2011-01-01

Two High-Yield Funds To Consider In 2011

In my quest for high returns, high yield is an obvious candidate. It's also a tricky one for the same reason: if it's so obvious, it probably won't last long or is very risky.

Nonetheless, a little bit of research can help mitigate these things a bit. Research won't guarantee anything -- nothing is ever guaranteed in investing. But I digress.

Here are the two funds that may help boost a small part of your portfolio the same way they're boosting a small part of mine (emphasis on small).

CEF Income Composite (PCEF)

The PowerShares* Closed-End Fund Income Composite (ticker: PCEF) is a fund of closed-end funds seeking high current income. It tries to achieve this by rotating in and out of closed-end funds when they offer a discount to NAV (net asset value) and good risk-reward prospects based on PowerShares proprietary trading technology. It currently yields  about 8% and pays out monthly dividends. It has a very steep  fee: 1.81% (0.50% for the ETF and the rest as per the underlying funds).

What I like about this fund is in part derived from what I like about CEFs (Closed-End Funds): they often trade at a discount to NAV and attract less attention than other funds. CEFs are often leveraged and they use long and short strategies to boost performance (and thus increase risk). The subject of closed-end funds is very interesting, but long. I'll reserve the details for another post.

With PCEF in particular, the yield and the monthly payouts are very nice. I looked at the top 5 funds that compose this ETF and they are reasonable funds with the typical risk profile of CEFs: some leverage (20-30%), a good diversifications of securities and most are not managed payout funds, which in my opinion are horrible funds (managed payout funds are those that make a distribution whether or not they have gains, which means that in lean times they will return capital to shareholders, which is a waste of time). Sadly, out of the top five funds, two are returning capital to shareholders.

Here is the breakdown of investment of PCEF, according to PowerShares:

(source: PowerShares.com)

High Yield Bond Fund (DHY)

The Credit Suisse** High Yield Bond Fund (ticker: DHY) is a simple CEF, not a fund of funds. It invests primarily on US corporate "junk" bonds. These are bonds rated "below investment grade" by the credit agencies. What this means is that these securities are less likely to re-pay their debts than the theoretically safest bond out there: US treasury bonds. In reality, no company wants to default on their bonds, which would imply having to file for bankruptcy protection and possibly liquidate the company. But in practice, this does happen, so the credit rating is important. Just keep in mind that low doesn't mean investors won't get paid. It means investors should demand higher yields.

DHY offers a monthly "dividend" (treated as regular income at tax time) that yields about 11% annualized. The underlying portfolio has a medium duration -- 4.75 years -- which means that the portfolio is not super sensitive to interest rate changes like, say, a 30-year bond. But it is not immune either.

The fund is leveraged, about 29% and has an expense rate that is very steep: 2.65%. Typically, I don't invest in funds with high fees, but in the case of CEFs I allow a few exceptions when I can get the funds at a discount.

This fund in particular is offering about 1-2% discount to NAV right now (it was 1.1% when I bought it). But it recently traded at a large premium (see graph below), which means that an attentive investor may capture outsized returns.

(source: CEFConnect.com)

It has, however, traded at significant discounts to NAV in the previous 3 years, which means this is a short-term play only.

Conclusion

I consider both of these investments to deviate from my value strategy. First, they are expensive and leveraged and second, at least DHY is a short-term investment only given its long history of premium/discount. So, consider yourself warned. However, the yields are decent and given that inflation is pretty much staying under wraps for a short while (at least until the Fed hits again with QE3), these two funds can offer a nice current yield.

Have a profitable 2011 everyone.

Disclosures: I own both of these funds at the time of writing.

* I'm not affiliated with PowerShares in anyway. Moreover, I usually don't endorse their dynamic way of portfolio construction and higher fees. This is one of the exceptions.

** I'm also not affiliated with Credit Suisse either.

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