business news5 Big-Yield Funds to Watch
You can go out and hunt for yields, or you can find a good manager who knows how to "make" yields using options. After setting some rigorous criteria, this handful made the cut.
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Today’s low-yield world puts income investors in a tough spot.
Fixed-income alternatives are uninspiring: five-year US Treasuries yield 0.74%, ten-year US Treasuries yield 1.73%, and investment-grade corporate bonds yield only 3.18%. Newly issued corporate bonds—which have reached $3.3 trillion in value so far in 2012—are being sold at an even lower average yield of 2.68%.
To earn a decent annual return, a fixed-income investor currently needs to assume much greater credit risk in the form of non-investment-grade bonds (i.e., less than triple-B rated, also known as “junk”), which currently average 6.68%.
The problem with junk bonds is that there is an increased risk of default, especially in a weak economic environment as we are experiencing now. Since the beginning of 2011, the default rate on junk bonds has more than doubled, from 0.8% to 1.8%, and JP Morgan forecasts the default rate to rise further into 2014.
High-yield, dividend-paying stocks are another alternative, but investors have already bid up high-yield stocks to arguably nosebleed levels. According to fund manager AllianceBernstein, stocks with yields 20% or more above the market’s now account for 44% of the S&P 500 on a cap-weighted basis. That’s their highest share in the last three decades, and well above the historical average of 36%.
High Yields at a Discount
One high-yield asset class flying under investors’ radar and which remains attractively priced is covered-call closed-end funds (CEFs).
Studies have demonstrated that a covered-call equity portfolio outperforms a buy-and-hold stock portfolio over the long-term. The outperformance of covered calls is most pronounced in down markets, which makes the strategy especially attractive to risk-averse investors. The strategy may also offer a tax shelter, since the option income is classified as capital gains, and thus can be used to offset capital losses.
There are 600 CEFs in existence, and about 300 of them are currently trading at a premium to their net asset value (NAV)—“the largest number of funds at a premium we’ve seen.”
I don’t recommend buying CEFs at a premium to NAV, because it means buying securities for more than they are worth. It would be like paying $1.05 for a dollar bill. Almost all of the CEFs trading at premiums hold fixed-income securities. However, CEFs that invest in stocks remain reasonably priced, and on average are trading at a 6% discount to NAV.
Using the www.cefconnect.com screener, I found 31 stock CEFs that focus exclusively on a covered-call option strategy. Their average disÂcount to NAV is -8.1%, which is greater than the stock-CEF average (a good thing).
Only one covered-call CEF trades at a premium to NAV (+9.86%) and I consequently would avoid it—the GAMCO Natural Resources Gold & Income Trust (NYSE:GNT). This CEF pays a super-high 10.66% annual yield, but if the CEF were to trade at NAV, the capital loss from the CEF price decline would almost wipe out this yield.
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