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CEF Specialist

4 Contrarian Income Funds

Bold investors might want to consider these attractively valued CEFs.

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As interest rates spiked over the past few months, many fixed-income sectors were hit hard. Investors poured out of mutual funds and exchange-traded funds; even Vanguard saw its first net outflows in 20 years. With fixed income leaning out of favor (or, at least less in-favor than it was earlier this year), many investors argue that certain sectors of the bond market are now oversold. Municipal bonds, in particular, look increasingly attractive with their spread over longer-term U.S. Treasuries increasing drastically in the wake of Detroit's publicized insolvency.

In light of these fears, it can be difficult to go against the grain. As we recently pointed out, availability bias (the tendency to weight recent impressions--such as a large price drop--more heavily than boring data points, for example) can be hard to overcome. But without making sweeping, absolute statements about sector valuation, the concurrent sell-off in fixed-income closed-end funds has given rise to some slightly less ambiguous deals. Valuing an entire asset class is difficult; valuing a CEF that invests in that asset class but is trading at a large discount, is less difficult. What's more, opportunistic investors looking to take advantage of attractive valuations without taking on as much market risk might want to consider hedging their exposure, as we discussed at the end of this article.

With this in mind, let's take a look at four out-of-favor CEFs (three muni funds and one emerging-markets debt fund) that look attractive on a sector-agnostic basis.

BlackRock Municipal Income Investment Quality (BAF)
For investors who expect rates to remain low, BAF is a good option. The fund has very little call exposure (less than 3% of assets will mature or become callable in the next five years), which means that reinvestment risk in a low rate environment is minimal. BAF's biggest risk is its sensitivity to increasing interest rates, which is amplified by a relatively high leverage ratio (total assets/net assets) of 1.69. The portfolio's resulting effective duration of 10.7 years is fairly long on an absolute basis, although this is hardly unusual for leveraged-muni CEFs. In terms of credit quality, 97% of assets are rated A or higher, giving it one of the highest credit-quality profiles of any muni CEF.

Aside from the risk associated with its long duration, the fundamentals of the fund are sound. It does have some slight exposure to Detroit, but this consists of insured water and sewer debt, which has an increased margin of safety over the uninsured city general-obligation debt. Nevertheless, the discount has widened to 11.7% after shares traded at net asset value as recently as January. On a three-year statistical basis, BAF is one of the most undervalued CEFs, with a z-score of 2.9 for the period (in other words, its current discount is close to three standard deviations lower than its three-year average discount). The widened discount boosts the distribution rate by 75 basis points to 6.5% at share price.

Two High-Yield Municipal CEFs
More aggressive muni investors might want to venture into the high-yield muni space. While many of these funds look pretty junky from a credit-quality perspective, it's important to keep in mind that municipal portfolios do not equate with a similarly rated corporate high-yield fund. Rating agencies look at the two classes of bonds with different criteria, and corporate bonds historically have exhibited much higher default rates than munis with the same credit ratings.

Among the high-yield muni group,  PIMCO Municipal Income (PMF) stands out mostly for its 7.9% distribution rate at share price. The fund achieves this by investing in a low-credit-quality portfolio (about 40% of assets are rated below BBB or are nonrated) with a leverage ratio of 1.68. At a 4.4% premium, it is trading well below its 17.1% three-year average premium. But considering that PIMCO has held on to its auction-rate preferred shares (ARPS) for leveraging this fund, the small premium is somewhat justifiable: The fund's ARPS allow for much cheaper leverage financing, for now. This gives it a cost advantage over its peers, many of whom have refinanced with more expensive forms of leverage.

Nuveen Municipal High Income Opportunity (NMZ) is another good option in the high-yield muni category, currently trading at a 6.2% discount (its widest since 2008). To be sure, it has advantages and disadvantages compared with PMF. On the plus side, Nuveen devotes more resources toward its municipal research operation than does PIMCO. While the Nuveen research team employs nearly two dozen credit analysts to parse through the muni universe, PIMCO's team only contains six analysts. This means that Nuveen can spend more time finding value among the junk and spread its bets over a greater number of securities. On the negative side, it appears that NMZ is taking on more risk to generate less income: 61% of assets are rated below investment grade or are nonrated bonds, and its effective duration of 13.3 years is longer than PMF's 9.3 years. Meanwhile, its distribution rate at share price is 20 basis points lower than PMF's.

Nevertheless, the amount of unrated debt in each portfolio makes it difficult to conclusively say which fund is truly taking on more credit risk.

Morgan Stanley Emerging Markets Domestic (EDD)
Finally, for investors avoiding the muni game all together, EDD presents another interesting opportunity. This fund focuses exclusively on emerging-markets debt denominated in local currencies. Like  Nuveen Diversified Currency Opportunities (JGT) (which we highlight here), this fund's share price took a hit when interest rates spiked and concern over the global "reach for yield" ending gained speed. This means that even though the fund does not take on much explicit interest-rate risk (the portfolio has a duration of 5.2 years), its exposure against the U.S. dollar still can be problematic if the currency markets move against the portfolio. In addition, the fund also takes on some credit risk, with a little less than one third of assets either nonrated or BB.

The portfolio is tilted mainly toward Latin America and Eastern Europe, with exposure to Brazil, Turkey, Russia, and Mexico comprising 57% of assets. Although some of the portfolio was positioned in corporate bonds, 90% was invested in sovereign debt. In addition, the fund leverages its portfolio 1.24 times and uses currency forwards to gain extra currency exposure (its biggest position here was against the Japanese yen).

Overall, the fund is trading at a 13.3% discount, which is well below its three-year average discount of 8.0% and brings the distribution rate at share price up to 7.1%.

It's worth reiterating that these funds are not for everyone. If you don't want long interest-rate exposure, for example, buying a leveraged long-duration fund might be a bad idea, despite the discount. But for those taking contrarian viewpoints, or looking to hedge their market exposure, these funds can be good instruments. 

Steven Pikelny does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.