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A Diversified, High-Income Bond Portfolio For 2015

Summary A portfolio of selected bond CEFs provides an average distribution of 8.6%. Since 2007, the composite portfolio of selected bond CEFs outperformed HYG, the popular high-yielding bond ETF. Bond CEFs offer excellent diversification when included in a traditional high-yield bond portfolio. I recently wrote an article on a diversified closed-end fund (CEF) portfolio that included a range of equity funds but had only 28% of the assets allocated to bonds. I realized that many retirees would like to have a higher percentage in bonds, so I wrote this article, which focuses exclusively on bond CEFs. I chose only funds that were in existence during the 2008 bear market so that I could judge performance during a recessionary period. Other criteria included: An average daily volume of at least 100,000 shares per day to facilitate liquidity A distribution of at least 6% without excessive amounts of Return of Capital (ROC) A market cap of at least $150 million, but the larger the better A premium of no more than 5% Using these criteria, I then selected funds that would provide a diversified mix of: government and corporate bonds from both the U.S. and internationally, asset-backed bonds, convertible bonds, and senior loans. The 10 CEFs that I chose are summarized below. There is a large universe of bond CEFs, so I welcome alternative suggestions from readers. BlackRock Duration Income Trust (NYSE: BLW ): This CEF sells for a discount of 8.2%, which is a substantially larger discount than the 3-year average discount of 1.7%. The fund concentrates on intermediate-duration debt securities and senior loans. It has a portfolio of 873 securities, with 41% invested in corporate bonds, 32% in loans, and 12% in asset-backed bonds. About 25% of the portfolio is investment-grade. In 2008, the price of this fund dropped about 25%. The fund utilizes 30% leverage and has an expense ratio of 1.1%. The distribution is 7.6%, funded by income with no ROC. Calamos Convertible Opportunities & Income Fund (NASDAQ: CHI ): This CEF sells for a small premium of 1.1%, which is in contrast to 0.1% average discount over the past 3 years. The fund has a portfolio of 278 securities, with 53% in convertible bonds and 41% in corporate bonds. Only about 17% of the portfolio is rated investment-grade. In 2008, the price of this fund dropped 35%. The fund utilizes 28% leverage, and has an expense ratio of 1.5%. The distribution is 8.9%, funded mostly by income but with some ROC. Calamos Convertible & High Income Fund (NASDAQ: CHY ): This CEF sells at a premium of 3.4%, in contrast to a 3-year average discount of 3.7%. The fund has a portfolio of 277 securities, with 59% in convertibles and 36% in corporate bonds. Only about 15% of the bonds are investment-grade. This fund dropped 27% in price during 2008. It utilizes 28% leverage, and has an expense ratio of 1.5%. The distribution is 8.6%, funded primarily from income, but with some ROC. This fund is about 74% correlated with its sister fund CHI. Western Asset Global High Income Fund (NYSE: EHI ): This CEF sells for a discount of 8.8%, which is a greater discount than the 3-year average discount of 4%. The fund has a portfolio of 558 securities, with 77% in high-yield bonds and 16% in government bonds. This fund lost 30% in 2008. It utilizes 22% leverage, and has an expense ratio of 1.5%. The distribution is a high 10.6%, funded by income with no ROC. Wells Fargo Advantage Multi-Sector Income Fund (NYSEMKT: ERC ): This CEF sells at a discount of 11.5%, which is a larger discount than the 3-year average discount of 8.8%. The fund has a portfolio of 679 securities, spread among corporate bonds (54%), government bonds (19%), senior loans (12%), and asset-backed bonds (6%). About 36% of the holdings are investment-grade. The fund only lost 20% in 2008. It utilized 25% leverage, and has an expense ratio of 1.2%. The distribution is 8.5%, funded by income with no ROC. Eaton Vance Limited Duration Income Fund (NYSEMKT: EVV ): This CEF sells at a discount of 10.8%, which is a larger discount than the 3-year average discount of 4.4%. The fund has a large portfolio of 1692 securities spread across loans (38%), corporate bonds (35%), and asset-backed bonds (24%). About 32% of the holdings are investment-grade. The price of this fund dropped 27% in 2008. The fund utilizes a relatively high 40% leverage, and has an expense ratio of 1.7%. The distribution is 8.7%, funded primarily by income, with a very small ROC component. Western Asset Emerging Markets Debt Fund (NYSE: ESD ): This CEF sells at a discount of 11.1%, which is a larger discount than the 3-year average discount of 7.2%. The fund has a portfolio of 222 securities, with 54% in government bonds, and 46% in corporate bonds. About 64% of the bonds in the portfolio are rated investment-grade. This fund only lost about 20% in 2008. The fund only uses 10% leverage, and has an expense ratio of 1%. The distribution is 8.7%, funded by income with no ROC. MFS Charter Income Trust (NYSE: MCR ): This CEF sells at a discount of 11.7%, which is a larger discount than the 3-year average discount of 7.8%. The fund has a portfolio of 857 securities, with about 45% in corporate bonds, 12% in government debt, and 35% in foreign securities. About 34% of the portfolio is investment-grade. The fund utilizes 15% leverage, and has an expense ratio of 0.9%. The distribution is 6.2%, funded by income with no ROC. PCM Fund (NYSE: PCM ) : This CEF sells at a discount of 1.3%, which is well below the 3-year average premium of 5.8%. The fund focuses on commercial mortgage backed securities and non-investment grade securities. The portfolio is spread over 247 holdings, with 82% in asset-backed bonds and 18% in corporate bonds. About 35% of the holdings are investment-grade. The price of the fund dropped about 30% in 2008. The fund utilizes 32% leverage, and has an expense ratio of 2%. The distribution is 9%, with only a small ROC component. PIMCO Income Opportunity Fund (NYSE: PKO ): This CEF currently sells at a discount of 2.2%, which is in contrast to the 3-year average premium of 2.5%. The portfolio has 470 holdings allocated primarily among asset-backed bonds (42%) and corporate bonds (40%). Only about 30% of the holdings are investment-grade. The price of the fund dropped 24% in 2008. The fund utilizes 38% leverage, and has an expense ratio of 1.9%. The distribution is 8.3%, with only a small return of capital component. For comparison with other popular high-yield bond funds, I also added the following Exchange Traded Fund (ETF) to my analysis. iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ): This ETF tracks an index of about a thousand high-yield U.S. corporate bonds across all sectors of the economy. The fund does not use leverage, and has an expense ratio of 0.5%. It yields 5.7% without any ROC. During 2008, the price of this ETF dropped by 17%, but the NAV dropped by 23%. It is unusual for an ETF to have a large difference between price and NAV, but this just illustrates the dislocations that occurred during the 2008 bear market. Composite Portfolio If you equal-weight each of the selected CEFs, the resulting composite portfolio has the allocations shown graphically in Figure 1. As you can see, the composite portfolio is well diversified. Numerically, the allocations are: 5% U.S. government, 30% corporate, 16% asset-backed, 11% convertibles, 9% senior loans, 9% foreign government, 16% foreign corporate, and 4% other (cash, preferred issues, etc.). Personally, I would have liked a larger allocation to U.S. government bonds, but it was difficult to find Treasury-focused funds that had distributions exceeding 6%. Overall, this portfolio had 31% investment-grade securities. Figure 1: Composition of bond portfolio The composite portfolio has an average distribution of 8.6%, which certainly meets my criteria for high income. But total return and risk are as important to me as income, so I plotted the annualized rate of return in excess of the risk-free rate (called Excess Mu in the charts) versus the volatility for each of the component funds. I used a look-back period from October 12, 2007 (the market high before the bear market collapse) to 21 January, 2015. The Smartfolio 3 program was used to generate the plot shown in Figure 2. (click to enlarge) Figure 2: Risks versus rewards over the bear-bull cycle The plot illustrates that the CEFs have booked a wide range of returns and volatilities since 2007. 