Tag Archives: bargains

Where Can I Find Safe Income For Retirement?

Summary What should a retiree do? Where should he go? How can one get income with safety? The Question You don’t want to rely on ever seeing another paycheck. You want a steady income. But you demand safety – the lowest possible chance of a permanent impairment of capital. So you won’t simply overpay in order to construct the appearance of steady income. So, what are you supposed to do? Non-Answers and Bad Answers The easiest way to address the question is to ignore it, then offer a non-answer by violating at least one critical element. You could take a flier on something and then double down when it crashes… but that is problematic if you are not expecting subsequent paychecks with which to double down. You could forego a steady income, draw down savings, and live above or below your means… but above sounds dangerous and below sounds miserable. You could invest heavily in investment grade and government bonds for a steady paycheck… but that does not take into account the risk of overpaying. These are all non-answers. High priced helpers/”HPHs” are typically enthusiastic in their view that this is all so complex that you should spend a lot of money on fees for high priced helpers. Annuity salesmen are second to none in their single-minded view that you should buy an annuity. Private bankers are no better (but mine has good coffee and real paintings instead of burnt coffee and motivational posters). You hear folksy advice such as, “own bonds in a percentage equal to your age” or “focus exclusively on dividends and high-quality companies.” This is real advice, but it is also bad advice. Part of the problem that allows charlatans to get away with flimflam is that older folks are often easy prey. They are often honest and expect others to be too. They are often used to their lives before retirement, so are a bit disoriented by changes as they move into retirement. Many want a reassuring, friendly advisor. These obvious and perfectly reasonable market demands are supplied by many people with firm handshakes, steady eye contact, reassuringly modulated vocal tones, and utterly vacuous ideas about investing. The Standard Before trying to offer a sensible answer, I want to raise the standard for what a valuable answer would look like. It takes seriously the charge that you have seen your last paycheck. You know that it is increasingly common to see 80-year old Wal-Mart (NYSE: WMT ) greeters and you do not intend to ever be one. That means that your investments need to sustain you and your spouse for your remaining years. Oh, and thanks to modern medicine, that life expectancy could be much longer and much more expensive than anything you ever imagined. Your steady income should come from investments that meet the same standard that should be maintained by anyone else: they should be available for purchase at a significant discount to their intrinsic values. Never overpay. You certainly should not start now. Cost Savings and Tax Efficiency I am not a big fan of self-sacrifice. At least I prefer getting onto the efficiency curve before doing anything sacrificial. To that end, a key step in retirement planning is to zero out all of the expenses for goods and services that you don’t care about. This is a great time to kill off any habits. You might have paid a given bill for five years or for fifty years, but if it is not for something that you need or love, then cancel it. One of the biggest cost centers can be your home. Are you paying for a lot of externalities (if you live in Manhattan, the answer is “yes”)? Do you love your nightly table at Masa and front row seats at Broadway openings? If not, then move. I do not intend this to be overly prescriptive. Instead, my goal is to advocate for intentionality. But there are some great choices beyond heaven’s Floridian waiting room. Domestically, Wyoming is a favorite of mine. Internationally, Dominica is worth checking out. But any expenses should be reflective of only what you need or what you love. Just because you come from Detroit, doesn’t mean that you have to stay (even if there are some real estate bargains ). While everybody has unique preferences, I cannot imagine a good reason to pay any state income tax in retirement. My wife vetoed Alaskan winters, but other than that, there are some great income-tax-free states. In terms of weather and other seasonal hardships associated with income-tax-free states, that can be avoided, too, if you are willing to couple undesirable seasons at home with off-season travel abroad. I, for example, dislike turkey so have gone to Paris for several Thanksgivings at dirt cheap prices. No Bonds HPHs frequently think of risk as a function of asset class along the lines of “cash is safe, stock is risky, and bonds are in the middle”. In reality, risk is never a function of asset class; it is a function of price. Thinking proxies such as asset class-based risk models are designed only to excuse HPHs from doing any fundamental analysis to determine value. They can’t make you safe because they can’t even define, let alone quantify, risk. If you are a 65-year-old retiree, a smart sounding HPHs might say that you should be 65% in bonds, with others arguing importantly that the right number is 70% or 60%. The right number is 0%. Alternatively, come up with an explanation of how the credit market is currently undervalued. I could, of course, be completely wrong, but the current credit market looks like an epic bubble. It is