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The Search for Income: Go-Anywhere Bond Funds

A new crop of CEFs have flexible income mandates, giving managers freedom to roam. 

Cara Esser, 02/15/2013

The idea of a "set it and forget it" portfolio is appealing to many investors, but, in reality, this rarely works. Investors must check in with their holdings at least annually to gauge performance, reassess investment objectives, and consider whether the current holdings or allocations will meet these goals. Determining whether a specific holding or allocation will continue to meet an investor's goal is difficult and requires an assessment of the current and future market environment. Most individual investors don't have the time or wherewithal to take on these important questions. Even deciding how much to allocate to each asset class and when to change the allocations are common and difficult issues to tackle. Unfortunately, we won't tackle that issue here, but there are some interesting new closed-end funds, or CEFs, emerging that may eliminate at least one headache.

When it comes to allocating assets to fixed-income securities, it may be tempting to dump the full allocation to a single fund or strategy, but this is misguided. There are varying sectors underneath the fixed-income umbrella, each with its own risk and reward profiles. Yield-hungry investors might be lured by the high payouts of junk (or high-yield) bonds while risk-averse investors might lean toward U.S. Treasuries. This kind of thinking isn't wrong, but it can be detrimental to future income and investment goals. Individual investors, in general, have woefully poor market-timing skills, and the yield-hungry investor is likely to jump into the high-yield market at exactly the wrong time. We saw this last year as a few high-paying CEFs were pushed to unbelievably high premiums by investors blinded by impressive distribution rates. But playing it too safe by hoarding Treasuries may mean losing money on an inflation-adjusted basis.

So, what's an investor to do? One answer is to leave these allocation decisions to the professionals. Last year, five "go-anywhere" fixed-income CEFs were launched, and PIMCO launched its second in January of this year (PIMCO Dynamic Credit Income PCI). During the past six months, nearly half a dozen funds with flexible fixed-income strategies have filed with the SEC, including funds from Eaton Vance, Western Asset, BlackRock, and DoubleLine. Of course, just because a fund has filed with the SEC in no way guarantees that it will launch, but this is certainly a trend many firms are trying to capitalize on.

Evaluating "Go-Anywhere" Funds
Evaluating these types of funds can be difficult, especially in the context of the newly launched CEFs. While there are a number of multistrategy CEFs, those funds generally devote a pre-specified allocation to various sectors, say one third each to high-yield, senior loans, and mortgage bonds. In practice, weightings may vary slightly, but the overall allocations remain relatively stable over the long term. Two of the largest multistrategy CEFs are Calamos Convertible & High Income CHY and Calamos Convertible Opportunities & Income CHI. Both have earned Morningstar Analyst Ratings of Bronze.

On the other hand, many of these newly launched and perhaps soon-to-be-launched funds use the words "flexible" and "open mandate" to describe their strategies. These funds may have no stated benchmark or use a broad index like the Barclays Capital Aggregate Bond Index. Managers might be evaluated and paid based on absolute total returns, as opposed to returns relative to a peer group or specific benchmark. This can make any analysis of returns challenging.

To gauge how a manager is likely to react in different markets, investors can sift through old portfolios or, in the case of a new fund, look at holdings and allocations from other funds the manager runs. (In the case of three CEFs, there are similarly invested open-end mutual funds with longer track records that can be used as a guide. The discussion below Table 1 includes the funds' tickers.) Some managers (particularly PIMCO's Bill Gross and DoubleLine's Jeffrey Gundlach) have outsize personalities and often speak with the media about their ideas on the market. Investors can catch glimpses of potential portfolio action through these outlets as well. At the end of the day, though, investors are putting their faith in the manager and his or her team to correctly and quickly identify risks and opportunities. The ability for a manager to be nimble is imperative, especially if he is taking a concentrated bet, which we've seen in a number of funds launched last year.

