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3 Closed-End Funds With Big, Sustainable Yields

Although often overlooked by individual investors thirsty for yield, many closed-end funds (CEFs) have built notorious reputations for providing great returns to their holders.

High-Yield Dividend StocksFor CEF investors, it’s more important than ever to understand the inner workings of fund management and distribution policies.

A great way to start is evaluating a fund’s distribution history alongside its portfolio’s earnings — that will immediately give you a picture of a sponsor or board’s management practices. A look at a semiannual or annual report will reveals fine details such as undistributed net investment income (UNII), changes in portfolio holdings and prospects for dividend coverage.

The key to this strategy is to uncover and then focus on funds that use their leverage from borrowings productively, and avoid funds that have excessively high stated distribution policies. I prefer to own funds that pay a special dividend each year for the purpose of balancing tax liability because of an over-earning portfolio than a fund that struggles to make ends meet. It offers additional peace of mind to investors that a dividend cut isn’t looming, which in turn can cause erratic price volatility.

My top three funds include selections from managers that have long histories of generating excellent returns and providing their shareholders with a nice cushion of investment income in excess of distributions. Here they are:

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CEFs With Yield: Pimco Dynamic Income Fund (PDI)

Dividend Yield: 7%

Pimco Dynamic Income Fund (PDI) CEFs closed-end fundsThe Pimco Dynamic Income Fund (PDI) is truly a dominant force in the multi-sector/mortgage-backed securities category. The CEF, which is managed by fixed income genius Daniel Ivascyn, commenced operations in May 2012 and has generated significant amounts of UNII ever since posting its first annual report.

PDI’s strategy relies heavily on the discounted pricing of mid- to late-2000s vintage non-agency MBSes. The fund works by pairing written-down packages of loans with other high-yield and emerging-market fixed income, then leveraging the portfolio by roughly 45%.

Ivascyn was able to out-earn the fund’s distribution policy of 19.1 cents per month by a margin of roughly 10 cents through the last reporting period. In addition, the portfolio management team implements hedging strategies using interest-rate and credit-default swaps to control volatility.

Although non-agency MBSes are essentially a shrinking market due to lack of issuance following the financial crisis, I believe Ivascyn as demonstrated an amazing ability to seek out undervalued sectors of the fixed income market to keep income flowing to his shareholders.

PDI’s track record since its inception is nearly unrivaled by other CEFs, and I believe superior expertise of management will allow it to continue well into the future.

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CEFs With Yield: Pioneer Diversified High Income Fund (HNW)

Pioneer Diversified High Income Fund (HNW) closed-end funds CEFsDividend Yield: 9.1%

The Pioneer Diversified High Income Fund (HNW) seeks income through investments in several sectors of the high-yield bond market. Specifically, HNW specializes in global credit, with the majority of its portfolio allocated to U.S. high yield, senior loans, event-linked securities and emerging markets. With the exception of the catastrophe bond sleeve, the stated portfolio mix is not uncommon in the CEF marketplace.

For those that are not familiar with catastrophe bonds, or “cat” bonds, they are sold by insurance companies seeking alternative means of reinsurance and risk-transfer through capital market investment. The coupon rate traditionally floats in relation to an index similar to senior loans, while the principal value is attached to natural disasters or other insurance claims. Interestingly, if a natural disaster does occur, there are triggers that can lead to principle forgiveness or writedowns to investors. Conversely, if no loss claims occur, investors stand to collect very attractive cash flows as event-linked bonds are typically rated below investment grade.

HNW has a long history of not only trading at a premium, but also earning more than it distributes to its shareholders. Currently the portfolio has a comfortable buffer of out-earning its distribution policy of 16 cents per month by a margin of roughly 1 cent per month. Although credit conditions might be overextended in the near term, HNW’s management team has a knack for taking advantage of esoteric and small float issues most other managers or ETFs avoid altogether.

By dodging mainstream credits, HNW has the potential for shaping an attractive income and risk profile.

CEFs With Yield: The Blackrock Multi Sector Income Fund (BIT)

BlackRock185Dividend Yield: 7.5%

BlackRock’s (BLK) team of three managers equally contribute their respective specialties to the Blackrock Multi Sector Income Fund’s (BIT) underlying portfolio, which began operations in March 2013.

The portfolio is generally constructed of low-duration fixed-income, mortgage-backed securities, and securitized products. With its heaviest and most differentiated weighting is in securitized products such as asset backed securities (ABSes), collateralized loan obligations (CLOs) and collateralized mortgage obligations (CMOs). With smaller allocations to high-yield bonds, bank loans, non-U.S. developed, emerging-market and investment-grade credit.

BIT’s portfolio, which is leveraged by 42%, could exhibit excellent relative performance in a longer-term rising-rate environment due to the floating rate nature of many securitized products, and the moderate use of interest rate swaps to offset volatility. As a result, its current effective duration rests at just 3.02 years. In addition, the fund has very few restrictions on the sectors of the market in which it can operate in, which give the management team added flexibility to meet the funds distribution policy.

BIT’s portfolio currently generates roughly 11.7 cents a month in earnings compared with the 9.3 cents a month is distributes to shareholders, making for an attractive margin of UNII.

While portfolio earnings and distribution policies are just one important metric of sound CEF management, investors should be vigilant in their due diligence and ongoing monitoring. Developing a plan and then implementing it decisively will always yield the most favorable result.

Michael Fabian is Managing Partner and Chief Investment Officer of FMD Capital Management. As of this writing, he held PDI and BIT. To get more investor insights from FMD Capital, visit their blog.

Article printed from InvestorPlace Media, https://investorplace.com/2014/06/3-closed-end-funds-cefs-yield/.

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