conventional to own a lot of bonds, but when the bubble bursts, you will conventionally lose a lot of money. Bond Substitutes The equity market offers compelling bond substitutes that offer yields in excess of investment grade bonds with less risk in the form of event-driven opportunities. Here are the prospective opportunities in current deal spreads. A portfolio of these, whether in a fund or on their own, is both safer and more lucrative than bonds. Returns are listed on an annualized basis. Click on comments for additional deals on the specific opportunities. The best seven risk-adjusted opportunities are in bold. Either a concentration on the seven that I identified as the best risk-adjusted returns or portfolio of the broader list could help diversify and add yield to a portfolio while lowering its sensitivity to the overall market direction. Cash Cash is an investment in your future flexibility. I keep a cash balance of at least 20% of my assets. In addition to its convenience and its stability, I recently mentioned that: Cash has other virtues. Instead of buying real estate with cash, my local mortgage broker got me a tax-efficient mortgage that costs 2% before taxes (and less on an after tax net basis). This allows me to build up a larger pile of cash on the sidelines to use opportunistically. I have hundreds of separate deposit accounts, most with balances beneath the $250,000 deposit insurance cap. I keep these accounts in institutions with diverse geographies and regulatory jurisdictions. Most are at institutions that have equity options attached to their deposits in the form of potential future mutual conversions. So even if your cash allocation is on the high side, it does not dilute your overall performance, as long as you can exploit a half-dozen to dozen conversions each decade. Equity For some significant part of your equity exposure, you will beat most peers by simple, low-cost, tax-efficient passive exposure. While I would not quibble over details, Vanguard’s Total Stock Market Portfolio is my personal favorite. You get a bunch of free trades with balances over $10 million, too (and some with balances over $1 million). I have a mild preference for the mutual structure (I appreciate the irony given that a large part of my investment history has been exploiting de-mutualizations). Real Estate Inflation is a retirement killer. My #1 favorite inflation hedge is to simply pre-purchase the stuff you want in retirement. As I recently wrote : This doesn’t work with technology or lettuce, but if you have a good sense of what you want when you retire, just go ahead and buy it. Pre-purchasing the stuff you are going to want is the world’s most perfect inflation hedge. This works best if you have pretty durable tastes. For instance, if (as is my case) you are land-crazy and want to live on the water… just buy up waterfront land. If it is just what I want to own, it matters little to me if it goes down 99% or up 99% in terms of nominal dollar value. Either way, it is still worth 1x the land that I want to own and am not going to sell. It is an end in itself. So, if you know where you want to end up, lock in the real estate at today’s prices. Conclusion If this sounds much like what anyone else should do, that is because it is. Your investments are not about you. They are about upsides, downsides, and probabilities. Anything else is just patronizing HPHs putting your money at risk and jeopardizing your retirement. But if you think for yourself and focus on safety, the decades ahead could look like one long Cialis commercial. Disclosure: I am/we are long DEPO, PRGO, ALTR, WMB, ISSI, PNK, BHI. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital. Rangeley invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our investors, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.

Finding Bargains Among High Yield Bond CEFs

Summary High yield bond CEFs are selling at historically large discounts. HYT was consistently the best CEF performer on a risk-adjusted basis among the CEFs analyzed. High yield CEFs are not for the fainthearted since their volatility is substantially higher than HYG. As an income-focused investor, I was a fan of high yield bond funds until the Fed crashed the party by discussing plan to increase interest rates. Then the bear market in oil put additional pressure on energy-related high yielding bonds. Figure 1 shows a plot of the iShares iBoxx $ High Yield Corporate Bond (NYSEARCA: HYG ) ETF. This fund has a portfolio of over 1,000 dollar denominated high yielding bonds, with most coming from the following sectors: telecom (23%), energy (14%), consumer discretionary (13%), and consumer staples (13%). The fund has an expense ratio of 0.5% and yields 5.5%. The price of HYG plummeted over 40% during the 2008 bear market but recovered a significantly before heading south again in May, 2013. (click to enlarge) Figure 1. Plot of HYG The recent selloff in high yields has taken an even larger toll on Closed End Funds (CEFs). The discounts associated with high yield CEFs has widened substantially over the past couple of years. This is evidenced by their Z-score, a statistic popularized by Morningstar to measure how far a discount (or premium) is from the average discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A Z-score greater than 2 is a rare event and is worthy of notice. Figure 2 tabulates the high yield CEFs that have a Z-score of 2 or greater. For a particular CEFs, this will occur less than 2.25% of the time. Figure 2. Z-scores of