By Brett Owens
Certain closed-end fund ( CEF ) investors are getting a little desperate for dividends. ItaEURtms tough to blame them for reaching for 5%, 6% and even 7%+ yields in a 2% to 3% world.
But by grossly overpaying for funds, they are risking too much capital to bank these payouts. If you own any of the five popular funds IaEURtmm about to call out, you should consider selling them immediately.
(There are bargain replacements, after all. IaEURtmm talking about funds trading as cheap as $0.88 on the dollar and yielding 7.2%. WeaEURtmll discuss specifics in a moment.)
aEURoeFirst-levelaEUR income seekers can be greedy one minute and fearful the next. We contrarians make our living (and retirement) by purchasing out-of-favor payouts and selling dividends that are too dear.
Today there are funds trading for as much as $1.39 per share for just $1 in assets. There are others selling at half that price for equivalent portfolios! HereaEURtms why this happens aEUR" and how we can capitalize on it.
This Discount/Premium as Margin of Safety (or Lack Thereof)
CEFs, unlike their (aEURoeopen endaEUR) mutual fund cousins, have fixed share counts. This makes their prices subject to the animal spirit whims of the market aEUR" for better or for worse.
As usual, despair is our friend. When CEF investors throw in the towel, the funds they discard can see their shares trade at discounts to their net asset value ( NAV ). This is basically aEURoefree moneyaEUR for us.
If a fund trades at a 12% discount to its NAV, it means weaEURtmre able to buy its underlying assets for just 88 cents on the dollar. ThataEURtms exactly the type of aEURoediscount to intrinsic valueaEUR that many successful stock market investors strive for.
Plus, savvy managers have ways they can force their own discount window to shut again. Such as buying back their own cheap shares .
On the other hand, when CEF investors get greedy, they actually pay premiums for funds. Bad idea! Let me show you why, and give you five aEURoefirst-level favoritesaEUR to avoid.
DonaEURtmt Overpay: A 9%+ Payer Returns Just 2%+ Annually
DoubleLineaEURtms Opportunistic Credit Fund ( DBL ) has traded at a rich 8% average premium for the last three years as investors flocked to its high (9%+) yield and celebrity aEURoeBond GodaEUR manager Jeffrey Gundlach. An 8% premium means buyers paid $1.08 for just $1 in assets.
HowaEURtmd that bidding war work out? Not well, with the fund returning just 7% over the entire three-year period aEUR" including the dividends :
A Lackluster Total Return: Just 7% in 3 Years
Income investors bought the generous dividend but lost most of it in price depreciation . They made the same mistake as those who pay a high price-to-earnings (P/E) multiple for a stock. They simply got crushed when the multiple began to contract:
Why? The aEURoePremium MultipleaEUR Contracted
Unfortunately folks are still paying a 3% premium to get into this fund. And that doesnaEURtmt make much sense with sister fund DoubleLine Income Solutions ( DSL ) trading for a 1% discount to its NAV. Same brilliant bond guru, same wide mandate, way better price!
My Contrarian Income Report subscribers smartly chose DSL over DBL in April 2016. A The discount disparity was even larger back then, making it extra lucrative to think contrarily:
Price Matters: DSL Returned 56% to DBLaEURtms 7%
If weaEURtmre looking for yield to provide us with retirement income without having to worry about share prices , then we should generally fade premiums.
4 More First-Level Favorites, for Mediocre Returns (or Worse)
You probably know the aEURoeBond KingaEUR Bill Gross. How about his successor, Dan Ivascyn?
When Gross left PIMCO, a tide of cash followed him out the door. But the flow of money quickly subsided when Ivascyn stepped to the plate and outperformed Gross himself. PIMCO let the King walk because they had their next superstar in waiting.
A money manager of IvascynaEURtms caliber will usually cost 2% annually (plus 20% of profits). And itaEURtmd take a million bucks or two to get his attention.
So itaEURtms understandable that investors would try to aEURoereachaEUR for Ivascyn and overpay for his fund. ThataEURtms exactly what happened with PIMCO Global StocksPLUS ( PGP ) .
In fact, two more PIMCO funds round out our aEURoe5 most overpricedaEUR list. If Ivascyn & Co. are at fault, itaEURtms for being too good at what they do. Sadly, though, investors who buy today are paying too much aEUR" and likely to see their dividends eaten up by price declines (or worse) in the years ahead:
4 More Popular Premiums to Avoid
DonaEURtmt despair though. While there is certainly some froth in CEF-land, there are still some dividend superstars to be had. All we need is a bit of second-level thinking.
Contrarian Income Tip: Buy Discounted CEFs as Rates Rise
HereaEURtms a little-known secret that will help you identify funds that are unfairly discounted:
Higher rates donaEURtmt really hurt CEFs .
The theory scares people because it sounds true. Closed-ends have the benefit of borrowing money at Libor to leverage up their returns. Libor is tied closely to the Fed funds rate. So, the thinking goes, higher Fed rates will end the aEURoecheap moneyaEUR party that benefits CEFs.
Some funds today are selling at discounts to their NAVs on the fear that rate increases will hurt them. But this lazy conclusion is wrong.
In June 2004, Fed chair Alan Greenspan began boosting rates from then-historic lows. Over a two-year period, he increased the federal funds rate from 1% to 5.25%. A dizzying pace by todayaEURtms standards!
HowaEURtmd CEFs perform? LetaEURtms consider the tax-advantaged Nuveen AMT-Free Muni Credit Fund (NVG) , which rose in harmony with Alan GreenspanaEURtms Fed Funds Rate:
Fed Rate and Muni CEFs Rose in Harmony ThenaEUR