Make Volatility Pay With This Investment Vehicle

Adem is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There’s a tremendous opportunity in a little known world of the investment community, and it's bound to only get more attractive.  With all the panic in recent weeks over the “fiscal cliff” the world of CEF’s, particularly those in municipal bonds have been selling off at a ridiculous pace. Before we get into the best opportunities available in this space, let’s talk a little bit about the actual investment vehicle itself (for those who are unaware) and why such an opportunity is presenting itself right now.

What is a CEF?

A Close Ended Fund (CEF) is essentially similar to ETF’s or mutual funds with only a limited number of units available. CEF’s were a huge investment instrument in the 1980’s in the pre-ETF days because they offered the diversification of a mutual fund while trading liquid and at a low share price, like a stock.

Where is the Opportunity Now and What are the Potential Pitfalls?

Unlike a mutual fund, which is open ended and whose managers use this ability to meet demand, a CEF is closed. That means when demand is high and the shares get driven up, a CEF will trade at a ridiculous premium to its net asset value, and the same is true in reverse. While mutual funds and single leveraged ETF’s trade close to their NAV’s, CEF’s almost never do. This means that when people start to panic about the economy the rapid selling can create amazing opportunities in CEF’s, which can trade at huge discounts to the value of their assets in a matter of a trading day.

So why not pile all the money we have into CEF’s? For one thing, CEF’s are risky in nature and require competent managers. There’s more leeway in a CEF for risky business. Managers can typically invest using leverage and borrowing money, and for that reason alone we’ll want to be selective.

Three Buy Signals For CEF’s

For the reasons stated above and more, I’m not buying stock CEF’s; but if a bond CEF can trade with great volatility and at a discount to its NAV, then the opportunity for capital appreciation is already there. I can’t find a lot of good places these days to invest in bonds, so let’s do it in the CEF world; besides, stocks have upside through other means.

A quick example: with the fears of the “fiscal cliff” Pimco High Income Fund (NYSE: PHK) sold off in less than a month from $14/share to $9.88, pushing its yield (it’s a junk bond fund) over 14%. I’ve tended to avoid this stock as it’s been way over NAV, but this past Thursday, when it went under $10, that changed. That day, I said “enough is enough” and bought some shares. The next day the shares went up 11%. I say this not to gloat but rather to show the opportunity; where else in the bond world can you get a 14% yield? Where else in bonds do you see that kind of volatility and a chance for capital appreciation? For those reasons alone, I’m sticking to bonds when it comes to CEF’s.

Next, I’m not investing in a CEF that yields less than 6% or has a management team I’ve never heard of. If I want a safe bond yield without any risks and low costs (yes, CEF’s have higher fees than ETF’s), then I’m buying the Vanguard Short-Term Bond Fund (NYSEMKT: BSV) and ETF, which offers a low, steady, and essentially risk free yield. If it doesn’t offer 6%, then the risk isn’t worth the return, and I’d rather skip the leveraging all together; yet even at 6% I am taking a risk, so I want a manager with a solid reputation.

My final rule has two parts as it requires a fund that offers the combination of both these factors, but isn't necessarily the best at either; I’m talking about dividends and net asset value. I want shares that offer the highest yield and are trading as closely as possible to their net asset value. It raises some red flags if the fund is paying a ridiculously high yield and is trading at a premium to its NAV; after all, where is the money coming from? At some point, that mix can be unsustainable and worrisome (management might be over-leveraging).

Finally, I want shares that have gone a long time without lowering their dividend yield. People essentially buy these shares for yield, so if the yield isn’t gyrating, the NAV is close, and the yield is high, you’re essentially taking away most risk factors for a share drop.

 A "not so bad" CEF/bond shortlist:

Fund name Dividend Yield% Fund Type NAV Premium/Discount Consecutive Months w/out Dividend Cut Fund Manager
Pimco Municipal Income Fund III (NYSE: PMX) 6.84% Muni (tax exempt) 9.54% 70 Joe Deane
Pimco Income Strategy Fund II (NYSE: PFN) 8.76% Corporate (mix) 1.74% 29 (with two increases) Bill Gross
Pimco Income Strategy Fund (NYSE: PFL) 8.61% Corporate (mix) 3.12% 27 (with two increases) Bill Gross

As you can guess from this short list, I'm a fan of Pimco--but there are plenty of other quality firms as well. I just like the fact that Pimco has a track record of being resistant to cutting dividends. I'm also (as you can tell) a fan of "Bond King" Bill Gross, or at least his reputation--and the need to protect it by keeping dividend rates up.

How to Trade it All

As you’ll notice, the above “short list” is chiefly a collection of high yield bond (junk) and municipal bond funds. The  reason for that is these are the areas that will induce the most market panic with all the political theatre of the fiscal cliff, much of which will be overblown, and they will rally the hardest on any deal (like Friday's 10% gain on “talks”). I want you to be in these, but not now; hold a short list and wait until the yield and NAV situation gets ridiculously favorable, and then buy.

A final note; while this may seem risky investing to some, keep in mind the only real risk is not mastering your temperament. These funds own real assets, so any money you put in the market is at risk, but if you have the emotional fortitude to wait for the “ideal situation” listed above you’ll be in great shape. Repeat after me (and this is true of all investments): “when the price drops, so does the risk.” Happy hunting.

 


mrrightside owns the Pimco High Income Fund, and Vanguard Short-Term Bond Fund . The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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