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.

Why corporate bonds are still expensive

Think fast: what yields the most, municipal bonds or corporate bonds?

It used to be the case that munis yielded less, since they have the benefit of being tax free -- Federal and oftentimes state too. So investors typically pay more for them, which then brings their yields lower. Also, many muni bonds are backed by state taxes, and the state can always raise taxes to cover their interest expense. Which mean munis in general are a lot safer than corporate bonds -- in general, there are many exceptions of course.

These days, for reasons that I don't understand, Muni bonds in California are yielding a lot more on an after-tax basis than corporate bonds, when comparing similarly-rated credit scores and maturity.

In fact, the spreads are so out-of-whack that I can get a safer (higher credit rate) Muni right now for a much better after-tax yield than a corporate bond with similar maturity.

Just for fun, I checked out a few high-yielding California Munis. Consider this:

California St Var Purp, 2034 (CUSIP:13062R3Y2) was recently seen trading for $80-$89 for an yield of 6.13-5.4%. Not bad for a tax-free return.

A few more:

San Gorgonio Mem Healthcare Dist Calif Go Bds, 2031 (CUSIP: 13062R3Y2) $80-89 6.13-5.4%, rated A3 by Moodys.

California St Go And Go Refunding Bds, 2036, (CUSIP: 13062TSB1) $83.454 5.684%, rated A2 by Moodys and A by Fitch and S&P.

To get a 6% yield after tax, one needs an yield of at least 6/(1-.28) = 8.33% pre-tax. And that's only considering a moderate tax bracket of 28% and no state taxes.

A more reasonable tax bracket for a California investor in the upper tax brackets would be 33% + 9.3% = 42.3%. So, to get an after-tax yield of 6% on that basis one would need to find a bond yielding upwards of 10%.

But let's be conservative and require a 9% yield. What can I find with that kind of yield?

Well, mostly only financials. Here are some issues:

Citigroup Inc, 2012 86.631 9.187 A3/A
Viacom Inc, 2036 77.03 9.191 Baa3/BBB
Bank of America, 2013 84.498 9.202 A3/A-

So, while it's not impossible to get a good deal on corporate bonds, one needs to be really careful to:

1. Pick a maturity that you're comfortable with. Don't expect the market to fully value your bonds soon. If you can't wait for maturity, don't buy it!


2. Be wary of credit ratings of financials. Financials are really a black box these days. While the Fed is currently backing them up, they may not do so forever. Or they might split banks apart and you may end up owning the debt of the "bad" part.


3. Stick with G.O. bonds. As I mentioned before, General Obligation bonds are backed by state taxes and hence are generally safer. Be careful with some kinds of non-GO bonds which are not even issues by the state, but merely use the state as conduit to reach the bond market. These are the worst, usually not backed by anything.


4. Avoid insured munis. There are issues that are backed by some private company (MBIA, AMBAC, FGIC, etc). Why is this bad? Because if the state is going to default, it will start with those it knows someone else is going to pick up the tab for them.


5. Avoid low-quality for long-term bonds. Anything below BBB+ (Baa for Moodys) is probably too dangerous to own beyond a year or two, unless you have insight into the company's financial position. Which brings me to...


6. Do your homework. Look at the terms of the bonds, its seniority, the terms of any sinking fund, call terms, etc. Look at what else the company owes and who the creditors are (if there are lots of more senior bonds than yours you may not get paid in the event of a default). Check the details on the MSRB website.
   

To summarize: Munis are offering higher yields than corporate bonds, for higher-quality issues and with the backing of a tax authority (for G.O. bonds). No one should invest in corporate America today unless they can find a much better deal with much larger margin of safety.