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 2, 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. Over the bear-bull cycle, all the individual bond CEFs were more volatile than HYG. However, when combined into an equally weighted composite portfolio, the volatility was only slightly more than HYG. This is an illustration of an amazing discovery made by an economist named Markowitz in 1950. He found that if you combined certain types of risky assets, you could construct a portfolio that had less risk than the components. His work was so revolutionary that he was awarded the Nobel Prize. The key to constructing such a portfolio was to select components that were not highly correlated with one another. In other words, the more diversified the portfolio, the more potential volatility reduction you can receive. Some other interesting observations are evident from the figure. All the bonds CEFs had a higher volatility than HYG, but in each case, this was coupled with a higher return. All the CEFs except for CHI were above the “red line,” which means that the investor was adequately compensated for increased risks. The best-performing bond CEF on a risk-adjusted basis was MCR, but PKO was not far behind. The worst-performing bond CEF was CHI, which had a higher return than HYG, but a much larger volatility. This caused the risk-adjusted return associated with CHI to lag slightly behind HYG. The least volatile bond CEF was MCR, and the most volatile was CHI. The composite portfolio handily outperformed HYG on a risk-adjusted basis. I next wanted to assess the diversification of this portfolio. To be “diversified,” you want to choose assets such that when some of them 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 data is presented in Figure 3. All the CEFs had relatively low correlations with HYG (in the 40%-60% range). This bodes well for including these CEFs in a more traditional high-yield bond portfolio. Among the CEFs, the correlations were also low, with only a few above 70%. Overall, these results were consistent with a well-diversified portfolio. (click to enlarge) Figure 3: Correlations over the bear-bull cycle My next step was to assess this portfolio over a shorter time frame when the stock market was in a strong bull market. I chose a look-back period of 5 years, from January 2010 to January 2015. The data is shown in Figure 4. During this period, the bond CEFs did not fare as well, with many of the CEF booking a risk-adjusted performance less than HYG. Only 3 of the CEFs (CHY, PKO, and PCM) outperformed HGY. However, I was happy to see that the combined portfolio continued to outperform HYG during this bull market period. (click to enlarge) Figure 4: Risks versus rewards over the past 5 years Based on the above, I wanted to see if the outperformance continued during the more recent past. I next used a look-back period of 3 years, and the results are shown in Figure 5. As you might have expected, HYG had an impressive run during this strong bull period. Only the convertible CEFs (CHI and CHY) were able to keep pace on a risk-adjusted basis. However, as with the 5-year period, the combined portfolio performed well, lagging HYG by only a small amount on a risk-adjusted basis. The major detriment to the portfolio performance was ESD, which has had a horrible 3 years, just barely managing to remain in the black. This was because of a general sell-off in emerging market assets that has only recently abated. Many investors might be tempted to drop ESD from the portfolio, but I am inclined to give it the benefit of the doubt with the expectation that emerging markets may recover in the future. Overall, I continue to be pleased with the portfolio performance. (click to enlarge) Figure 5: Risks versus rewards over the past 3 years Bottom Line The bond CEFs in this portfolio were all volatile, and taken individually, they would not be suitable for a risk-averse investor. As discussed, most of these funds also had substantial losses during 2008. However, if you risk profile allows you to purchase high-yield bonds, the composite portfolio delivered some excellent risk-adjusted performances over the periods analyzed. No one know how this portfolio will perform in the future, but based on past history, I believe it is worthy of consideration for an income investor who is also seeking total return at a reasonable risk.