High Yield CEFs. The CEFs in the table also satisfied the following selection criteria: History of at least 5 years Market cap greater than $150 million Average daily trading volume greater than 100,000 shares. Based on the Z-score, these high yield CEFs appear to be bargains but which ones are “best” value. There are many ways to define “best”. Some investors may use total return as a metric, but as a retiree, risk in as important to me as return. Therefore, I define “best” as the fund that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define “best”. I am just saying that this is the definition that works for me. This article will analyze these high yield CEFs in terms of risk versus reward to help you assess which may be right for your portfolio. But before I delve into the analysis, it might be instructive to review the characteristics of high yield bonds, which are popularly referred to as “junk” bonds. From a technical point of view, junk bonds are no different and any other bond. The issuer of junk bonds is a corporation that promises to repay you interest until a specified time in the future, called the maturity date, and at maturity, the corporation will repay you the principal. Default will occur if the corporation, for whatever reason, is unwilling or unable to repay the debt. For example, if the corporation goes bankrupt before the maturity date, the owner of the bond will have to stand in line with other creditors in the hope of receiving some payment. It is therefore critical for bond investors to assess the probability of default. This is not an easy task, especially for retail investors. Therefore rating agencies, such as Moody’s, Standard and Poor’s, and Fitch have come to the rescue by assigning a rating for most bonds. The ratings range from AAA to C (or D depending on the rating agency). The lower the rating, the higher the probability of default. Bonds rated Ba or below by Moody’s (which corresponds to a BB rating by Standard and Poor’s and Fitch) are considered to be “below investment grade” and are called junk bonds. Since it is harder to sell junk bonds to investors, the corporations need to “sweeten” the deal by offering higher interest rates, hence the term high yield. The CEFs listed in Figure 2 are summarized below: Western Asset Managed High Income (NYSE: MHY ). This CEF is selling for a discount of 16.4%, which is a much larger discount than the 5-year average discount of 2.6%. The fund has a portfolio of 349 securities with 85% in high yield bonds and 6% in investment grade bonds. About 75% of the bonds are from companies domiciled within the U.S. The effective duration is 3.8 years. The fund does not use leverage and the expense ratio is 0.9%. The distribution is 8.9% with only a small amount (less than 1%) coming from Return of Capital (ROC). Wells Fargo Advantage Income Opportunity (NYSEMKT: EAD ). This CEF sells at a discount of 14.2%, which is a much larger discount than the 5-year average discount of 1.5%. The fund’s distribution rate is a high 10.5% without any ROC. The portfolio consists of 344 securities, mostly (81%) high yield bonds. About 7% of the portfolio is invested in investment grade bonds and another 7% in senior loans. Most (80%) of the securities are from companies domiciled in the U.S. The effective leveraged duration is 5.1 years. The fund utilizes 25% leverage and has an expense ratio of 1.2%. Western Asset High Income Opportunities (NYSE: HIO ). This CEF sells at a discount of 16.4%, which is a much larger discount than the 5-year average discount of 3.1%. The distribution rate is 8.9% with only a small amount (less than 3%) coming from ROC. The fund has 350 holdings, most of which (84%) are high yield bonds. About 6% are investment grade bonds and 77% of the securities are domiciled within the U.S. This fund does not use leverage and has an expense rate of 0.9%. The effective duration is 3.8 years. Western Asset High Income Fund II (NYSE: HIX ). This CEF sells at a discount of 13.1%, which is unusual since over the past 5-years this fund has averaged a premium of 4.3%. This fund distributes a high 12.2% with only a small amount (less than 1%) from ROC. The fund has 402 holdings, with 83% in high yield bonds. About 23% of the bonds are rated CCC or lower, which is one of the reasons for the high distribution. The fund also has 6% invested in investment grade bonds. About 71% of the securities are domiciled within the U.S. The fund uses leverage of 26% and has an expense ratio of 1.4%. The effective leveraged duration is 4.9 years. Alliance Bernstein Global High Income (NYSE: AWF ). This CEF sells for a discount of 15.2%, which is a larger discount than the 5-year average discount of 3%. The fund has a “go anywhere” strategy and only has 51% of the portfolio’s 1011 securities are invested in high yield bonds. About 27% of portfolio is invested in Government bonds and 9% in asset backed bonds. Overall about 17% of the bonds are investment grade and 72% are domiciled within the US. The fund utilizes 14% leverage and has an expense ratio of 1%. The distribution is 8.6% with no ROC. The effective leveraged duration is 5.5 years. Credit Suisse Asset Management Income (NYSEMKT: CIK ). This CEF sells at a discount of 16.1%, which is a much larger discount than the 5-year average discount of 2.5%. The holdings consists of 209 securities with 69% in high yield bonds and 24% in short term debt. About 78% of the holdings are domiciled within the US. The fund uses 11% leverage and has an expense ratio of 0.7%. The