The choppy gyrations of the equity and fixed income markets have caused a bit of a ruckus for closed-end fund investors during the first half of 2015. Driven primarily by shaky retail investors, the schizophrenic-like persona of many popular CEFs have created opportunities for investors with spare capital seeking high income.
Yet, I don’t see this as an opportunity that is universally applicable to every fixed-income CEF in the marketplace. Investors should be mindful of overly leveraged or risky high-yield strategies with upcoming Federal Reserve policy changes afoot.
A facet of quality, investment grade assets within a diversified bond portfolio could be a good way to insulate against these effects. Since high yield and high quality fixed-income securities typically counterbalance each other’s price movements.
As always, looking at funds that meet or exceed their distribution policies is a sound way to weed out funds that could erode your capital over time. In addition, I prefer to stay away from clunky Treasury or investment grade only funds that might not have a flexible enough mandate to capitalize on high yield assets in the event of unforeseen relative value opportunities down the line.
Two funds that I have an affinity towards as a result of our firm’s top-down research efforts with respect to sponsor, manager, and portfolio strategy are the DoubleLine Opportunistic Credit Fund (DBL) and the PIMCO Strategic Income Fund (RCS).
While managed completely different from a portfolio strategy perspective, DBL utilizes a more traditional approach to fixed-income portfolio management with a prospectus rule requiring at least 50% of the fund be invested in high-quality securities. As a result of Jeffrey Gundlach’s experience and inclination toward mortgage backed securities (MBS), DBL benefits from both agency and non-agency exposure.
In addition to a complimentary slice of MBS derivatives to control prepayments, credit, and interest rate fluctuations.
DBL carries a relatively long effective duration of about nine years, which should allow investors to capitalize on yield curve flattening or inverting following a bump in short-term interest rates.
I also like DBL since it operates with the minimum amount of portfolio leverage to achieve its distribution rate; so when short-term interest rates begin to rise, the fund’s borrowing costs shouldn’t significantly cut into portfolio earnings.
On the other hand, Dan Ivascyn, the manager of RCS, opts for a more exotic mix of interest rate and credit default swap overlays to control fluctuations of the cash-settled securities within the portfolio. For example, Ivascyn currently has 61% of the fund allocated to high quality agency MBS; yet also carries enough notional exposure to long dated pay-fixed interest rate swaps to counterbalance the duration effects of the long maturity agency MBS.
To achieve its relatively large distribution rate of about 11%, RCS is also allocated to emerging market and high-yield securities. In addition, RCS carries a much shorter duration of just 2.6 years due to the swap hedges. In turn, RCS may be a better stand-alone choice for investors without other risk assets to offset or those investors seeking a more balanced and diversified strategy.
I think both DBL and RCS present excellent opportunities at current levels, since both funds typically trade at healthy premiums and have recently come back into line with their respective NAV’s. Just be mindful of sizing your allocation or consider averaging in a cost basis with multiple purchases since the recent price volatility may continue for the next several months.
Purchasing one or both funds can ultimately increase your portfolio’s income stream and potential for capital appreciation if the funds are drawn back to their respective trailing 12-month average premiums. Just be careful with assuming too much risk too quickly, so that you don’t become another casualty of interest rate volatility.
Michael Fabian is Managing Partner and Chief Investment Officer of FMD Capital Management. To get more investor insights from FMD Capital, visit their blog. Click here to download their latest special report, The Strategic Approach to Income Investing.
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