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The Generation Portfolio: Wells Fargo, Disney, MFA Financial, Bristol-Myers Squibb

Summary Last week provided some good buying opportunities, but they became fewer as the week went along. I used the market volatility to add Disney, Wells Fargo, Bristol-Myers Squibb, and MFA Financial to the Generation Fund. The next two weeks are likely to provide more buying opportunities as the markets strive for clarity from the Fed about the timing of the first rate hike. As I explained at some length in my recent article ” The Generation Portfolio ,” I am managing a portfolio of stocks in which I do not have a personal interest for another party. The goal of the portfolio is to create a low-risk income generating machine populated with a core of Quality Stock plays. I began the portfolio from scratch during the week of 24 August 2015, though it had a large legacy position of Ford Motor Company (NYSE: F ) stock that is untouchable. I will use these updates to show what I have done with the positions and give my general strategy and thoughts on the market. Market Summary The week of 24 August 2015 was volatile. The Friday before, the market sold off heavily, and anxiety built up during the weekend. Monday morning saw a “flash crash” in which stocks and other securities either opened late or opened with unusual drops in price. However, those prices easily were the lows of the entire week. The next several days were extremely volatile, with the market rallying into a status quo Friday. For the week, the market was up slightly, but overall the market remains well off its highs. Long-Range Objective for the Generation Fund I intend to form a hard core of at least 50%-75% Quality Stocks, and around that orbit a number of more speculative REITs and other plays for cash flow. This objective is subject to tweaking. Transactions I was unable to log in first thing Monday morning, like many other traders. Once I got in, the market was too volatile for me to get a good read, so I placed no trades that day. On Tuesday afternoon, the market seemed to be providing some more good opportunities. I placed four limit orders and picked up average-sized positions (as discussed in my previous article) in the following: Wells Fargo (NYSE: WFC ) Disney (NYSE: DIS ) MFA Financial (NYSE: MFA ) Bristol-Myers Squibb Co (NYSE: BMY ) Those positions remain in the account and, including the Ford stock, are the only positions I am tracking here (there also are some other minor legacy positions). Those positions constitute roughly 10% of the entire tradeable funds as of the time of writing, the rest of the Generation Portfolio remains in cash. Analysis of Trades Due to the subsequent market rally on Wednesday and Thursday, all new positions in the Generation Portfolio show a profit. Basically, with few exceptions, the market lifted all boats on those days. This simply illustrates that timing is the most important part of trading, and you don’t need to be much of a stock picker if you can ride the general market waves higher. I placed all the trades on Tuesday, using limit orders. With a few hours left in the trading day I staggered the limit price distance from then-current prices, not expecting to pick up all four unless there was a major sell-off in the final hour of trading. So, one order was roughly .25% below the current price of the stock, the other .50% below, and so forth. Normally, those types of orders would not hit due to lack of volatility. As it turned out, a major sell program hit an hour before the close of trading, and – to my surprise – all four limit orders hit, the final one a limit order I had set a full 1% below the market price at the time, were filled. Reasons for Picking Up Those Stocks Basically, as events subsequently transpired, I could have bought practically anything when I did and the rising market would have turned them into quick winners. I consider BMY, DIS and WFC to be “Quality Stocks” as I have defined that term in my recent article linked above, and all were down substantially from their highs when I placed my limit orders. As for MFA, I recently wrote about that mortgage REIT here . It has been around as long as Annaly (NYSE: NLY ), surviving numerous Fed actions, giving me confidence in its survivability come what may. It also appeared to be heavily oversold on the chart, more so than the other REITs I am interested in. Quality of the Trades Overall, it was a successful week. My intention was to go slower than turned out to be the case in populating the Generation Portfolio, spreading it out over time more with maybe one transaction a week, but the opportunities proved irresistible. As the old military aphorism goes, no plan survives contact with the enemy. Regrets were entirely along the line of missed opportunities. I intended to pick up some Apple (NASDAQ: AAPL ), but never found a comfort zone with it. Most of the huge bargains that some traders were bragging about during the happened only during the first half hour of trading, when I was off-line. Still, I should have grabbed some, and that is the main regret for the week. Overall, only buying 10% of the Generation Portfolio’s tradeable value (less the Ford position) during a week of such bargains may seem like a missed opportunity. Perhaps it was, but I anticipate further volatility ahead, as discussed below. If not, there is nothing wrong with waiting. The Week Ahead The market likely is to be preoccupied throughout the week of 31 August with the August employment numbers that are due out on Friday. The importance of that report was heightened by an interview given on Friday 28 August to CNBC by Fed Vice Chair Stanley Fischer, and other remarks that he made on Saturday . While, as one would expect, Fischer was cagey about the likelihood of a September rate hike, one thing that he said during his CNBC interview stood out. When asked about the importance of data between the time of the interview and the Fed meeting on 15/16 September in influencing a rate hike at that meeting, Fischer said: Well, we’ve got to take data into account. Those are the only things we really have, that and our economic analysis. And if a decision is close, it will be influenced by data that [have] come in recently. Pretty much everybody expects the decision to be “close.” Since the Fed has not made a decision about rates, and Fischer stated that the data leading into the data could be decisive, that puts immense influence on the Friday jobs report. Given that statement by vice chair Fischer, I would not be surprised by some