Scott Burns: A couple of high-yield ideas from the closed-end fund space.
Hi there. I'm Scott Burns, director of ETF and closed-end fund research with Morningstar. Joining me today is Mike Taggart, our closed-end fund strategist. Mike, thanks for joining me.
Mike Taggart: Yeah, good to be here.
Burns: First of all, when we talk about yield with closed-end funds, there's a common mistake that so many investors make. Maybe you can talk a little bit about what the composition of that yield is, and what they should look for?
Taggart: Sure, Scott. When you look at the distribution that you're receiving from a closed-end fund, it's really important to look at the source of that distribution. There are three areas where that income can come from. It can come from the net investment income. That would be the bond's interest payments that had been made to the portfolio or stock dividends. Then you have realized capital gains.
Then the third one creates all the mistakes. It's return of capital, where they are actually returning your invested capital to you.
Burns: So it's not really a true yield. It's just your money back.
Taggart: Exactly. If there's a return of capital component to it, it's not a true yield. Investors really don't understand this fully, I don't believe. A lot of times you'll see investors flocking towards the funds with the highest headline yield, when it's not really a yield at all.Read Full Transcript
Burns: Right. You actually wrote a great piece of that in your most recent closed-end fund weekly. So watchers can check on that and look at that link for a more further description into how to really assess a closed-end fund's yield.
But anyway, onto the moment. You've got a couple of ideas for us here. Yield is top of every investor's mind right now. Closed-end funds are great vehicles for delivering yield. What have you got for us here?
Taggart: First of all, both of these ideas, neither of them have the return of capital component to them. That's one thing we screened out.
The first idea is Dreyfus High Yield Strategies Fund. It's a 3-star rated fund. Its ticker symbol is DHF. The fund is trading right now around $4 a share, when we came in here.
Taggart: That equates to about a 2% discount of its NAV, and that's just a little over 13% yield on the fund. It pays out 4.3 cents per share every month.
One of the reasons I like this fund is that just in March the board of directors hiked the payout by 23%. The second reason is with closed-end funds, when they're paying these out monthly, they have undistributed net investment income. So if it's a positive balance, it can act as a cushion to the payout.
Taggart: It's called UNI, and the UNI balance is eight cents a share.
Burns: That will help keep the dividend stream smooth if there's a little volatility in the underlying...
Taggart: If there's a little volatility, if they're a cent short one month, they can just take it out of the UNI.
Burns: OK. That sounds great. Are there any risks people should think about with this? What's the credit quality of the portfolio?
Taggart: The credit quality of the portfolio right now is a single B, average credit quality.
Burns: So it's definitely junk?
Taggart: Oh yes. Both of these are going to be high-yielding funds. That's where you're getting your yield from. You're definitely taking on some more risk. In addition to that single B credit rating, which they get from investing right now about 100% in U.S. non-investment grade corporate bonds...
Taggart: In addition to that, you have a pretty high headline expense ratio. Closed-end funds have to report the cost of their leverage as part of their expenses. So in the last full annual year for them, their expense ratio was like 2.7%. Half of that came from leverage.
Burns: OK. Their costs of borrowing.
Taggart: Right. As an investor, you say, "Wow, I'm paying like 1.35% for my leverage." Yes, but you're also getting the benefit of that in the additional yield, hopefully, if the managers are doing their job right. It's 29% levered, so that can increase its volatility. And like most closed-end funds, it's not highly liquid. Over the last year, its average trading volume was about 270,000 shares a day.
Burns: OK. Definitely something for the risk part of an investor's portfolio. This isn't really a core holding.
Taggart: No, you don't want this as a core holding. This is something satellite maybe, for an opportunity to give your overall portfolio a little boost.
Burns: A little yield enhancement.
Burns: What about the other fund?
Taggart. Yes. The second one's the same way. You don't want this as a core holding. It's the John Hancock Investors Trust. It's a 4-star rated fund. Ticker symbol is JHI. This one actually has an average credit quality of double B.
Burns: So it's a little higher up the credit chain.
Taggart: A little higher up the credit chain. It does have some overseas risk. 85% of its assets at the end of February were invested in U.S. entities. It's trading right now about $20.25 a share. It's actually trading at a bit of a premium, but we don't think it's overvalued compared to its long-term historic average discount. It's a 4.4% premium, but it's offering a 10.3% yield.
Burns: Is there any leverage on the fund?
Taggart: Yes. Similar with the Dreyfus fund. 26% leverage on the fund.
Burns: OK. Again, this is not really a core holding, but it's a little higher credit quality. A little lower yield, a little lower leverage.
Taggart: Right. The actual expense ratio is quite a bit lower, 1.45%, and that would include the costs of leverage. About 40% of that expense ratio comes from the costs of leverage.
Burns: Well Mike, thanks for sharing that insight on just how investors should look at the distribution yields from a closed-end fund, and also for those great ideas. Just want to make sure once again, investors understand that risk and return are equal. So when you want that extra yield, there is going to be some extra risk to take on. But it's suitable depending on the situation.
Thanks for joining me.
Taggart: Thanks very much.
Burns: I'm Scott Burns, director of ETF and closed-end fund research for Morningstar. For this and other ETF and closed-end fund news and information, please check out morningstar.com's ETF and closed-end fund tab.