Telecom ETFs To Watch After Dull Verizon Earnings

Verizon Communications Inc . (NYSE: VZ ), the largest U.S. wireless carrier, has come out with lukewarm earnings for the fourth quarter of 2014. While the company managed to surpass the Zacks Consensus Estimate for revenues, it reported in line earnings results. Verizon Earnings in Details Excluding one-time items (pension and other post-employment benefit liabilities), adjusted earnings per share came in at 71 cents, up 7.6% from adjusted earnings of 66 cents per share in Q4 2013. Adjusted earnings were in line with the Zacks Consensus Estimate. Verizon however posted a net quarterly loss of $2.23 billion or 54 cents per share as against a profit of $1.76 per share in the year-ago-quarter, largely attributable to costs incurred for employee pensions and severance. Quarterly revenues increased 6.8% year over year to $33,192 million, beating the Zacks Consensus Estimate by 2%. The year-over-year rise was driven by increased demand for Verizon Wireless and its high-speed FiOS Internet services. During the reported quarter, the company added 2 million postpaid customers as compared to 1.5 million subscribers added in the last quarter. However, profit margins at its wireless business contracted to 42% in the fourth quarter from 47% in the year-ago period. Also, the quarterly retail postpaid churn rate, the percentage of subscribers who switched to another wireless provider, increased to 1.14% from 0.96% in the year-ago quarter. On the wireline side, the company added net 116,000 FiOS video subscribers, 145,000 FiOS Internet subscribers and 88,000 FiOS digital video residence connections. ETF Impact Despite reporting in line earnings results, Verizon’s share price closed roughly 1% lower on concerns of lower revenue growth at the wireless segment, higher churn rate, added customer acquisition costs and provision for pension payment. Investors seem to be worried about the ongoing wireless price war, which might affect margins further. Other telecom players like AT&T (NYSE: T ) and Sprint (NYSE: S ) also fell 0.62% and 2.3% respectively, following Verizon’s uninspiring results. However, T-Mobile (NYSE: TMUS ) rose 1.40% in yesterday’s trading session. Given the mixed reaction from the telecom players, Telecom ETFs closed marginally higher on Thursday’s trading session. Below, we have highlighted three telecom ETFs with the largest allocation to Verizon. Investors should keep a close eye on these ETFs as they might face volatile trading in the days ahead, given that AT&T is also set to report results towards the end of the month. ETFs to Watch Vanguard Telecommunication Services ETF (NYSEARCA: VOX ) The most popular telecom ETF – VOX – tracks the MSCI US Investable Market Telecommunication Services 25/50 Index and holds 31 stocks in its basket. Verizon occupies the top position in the basket with 22.2% of assets. Sector-wise, about two-thirds of the portfolio is skewed toward integrated telecom services, followed by alternative carriers and wireless telecommunication services. The product has amassed $841.6 million in its asset base and charges 14 bps in annual fees. VOX gained 0.65% in yesterday’s trading session and is up nearly 2% in the year-to-date time frame and has a Zacks ETF Rank of 3 or ‘Hold’ rating with a ‘Medium’ risk outlook. Fidelity MSCI Telecommunication Services Index ETF (NYSEARCA: FCOM ) This fund follows the MSCI USA IMI Telecommunication Services 25/50 Index, holding 30 stocks in its basket. Verizon takes the second spot at 21.5% and, from a sector look, diversified telecom services makes up for 81% of assets. The ETF manages an asset base of just $86.4 million in AUM while the expense ratio is 0.12%. The fund has gained over 2% year to date and currently has a Zacks ETF Rank of 3. iShares U.S. Telecommunications ETF (NYSEARCA: IYZ ) This is also one of the most popular ETFs in the broad telecom space with an AUM of $570 million. The product provides investors exposure to 26 telecom stocks while charging 45 bps in fees and expenses. Verizon takes the top spot in the basket with a 12.9% share. In terms of sector exposure, diversified telecom services accounts for 70% while wireless telecom services takes the rest. IYZ is up 1.4% so far this year, and has a Zacks ETF Rank of 3 or ‘Hold” rating with a ‘Medium’ risk outlook.

