the 10-year Treasury. Earnings rate refers to actual earnings from the underlying portfolio and we exclude funds that pay out more than they earn. The amount of borrowing is the leverage ratio and is reflected in the real yield and the risk profile. Finally, in assessing the quality of the bond manager we have applied both objective and subjective standards.
Three taxable funds that meet our criteria are the $2.3 billion DoubleLine Income Solutions Fund (DSL), the $3 billion PIMCO Dynamic Credit Income Fund (NYSE:PCI) and the $1 billion Prudential Global Short Duration High Yield Fund (NYSE:GHY). In the tax-free world the Eaton Vance Municipal Bond Fund (NYSEMKT: EIM) and the Nuveen Dividend Advantage Municipal Fund 2 (NYSEMKT: NXZ) are worth considering.
This bond investment strategy can make sense for investors seeking a relatively high level of income and who are willing to bet on two economic scenarios. First, it is a wager that short-term interest rates will remain low for an extended period of time. Second, it assumes that the time period ahead of us will more likely resemble the 1950s than the early 1980s. Please note many CEFs tend to be somewhat illiquid so if you, along with your adviser, decide this strategy is appropriate, make sure you use limit orders.
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