effective leveraged duration is 3.3 years. The distribution is 9% with a small amount (less than 7%) coming from ROC. BlackRock Corporate High Yield (NYSE: HYT ). This CEF sells at a discount of 15.1%, which is a much larger discount than the 5 year average discount of 4.6%. The fund holds 902 securities, with 83% in high yield bonds, 4% in investment grade bonds, 7% in equities, and 5% in preferred stock. About 82% of the holdings are domiciled within the US. The fund uses 31% leverage and has an expense ratio of 1.3%. The effective leveraged duration is 5.3 years. The distribution is 8.4% with only a small amount (less than 2%) coming from ROC. Credit Suisse High Yield Bond (NYSEMKT: DHY ). This CEF sells at a discount of 12.3%, which is unusual since over the past 5 years this fund has averaged a premium of 2.4%. The fund has a portfolio of 223 securities with 80% in high yield bonds and 15% in debt instruments. About 86% of the holdings are domiciled within the US. The fund uses 33% leverage and the expense ratio is 2%. The leveraged effective duration is 2.7 years. The distribution is 12.2% with a small amount (less than 10%) coming from ROC. To assess the performance of the selected CEFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the component funds over the past 5 years. The risk free rate was set at 0% so that performance could be easily assessed. This plot is shown in Figure 3. Note that the rate of return is based on price, not Net Asset Value (NAV). (click to enlarge) Figure 3. Risk versus Reward over past 5 years The plot illustrates that the high yield bonds have booked a wide range of returns. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 3, I plotted a red line that represents the Sharpe Ratio associated with HYG. If an asset is above the line, it has a higher Sharpe Ratio than HYG. Conversely, if an asset is below the line, the reward-to-risk is worse than HYG. Similarly, the blue line represents the Sharpe Ratio associated with HYT. Some interesting observations are evident from the figure. High yield CEFs are substantially more volatile than HYG. This is not surprising since CEFs can sell at discounts and many use leverage. The only CEF that had a higher absolute return than HYG was HYT. However, HYT was more volatile than HYG so HYG easily outperformed HYT on a risk-adjusted basis. Among the CEFs, HYT was the least volatile and had the highest return. Thus, HYT easily beat the other CEFs on a risk-adjusted basis. One of the reasons for HYT’s outperformance may have been its equity stake. The volatilities of most CEFs (except for HYT and DHY) were tightly bunched but the returns were widely different. The top 3 CEFS in order of risk-adjusted performance were HYT, AWF, and EAD. DHY came in fourth. The worst performer was MHY. That may be one of the reasons it had the largest negative Z-score. Since all the funds were associated with high yield bonds, I wanted to assess how much diversification you might receive by buying multiple funds. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds. The results are presented in Figure 4. (click to enlarge) Figure 4. Correlation over the past 5 years The figure presents what is called a correlation matrix. The symbols for the funds are listed in the first column on the left side of the figure. The symbols are also listed along the first row at the top. The number in the intersection of the row and column is the correlation between the two assets. For example, if you follow MHY to the right for three columns you will see that the intersection with DHY is 0.453. This indicates that, over the past 5 years, MHY and DHY were only 45% correlated. Note that all assets are 100% correlated with themselves so the values along the diagonal of the matrix are all ones. As shown in the figure, the CEFs are not very correlated with HYG or among themselves. This is a little surprising but indicates that you can obtain diversification by purchasing more than one of these funds. As a final analysis, I looked at the past 3 years. From Figure 1, I knew that this period had not been kind to high yield bonds but I wanted to how the funds held up relative to one another. The results are shown in Figure 5. (click to enlarge) Figure 5. Risk versus Reward over past 3 years What a difference a couple of years made! Over the past 3 years, only HYG and HYT were able to keep above water. AWF and DHY almost broke even but the rest had negative returns. Again, if you wanted to establish a high yield CEF position, HYT would have been your best bet. Bottom Line High yield bond CEFs can have a number of benefits as long as the risks are understood. In a robust economy there is the possibility of capital gains when prospect of companies improve and their bond ratings are upgraded. However, the reverse is also true when there is a recession. Currently, high yield CEFs are selling at historically large discounts and if you believe that neither interest rate hikes nor an economic recession is in the cards, then it may be time to consider these beaten down funds. Based on past performance, HYT clearly offered the best value in this sample of high Z-score CEFs. No one knows the future but in the past, HYT has consistently outperformed its peers on a risk-adjusted basis. But make no mistake, these are highly volatile assets and if you decide to add them to your portfolio, they will need to be managed carefully. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in HYT over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.