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Using CEFs for High-Yield Income

Steven Pikelny

Steven Pikelny: Hi, I'm Steve Pikelny, closed-end fund analyst with Morningstar. With me today I have Steve Walsh, the chief investment officer of Western Asset, and we are at the 2012 Morningstar Investment Conference. Thanks for joining me today, Steve.

Steve Walsh: Sure, good morning, Steve. Good to be here.

Pikelny: One theme that I've seen cropping up in a lot of the conversations I've had with advisors and some of the talks and even on our discussion board is the general search for income, and closed-end funds typically have a reputation of being super income generators. Now, you manage several open-end funds, but you also managed several closed-end funds, as well. What role do you think a closed-end fund should play in an investor's portfolio?

Walsh: Sure. You know again, I'm very happy to be here. Closed-end funds, I think, are an asset class that all investors should consider for some portion of their portfolio. It's a static portfolio that is allowed to be managed without consideration toward liquidity or having to provide cash flow, so that gives I think the portfolio manager an advantage in the marketplace. So, we look to manage a portfolio of targeted asset classes, and I think any investor ought to carry a closed-end fund as a portion. If they're going to invest in high yield, I certainly would have open-end high-yield funds, but I'd have a portion of that in a closed-end high-yield portfolio, as well. So, once you've decided on a segment of the marketplace that you want to invest in, I certainly would have a balance between open-end and closed-end. And I think, in particular closed-end funds offer that opportunity for income, which is the biggest component of return in a typical fixed-income portfolio.

Pikelny: You're talking about once you choose a segment of the market to invest in, anecdotally a lot of what we hear from managers is that more illiquid asset classes are more suited for close-end funds. Can you speak to that at all?

Walsh: Sure, I think that's true. I think, one of the big considerations in the marketplace today and in fixed-income markets is the impaired liquidity. The cumulative effect of the Basel Accord, the Dodd-Frank Rules and even the Volcker Rules that specifically address proprietary trading within fixed-income markets have rendered them a lot less liquid than any time in the 30 years I've been in the business. So, a closed-end fund by virtue of the fact that it doesn't have to worry as much about liquidity in terms of providing that to the investors within the fund, I think starts off with a big advantage. And that's why I believe that the closed-end funds that are targeted at specific segments like distressed mortgages, like bank loans, like high-yield, like even some emerging-markets debt sectors, have an advantage because they don't have to worry about the transaction costs associated with trading the bonds.

Pikelny: I was even looking at a fund the other day that invested in emerging-markets bonds. It was an open-end fund, and it held somewhere in the neighborhood of 10%-15% of assets in cash just to meet the expected inflows and outflows.

Walsh: A great example of that was the third and fourth quarter of last year. Remember the extraordinary stress markets were under given what was going on in Europe and given the concerns about maybe a double-dip recession in the U.S. We and our open-end high-yield funds, as did all investors, faced a great deal of outflows. To protect yourself against that and managing an open-end fund you have to have a buffer of cash to provide the liquidity that clients expect within that. In a closed-end universe, you don't need to worry about that as much, absolutely especially in times of stress, and I think especially in times of general liquidity like we face in markets today it's a pretty big advantage for closed-end fund manager.

Pikelny: Another benefit of closed-end funds is that because they're closed they could use leverage. Now, a lot of investors are afraid of that because a lot of these funds use leverage when interest rates rise. It's going to kind of squeeze the profit margins. Can you speak to that at all?

Walsh: Sure. A closed-end fund that is leveraged does need to manage both the asset side, that is investing in securities, as well as the liability side or the borrowing-money side. And clearly, we have been in a pretty extraordinary period for the last three or four years with interest rates basically at zero in the U.S. That has given those that are using leverage and extraordinary benefit. It's a great advantage because you're borrowing money at a very low interest rate and obviously you reinvesting it much higher. So, I think we all hope that one day rates will rise maybe, and while the Federal Reserve has guaranteed that that's OK out until 2014 pretty much that we're not going to raise rates until then, at some point in time, managing that, the borrowing side of a closed-end fund, managing the liability side will become more important. But, if you just took what the market's expectations are today, and a fund could lock in below 3% funding for almost 10 years, 10 years forward, the marketplace is certainly expecting very low and stable rates. 

And even when they start to rise in 2015, the broad expectation today is that they will stay relatively low for quite, quite some time, nothing like we experienced in the past. That should allow for leverage to continue to be a pretty important dynamic in managing closed-end funds. But it's something that needs to be managed, but the other thing is you have tools to manage that through futures contracts or through interest-rate swaps, a manager is able to extend the maturity of their borrowings, therein offer the closed-end fund from the pressures that would result from higher interest rates.