Southern Company Retains Appeal For Long-Term Investors

Summary Southern Company’s near-term may remain overshadowed due to ongoing construction projects. Ongoing capital expenditures will fuel rate base and long-term earnings growth. Attractive dividend yield of 4.1% makes SO a good investment for dividend-seeking investors. Southern Company (NYSE: SO ) is one of the leading energy companies in the U.S. utility sector. The company’s solid fundamental outlook is supported by its accelerated capital expenditures for several energy projects. In the near term, the company’s stock price can come under pressure due to its risk in delay and cost overruns for its ongoing projects, Kemper and Vogtle. But in the long run, once these projects are completed, they will help the company grow its rate base and fuel earnings growth. Also, as the company’s capital expenditures have been fueling its EPS growth, it will also fuel dividend growth for the company in the future. Currently, the stock has a dividend yield of 4.1%, which makes it attractive for dividend investors. Also, the low treasury yield environment will support the utility sector and SO’s performance in 2015. The following graph shows the low U.S. 10-year treasury yield. (click to enlarge) Source: Yahoo Finance Investors Have a Secure Long-Term with SO The company has been making capital expenditures to strengthen its electricity generation portfolio. Capital expenditures, which the company is making, are focused towards regulated operations, which will provide stability to its cash flows and earnings. The capital expenditures will also fuel long-term earnings growth for the company. As far as SO’s 582MW Kemper project is concerned, the project has been subjected to ongoing cost revisions and delays, and the issues of delays and cost overruns still prevail. As per the revised estimates, the project’s total cost will now reach $6.1 billion, an increase of $330 million as compared to previous estimates. However, the project is near completion and is expected to be completed by the end of 1H’15. In addition, the company is in the process of building two new nuclear power plants, Vogtle 3 and 4, with a power generation capacity of 2,200MW . These nuclear projects were previously estimated to be in running condition by the end of 2017 or 2018, but as per recent revisions, these projects are also expected to face operational delays. The Vogtle project is expected to experience a one-year delay and cost an additional $730 million to the company. Owing to these ongoing delays and expected cost increases, I believe the project will remain an overhang on its stock price performance in the near term. But in the long run, these projects will uplift SO’s production capacity and optimize its generational portfolio, which will help grow its rate base and earnings. In addition to these power generation projects, the company is bidding on the growth potentials of solar energy projects. SO is building a 131MW solar farm in Georgia, which is expected to be operational in 2016. The value of building this farm lies in generating healthy earnings growth for the company, by selling generated electricity to corporations through long-term power purchase contracts. Moreover, the company’s subsidiary Southern Power has accelerated acquisitions to improve the overall power generation capacity and to fuel its long-term earnings base growth. Southern Power won a bid for 100MW of solar projects in Georgia, and the subsidiary acquired the 150MW Solar Gen2 and 50MW Macho Spring solar facility. The company’s robust capital expenditures for future years will add to its rate base and long-term earnings growth. The company has plans to make capital expenditures of $17.4 billion from 2014-2016. The following chart shows the company’s expected capital expenditures for future. (click to enlarge) Source: Company’s Quarterly Earnings Report The company’s efforts to expand and strengthen its electricity generation portfolio will portend well for its long-term operational performance, and the capital expenditures will fuel its long-term earnings growth. Analysts are expecting a decent next five-year earnings growth rate of 3.63% for the company. Rewarding Investors SO has a strong history of rewarding its shareholders through healthy dividend payments. The company has a solid cash flow base to support its ongoing dividend increases. SO has recently announced a quarterly dividend payment of 52.50 cents . Currently, SO offers a high dividend yield of 4.10% , which is well covered by its cash flows, as indicated by the company’s strong dividend coverage ratio (Operating cash flows/ Annual Dividends) below. Based on the growth potentials of ongoing capital expenditures and large scale dependence on regulated operations, SO’s cash flow base will continue to grow at a decent pace. And owing to the company’s secure cash flow base, I believe SO’s dividends are secure and sustainable in the long run. The following table shows the company’s healthy dividend per share, dividend coverage and dividend payout ratio in the past three years, and for 2014 and 2015, based on estimates. Dividend Per Share Dividend Payout Ratio Dividend Coverage 2011 $1.87 73% 1.4x 2012 $1.94 73% 1.4x 2013 $2.01 75% 1.3x 2014(NYSE: E ) $2.10 74% 1.3x 2015( E ) $2.17 74% 1.3x Source: Company’s Annual Reports and Equity Watch Estimates Risks The company’s earnings growth faces risks of regulatory restrictions at the federal or state level, and an increase in environmental expenditure as directed by the EPA. Also, an increase in interest rates poses a risk to the stock price. Moreover, economic weaknesses in SO’s service territory are causing lower demand growth. Significant cost increases and delays due to the construction of Kemper and Vogtle plants, and unfavorable weather are key risks to the company’s future stock price performance. Conclusion The company’s near-term may remain overshadowed due to ongoing construction projects, but in the long run, as the construction projects will be completed and its generational portfolio will improve, its operational performance and stock price will be positively affected. The ongoing capital expenditures will fuel its rate base and long-term earnings growth. And as the company has significant regulated operations, it will portend well for its earnings and cash flows stability. Also, an attractive dividend yield of 4.1% makes it a good investment for dividend-seeking investors. Due to the aforementioned factors, I remain bullish on this stock.