Income investors have had a good run over the past year with
ETFs providing investment grade bond exposure. iShares Barclays
Intermediate Credit Bond Fund (
), SPDR Barclays Intermediate Bond Fund (
), and Vanguard Intermediate Term Bond (
) all performed well in 2010 as credit markets stabilized and
interest rates remained low.
There are also many closed end funds (CEFs) that provide
investment grade bond exposure. Here are two closed end funds -
Western Asset Investment Grade Defined Opportunity (
) and Western Asset Income Fund (
) - that are worth a look when considering investments in the above
mentioned ETFs or in the investment grade bond asset class.
The market cap and average daily volume for both IGI and PAI are
low, so potential investors need to be careful about entry/exit
timing and order type.
click to enlarge images
Comparing Investment Grade Bond ETFs and CEFs
- This is the most recent yield on the assets in the funds,
annualized. This will fluctuate. Based on the current price of IGI
and PAI, the effective yield is actually higher because of the
ability to buy the funds at a discount. The yield differential is
substantial and there is no leverage in the two CEFs so leverage is
not contributing to the yield difference. The yield difference is
coming from the higher coupon bonds held by the two CEFs (PAI and
IGI). The bonds have higher coupons for two reasons: (a) higher
risk and (b) longer maturities.
- All three ETFs and both CEFs are investment grade bond funds. PAI
and IGI appear to carry the highest credit risk of the group but
the average is still BBB+, well above junk ratings. CIU, ITR, and
BIV all have more bonds in the A and higher category than PAI and
- The two CEFs have longer average maturities than the three ETFs.
With the current shape of the yield curve, this means higher yields
are harvested by IGI and PAI, as evidenced by the higher average
- Duration measures the sensitivity of the portfolio to interest
rate moves. It is interesting to note that the CEFs with much
longer average maturities have less of a duration gap relative to
the ETFs. It appears that the CEFs might have more floating rate
debt, which is less sensitive to interest rate moves. This is a
plus for the CEFs, but given the much higher yields, it also
suggests that the credit risk gap may be larger.
The above analysis yields logical results and a pretty
straightforward investment conclusion: Higher yield requires an
investor to shoulder more credit risk and interest rate risk.
Investment Grade BondCEFs: Undervalued?
Which brings us to the current discount to net asset value.
These two CEFs have experienced recent price declines, primarily as
a result of the expansion of their discounts to NAV, discounts
which are now significantly in excess of their historical
IGI and PAI Current and Historical Average Discount to
IGI Historical Discount/Premium to NAV
PAI Historical Discount/Premium to NAV
The discount expansion can happen in CEFs for a variety of
reasons - year-end tax selling compounded by limited trading volume
may be a factor, as well as concern about upward pressure on
interest rates and a resulting heavy volume sell-off. The discount
expansion can provide opportunities for investors to collect a
solid investment grade bond yield and possibly to benefit from a
discount that narrows to the historical mean. There is risk though.
Discounts can expand further and remain stubbornly wide for many
In the case of IGI, the discount has recently expanded and is
now -4% below the average discount rate of the past year. For PAI,
the difference between the current and past year average is -5%.
Over the next year, if the discount returns to the average,
investors stand to pick up a nice bump in their return. But even if
IGI and PAI don't narrow the discount, the yield from the funds
should remain attractive absent rapidly rising interest rates or a
deteriorating economy that hurts corporate credit risk
- Consider PAI and IGI, and other closed end funds as a way of
diversifying and enhancing returns on your target investment
grade bond exposure. Pay special attention to price/NAV current
- Consider PAI and IGI if your outlook for 2011 is stable
interest rates and yield curve structure.
- Be careful about entry and exit price, and trades types given
- Understand that discounts can expand further and remain wide
for extended periods of time. You may have to hold these for a
long period or potentially take a principal loss if you have to
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
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