The table above lists four of the CEFs launched last year that have at least one month of portfolio data available. The iShares Core Total U.S. Bond Market ETF AGG is shown to provide broad context for holdings. Two of the funds, Legg Mason BW Global Income Opportunity BWG and Virtus Global Multi-Sector Income VGI, have global mandates, investing in various sectors across developed- and emerging-world markets. The remaining funds do not specifically outline a global or domestic strategy and seemingly have the ability to invest globally should managers see fit. While VGI has concentrated its holdings in lower-quality corporate bonds, BWG has focused on government bonds, mostly from developing markets, notably Brazil, Mexico, and South Africa. It also has a sizable allocation to collateralized mortgage bonds and U.S. corporate bonds. Silver-rated open-end fund, Legg Mason BW Global Opportunities Bond GOBAX, is run by the same team that manages BWG. The mutual fund's current holdings are similarly allocated to government bonds, with a sizable share investing in Mexico.

PIMCO Dynamic Income PDI and DoubleLine Opportunistic Credit DBL have taken a similar view on nonagency residential mortgage-backed securities, betting on a recovery in the housing market. While AGG has a sizable allocation to agency MBS, its holdings of RMBS are near zero. PDI manager Dan Ivascyn worked at Bear Sterns in the asset-backed securities group before joining PIMCO, while Gross made his interest in RMBS securities known at the end of 2010 when he suggested that the Fed's QE3 would be focused on mortgage securities. He was right, and, combined with Ivascyn's penchant for ABS, PDI shareholders have been rewarded thus far. The fund's NAV total return since inception is 38%, and it made a special distribution of $0.86 per share in December. Ivascyn also runs PIMCO Income PONAX, which has earned a Morningstar Analyst Rating of Silver. The fund follows a similar, but more constrained, strategy, currently holding about a third of assets in RMBS.

Beyond the risks already inherent in nonagency RMBS (default, prepayment, and liquidity being the most common), legal and congressional activity around mortgage securities are worth keeping an eye on. Several suits have been filed against mortgage originators alleging misconduct, and some states have floated ideas of forcing the refinancing of nonagency mortgages. This could bring mass prepayment to RMBS, hurting these funds. Gundlach has raised these concerns but is holding tight in DBL. However, Neutral-rated open-end DoubleLine Core Fixed Income DLFNX (which also has a fairly flexible investment strategy) holds only 15% in RMBS and a total of 48% in securitized securities.

Risks aside, people believe in the power of PIMCO and Gross. PDI's very short-term success likely bolstered interest in PIMCO's second go-anywhere fixed-income CEF, PIMCO Dynamic Credit Income PCI, which launched Jan. 29, raising $3 billion in assets. PCI is the sixth-largest CEF in existence and PIMCO's largest fund to date. DoubleLine may also capitalize on the recent success. It filed with the SEC to launch a second "go-anywhere" fund. DBL is up 14% since its launch, which initially may not look as impressive as PDI, but the DBL is unleveraged compared with PDI's leverage ratio of 46%, not uncommon of Ivascyn and PIMCO.

The table below lists the four funds and AGG, current discounts, distribution rates, leverage ratios, and total returns for the past six months. Interestingly, two of the four continue to sell at premiums (in general, IPO premiums tend dissipate within six months of the launch). DBL, in fact, has sold at a premium since day one. PDI's discount has been more volatile, dipping as low as 4% in November 2012. BWG's premium dissipated at the end of May, about two months after its IPO, and VGI's premium dissipated in mid-April, about two months after its launch.

Lest investors be concerned that investing in the funds at the IPO would have been a terrible idea, the table below shows that each of the funds has posted positive share price total returns since the respective inceptions. This says nothing for patient investors waiting to jump in after the IPO premium has dissipated.

While these types of funds are still not a "set it and forget it" option (investors still need to evaluate these funds at least annually to be sure they are meeting stated investment objectives), they are an interesting option for those willing to place all control in the fund manager's hands. This is a new and growing segment of the CEF universe, and I expect to see many more funds launched in the future, thanks in part to the success of their forebearers.

Click here for data and commentary on individual closed-end funds.

Cara Esser is a closed-end fund analyst at Morningstar.

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