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Diving Deeper Into the Strategic Income Portfolio

We take a closer look at the funds in our model portfolio of closed-end funds.

Steven Pikelny, 10/25/2013

On Tuesday we outlined a model portfolio of fixed-income closed-end funds, which includes seven of our best ideas. The funds were chosen because we like them on a stand-alone basis, but their respective valuations make them even more attractive. Today, we take a closer look at each of the funds and discuss the rationale behind the positions. From a top-down perspective, we constructed the portfolio based on three buckets: core, high yield, and long duration. Funds in the core bucket take on a moderate level of risk but are generally poised to do well in most market environments. Meanwhile, the remaining two buckets take their own distinct risks. (The high-yield bucket has substantial credit risk, while the long-duration bucket has substantial interest-rate risk.) The risks offset each other to some extent within a broader portfolio context.

This bucket comprises 50% of the portfolio’s total exposure and is split evenly between two funds: Templeton Global Income GIM and MFS Intermediate IncomeMIN. While neither falls into the top left corner of the Morningstar Fixed-Income Style Map (those of high quality and with limited interest-rate sensitivity), their risks are fairly moderate--especially by CEF standards. Neither fund uses leverage, so their dollar weightings of 25% match their respective exposure weightings.

GIM provides us with a healthy dose of sovereign debt, often issued by emerging markets. The fund doesn’t have a Morningstar Analyst Rating itself, but it is run by Michael Hasenstab, manager of Gold-rated Templeton Global Bond TPINX. We like Hasenstab’s sober approach to investing in the sovereign debt of countries with solid fundamentals rather than simply basing the fund off a benchmark (which, he argues, overweights the most indebted countries). As we’ve previously noted, the CEF flavor of this strategy has everything going for it that the open-end fund does, except it charges lower fees and focuses more on foreign currencies. The foreign currency component (about 56% of assets) adds an extra layer of volatility, but it also helps diversify away from the U.S. dollar. The fund’s current valuation makes it even more attractive: Although the 5.4% discount doesn’t seem very large on an absolute basis, it stands in stark contrast to its five-year average premium of 2.0%.

Bronze-rated MIN does a little bit of everything, dipping into high-grade and high-yield corporates, mortgage-backed securities, Treasuries, and emerging-markets debt; but it ultimately winds up with a short to intermediate duration (3.5 years) and overall investment-grade credit quality. While net asset value performance hasn’t been overly impressive (nor has it been extremely volatile), the main draw here is its valuation. At a 9% discount, the fund’s 3.3% earning rate jumps up to 3.6% at share price. In addition, the large discount makes the fund’s excessive return of capital accretive to shareholders.[1] Both of these factors more than compensate for the fund’s expense ratio (as we explain here), making its valuation very attractive.

Investors should note that CEF valuations often change quickly. When building positions in the more thinly traded funds, it is prudent to have a few back-up funds on deck. In many cases CEFs will have nearly identical sister funds that can be better investment options at certain valuations. For GIM, sister fund Templeton Emerging Markets Income TEI can be a decent substitute, though the strategy differs slightly. Also managed by Hasenstab, TEI has a larger focus on emerging markets and hedges its currency exposure. Currently, TEI is trading at a less attractive absolute and relative valuation. Meanwhile, there aren’t many good substitutes for MIN. MFS Charter Income Common MCR and MFS Multi-Market Income Common MMT come close, but they are both slightly riskier, use more leverage, and are not as attractively valued.

High Yield
The high-yield bucket is credit sensitive, which means it should do well in a rising-interest-rate environment where economic fundamentals continue to improve. Since taper talk, we’ve seen this sector continue to thrive as more interest-rate sensitive sectors have faltered. Although the new issue market for high-yield corporates and bank loans is becoming less attractive to many managers (fewer protections for buyers and relatively low coupons for some very risky firms), CEFs have a distinct advantage of being closed to new capital flows. As mutual fund managers struggle to find good deals to put the new money that is flooding in to work, CEF managers can be more discerning.

BlackRock Limited Duration Income Common BLW and Western Asset Global High Income EHI are each allocated 10% of portfolio exposure, but after adjusting for leverage they end up at 6.8% and 7.9% of dollar exposure, respectively. PIMCO Dynamic Income PDI, with two thirds of assets firmly in junk territory or unrated, makes up only 5% of portfolio exposure and 2.6% of assets. These funds aren’t for the faint of heart, but they don’t look very threatening standing next to the other funds in the portfolio. While this bucket comprises only 17.3% of the portfolio’s dollar weightings, it generates about one third of its income.

Bronze-rated BLW is run by a strong management team at BlackRock and focuses on credit risk in lieu of interest-rate risk. The fund achieves its 1.45 year duration by investing mainly in bank loans (issued by non-investment-grade firms), but also goes after shorter duration high-yield corporate debt and structured products. That said, it doesn’t get too junky with its selections, with a slightly above-average allocation to investment-grade securities and a slightly below-average allocation to CCC securities relative to other high-yield funds. The 6.7% discount doesn’t make it a screaming bargain, but it is comfortably wider than its 2.4% five-year average. On an absolute valuation basis, the implied expense ratio (which we explained in Tuesday’s article) suggests that it is cheaper than average for a high-yield fund. For potential alternatives, investors should look at BlackRock’s lineup of high-yield and multisector-bond CEFs. Even with the slated merger of some of its high-yield funds, there are enough redundancies here to offer a solid back up plan should valuations change.

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

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