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2 Ideas for High-Yield Investors

High-yield investors might want to consider the closed-end versions of these two funds.

Steven Pikelny, 08/16/2013

There are several differences between open-end and closed-end funds, but an important one is how each is affected by negative investor sentiment. Open-end funds may be harmed when investors redeem their shares, with the resulting outflows potentially affecting the funds' portfolio construction or performance to the detriment of remaining shareholders. Conversely, as investors sell their shares of CEFs, the funds start to trade at a cheaper valuation, presenting an opportunity for remaining investors (along with new investors) to pick up shares on the cheap.

One way to take advantage of widening CEF discounts is to hold an exchange-traded fund or mutual fund in normal market times, and then switch over to a CEF with a similar portfolio when its discount gaps out. If the discount converges back to historical levels, investors can then rotate back into their ETF or mutual fund of choice. We elaborate on some of the finer details of the strategy here. That said, switching funds can trigger taxable events. Investors always should be aware of the tax consequences of selling their open-end funds, as they could outweigh the potential benefits of switching vehicles. Also, finding substitute funds often can be more of an art than a science, due in part to the added complications of leverage and discount analysis.

Nevertheless, the current market environment presents several interesting opportunities to make lateral moves across funds. With CEF discounts now at historically wide levels, investors might want to consider buying the CEFs over or alongside their open-end counterparts. Depending on one's tax circumstances, investors might consider using CEFs to rebalance their portfolios or add market exposure, rather than shifting between vehicles. Investors less affected by potential taxable events might consider rotating into them altogether. Below we walk through two examples of how investors can view or use mutual funds and CEFs side by side.

AllianceBernstein High Income AGDAX
and AllianceBernstein Global High Income AWF

As the nearly identical names imply, these two funds are quite similar to one another, and even share the same investment mandate and portfolio management team. Both funds focused exclusively on emerging-markets debt for much of their operating histories, but this mandate was lifted for AWF in 2006 and AGDAX in 2008. Now they are unconstrained in their asset allocation within fixed income, and generally gravitate toward high-yield corporate bonds. As of June 2013, nearly three quarters of each portfolio was rated BB or lower, with nearly half of each portfolio concentrated in non-investment-grade industrials debt.

The two funds' expenses also appear similar: AGDAX (the fund's A shares) charges an expense ratio of 0.90%, while AWF charges a total expense ratio of 0.98%. New investors should note, however, that AWF does not charge a 4.25% front-end load. But even current investors in AGDAX (or new investors that can have the load waived) should consider AWF instead. Beyond the 8-basis-point difference in fees, the recent CEF sell-off left AWF trading at a 7.0% discount. This means that the fund's distribution rate at share price as of last week gets a 60-basis-point boost to 8.5% from 7.9%. Moreover, this discount is somewhat wide on a historical basis. This means that AWF investors would realize a gain relative to AGDAX if the discount converges toward more historically normal levels.

Aside from AWF's valuation, it also offers some structural advantages over AGDAX. Primarily, both funds delve into the less liquid portions of the bond markets. In our opinion, AWF's closed capital structure is better suited for this strategy, as the fund would not be forced to sell illiquid assets in a down market because of outflows. In addition, AWF is less constrained with respect to its moderate use of leverage. AWF and AGDAX each used reverse repurchase agreements to attain leverage ratios (total assets/net assets) of 1.09 and 1.03, respectively, as of their latest annual reports (March 2013 and April 2013).

Finally, investors should note that AWF does have some accrued tax liabilities in the form of undistributed net investment income ($0.1519 per share according to the last annual report). But this liability does not justify the fund's entire discount, in our opinion, nor is it a concern for investors holding the fund in a tax-sheltered account.

Western Asset High Yield WAHYX
and Western Asset High Income Opportunity HIO

Neither of these funds is for the faint of heart, but they are still good choices for investors looking to gain exposure to the lower end of the junk-bond spectrum. As of June 2013, each fund had more than three quarters of assets invested in bonds rated below BB or unrated (though HIO's portfolio was of marginally lower quality). In all, Western Asset's well-staffed high-yield team is suited to run such a strategy, in our opinion. Since Michael Buchanan took over management of the firm's high-yield operation in 2005, performance generally has been above average. While volatility also has been above average, 2007 was the only year that WAHYX underperformed the category average during Buchanan's tenure.

Up until this year, HIO has logged nearly identical performance to its open-end cousin. But the last few months highlight a key advantage of HIO, in that its closed capital structure protects against outflows. WAHYX saw sharp outflows during 2013's second quarter, and its 3.6% return for the year--while still above the category's 3.3% average--fell short of HIO's 4.7% return.

On top of the structural benefits, HIO is also trading at an 8.5% discount. While the low-credit-quality portfolio might play a role in this pricing, it is difficult to blame interest-rate fears for the widening discount. HIO's 3.9-year effective duration is relatively low, and it does not use leverage.

While HIO's 0.88% expense ratio is higher than WAHYX's 0.66%, the discount adds 68 basis points to HIO's distribution rate at share price, bringing it up to 8.0%. Even though the fund is underearning this distribution by a small amount, by Western's estimates, the resulting earning rate of 7.8% is still above WAHYX's 30-day SEC yield of 6.9%.

To be clear, both HIO and AWF might not be suitable for every investor, and are likely more appropriate for investors who already have high-yield bond allocations. But for many investors in AGDAX and WAHYX, considering the analog CEFs may present an attractive opportunity to add to existing exposure or to change vehicles entirely. 

Steven Pikelny is a closed-end fund analyst at Morningstar.

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