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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.

Core
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.

EHI provides good diversification to the high-yield bucket by reaching into emerging-markets corporate and sovereign bonds. This fund is not currently rated, but Western Asset’s emerging-markets debt and high-yield teams sport Bronze ratings elsewhere. Its 7.0% discount falls in line with its five-year average and makes its implied expense ratio about average for multisector bond funds. The fund is fairly valued, in our opinion, but its diversification qualities make it a good fit for the portfolio. Investors might also want to look at Western Asset’s trio of emerging-markets debt CEFs, as well the unleveraged Western Asset High Income Opportunity HIO (which we discuss here) as a pair trade to replicate similar levels of high-yield corporate and emerging-markets debt exposure.

Given the high level of credit risk implicit in PDI’s portfolio, this fund receives the lowest weighting on an exposure basis in the portfolio, which is then adjusted downward based on its high leverage ratio. If the fund blows up, it can’t do much damage at a 2.6% weighting in the overall portfolio. The fund’s high fees (2.91% in the last fiscal year) are another knock against it. Nevertheless, head manager Dan Ivascyn’s large personal stake in the fund suggests that he has confidence in his team’s ability to sift through the nonagency mortgage-backed securities market (which make up close to 70% of its assets). Ivascyn also manages Silver-rated PIMCO Income PIMIX and sister fund PIMCO Income Opportunity PKO. (PDI and PKO are highlighted in detail here.)

Long Duration
Finally, we split the last quarter of the portfolio between two funds with relatively high credit quality, but longer durations. If economic woes and low interest rates continue, this portion of the portfolio should do well relative to the high-yield bucket. AllianceBernstein Income ACG makes up 15% of total exposure (9.9% on a dollar basis) while Nuveen Build America Bond Common NBB makes up 10% and 6.9%, respectively.

On a NAV basis, ACG’s fundamental characteristics warrant a Morningstar Analyst Rating of Gold. The fund focuses on longer-dated Treasuries but also dips into high-yield corporates. This leaves the fund with 70% of assets securities rated AAA and 18% rated below-investment-grade. The 8.9-year duration certainly opens it up to some interest-rate risk but doesn’t lengthen the overall portfolio’s duration by much. This fund is also arguably the most undervalued fund in the entire portfolio: Its 15.1% discount is substantially wider than its 8.0% five-year average, and distribution-related benefits bestowed to shareholders by the large discount completely overtake the fund’s low fees. Because of the fund’s attractive valuation and strong Analyst rating, its position is slightly heavy relative to NBB.

NBB is primarily rated Neutral because of its asset class. The Build America Bond market is fairly small at a mere $181 billion, and we believe it would be very difficult for any management team to add enough value to outpace peers. Nevertheless, Nuveen has a competent muni team and has earned Silver ratings for several of its unleveraged municipal CEFs. The main attraction to this fund is its valuation, so sister fund Nuveen Build America Bond Opportunities NBD and BlackRock Build America Bond Common BBN should act as excellent substitutes if valuation moves against NBB. BABs also offer asset-class diversification into municipal bonds. (However, some managers note that these securities tend to trade like long-term corporate bonds rather than munis.) It also makes sense to put the fund in this bucket as most of the BAB market is concentrated in highly rated, long-maturity bonds. Investors should also be aware of the wind-up provisions for each fund (discussed here).

Cash & Distributions
To offset the effects of the funds’ leverage, the 15.9% cash allocation should reduce volatility. Investors are free to stash this in their go-to money market fund, or physically shove it under their mattresses as they see fit. Meanwhile, investors should be aware of the fact that, because of MIN’s distribution policy, the portfolio’s overall distribution rate will include a healthy amount of returned capital. Some of this represents real return (because the fund trades at a discount), but the rest of it should be reinvested, preferably though the funds own reinvestment plan. Specifically, the difference between the portfolio’s modified earnings rate outlined inTuesday’s article and the cumulative amount of distributions received should be the minimum amount reinvested.

Looking forward, we plan to update this portfolio at least once a quarter, or more frequently barring the emergence of interesting opportunities. Should the fixed-income CEF market become as frothy as it did earlier this year, we would not rule out using exchange-traded funds and open-end funds as alternatives.



[1] We suggest that the majority of this fund’s return of capital should be reinvested. Specifically, the different between the fund’s stated distribution rate and its modified earnings rate (outlined here) should be the minimum reinvestment.

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

 

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