volatility both ahead of the report and immediately after its release. The consensus figure for the September 2015 jobs report is 223k jobs added, up from the 215k figure reported in August. The market easily could interpret anything above 190k jobs added as locking in Fed action. The other major market-moving event in September, aside from the Fed meeting itself, could be the government deadline for raising the debt ceiling. The Congressional Budget Office projects the debt ceiling being hit either in mid-November or December. With several US Senators running for President, Presidential politics could enter the Calculus and cause some posturing that rattles the market as has happened before. One other major factor is the statistical fact that, historically, September is the worst month for stock gains. Combined with volatility overseas in China and other Asian markets, September could provide several buying opportunities. Universe of Stocks Under Consideration The stocks at the top of my list change slightly from week to week: AAPL, MMM, JPM, JNJ, NKE, ABT, UNH, XOM, CVX, PG, PSX, UTX, EMR, PEP, GILD, UNP, RDS.B, KMI, CAT, KO, T, STWD, OXY, COP, KKR, NFLX, WMT, PANW, MO, HD, PBY, EV, SCG, DLR, KSS, BPL, OHI, ETN, PFE, GIS, KMB, CAH, TOL, FCX, CYS, NLY, AGNC. These are stocks that I am most interested in and have performed due diligence on, but market opportunities may present in other stocks as well. Important Upcoming Ex-Dividend Dates 2 September: Baxter International (NYSE: BAX ) PepsiCo, Inc. (NYSE: PEP ) Coca-Cola Enterprises, Inc. (NYSE: CCE ) 9 September: Occidental Petroleum (NYSE: OXY ) 11 September: The Coca-Cola Co. (NYSE: KO ) General Discussion I was caught completely flat-footed by the market break on Monday 24 August 2015. After I finally got into my account, prices were racing higher like a car speeding along without a driver. Charts were taking several minutes to call up, making them useless. Basically, Monday was a lost day for trading, but fortunately there was no harm done. The major lesson of the market during the week was that corporations are watching their stock prices closely for opportunities. The Goldman Sachs buyback desk had its busiest day ever on Wednesday, when the market finally resolved its weakness to the upside. People always talk about a government “plunge protection team,” but the true supporters of the market are companies using cheap credit to buy back their own stock. My sense is that anything related to financials is going to be weak during early September. While some asset classes, such as REITs, appear to have priced in much of a September rate hike, other classes might not have done so yet. When vice chair Fischer said during his CNBC interview that market volatility would play a role in whether the Fed acted, I was surprised. That seems like a screwy rationale for raising or not raising rates. He may have said that just to calm the markets, which seemed to be a major objective of Fed personnel past and present during the week. If the Fed needs market volatility to postpone a rate hike, I’m sure the market would be happy to oblige. The key for the market is the uncertainty about what might happen, not what will actually happen. Fischer eliminated one potential uncertainty when he said that rates would rise in 25 basis point increments, but that was a minor point. At this point, it may be just as important what the Fed says about a second rate hike as whether it does one in September at all. The market hates uncertainty, so my focus this week heading into the all-important jobs number will be on interest-rate sensitive stocks such as banks and REITs. It is more likely than not that a new trading range will develop in the vicinity of current levels. My eye, along with everyone else’s, has been on the energy sector. As usual, the market seized on some transient concern – Saudi Arabian troop movements, a call for an emergency meeting of OPEC – to force shorts to cover. The supply/demand imbalance continues, though, so unless the energy market finds some new worry, the current rally is likely to fizzle. In addition, the Iran deal is a lock, and that will release even more oil into the market, so I am in no rush to add the oil plays I covet, including Exxon (NYSE: XOM ) and Chevron (NYSE: CVX ). The bottom line is that the market has its eye on the Fed, and until that clarifies, the trend into the end of the year will remain unclear. Actionable Ideas I still will be keeping an eye on Apple for any buying opportunities. The REITs such as CYS, NLY and AGNC are buys on dips, as is OHI. Realty Income (NYSE: O ) I would like in the low 40s. PEP will be of interest on a dip into the 80s, where it has support. MMM around 140 would be interesting, as would JP Morgan (NYSE: JPM ) in the low 60s. Looking through the charts, there still are a number of stocks near enough to their peaks that further distribution would not be unusual at all. September definitely is a month to be opportunistic. Conclusion Last week was a successful week of trading, but volatility still looms from multiple sources. Anyone thinking that we are headed straight back to all-time highs is much more bullish than I am. The next two weeks are more likely to be a good time to be opportunistic and grab some plays on dips, especially as the market dates of doom – the jobs report and the Fed meeting – approach. Disclosure: I am/we are long CYS. (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. Additional disclosure: The positions being discussed are for a portfolio I manage for someone else, not my own holdings.

Finding Bargains Among High Income CEFs Selling At Historic Discounts

Summary The discounts associated with CEFs are at historic highs, with many discounts over 2 standard deviations from the mean. The highly discounted CEFs have been significantly more volatile than high yield bonds. MGU and GLO had the best risk-adjusted performance among the CEFs analyzed. As an income focused investor, I was a fan of high distribution Closed End Funds (CEFs). Many of these funds have been hit hard by the Fed’s plans to increase interest rates. As the prices deteriorated, the discounts of these CEFs have widened to historically large levels. This is evidenced by their Z-score, a statistic popularized by Morningstar to measure how far a discount (or premium) is from the mean 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 good source for Z-scores is the CEFAnalysis website . (Thanks to SA author, Left Bank, for his article on where to find Z-scores). A Z-score more negative than minus 2 is relatively rare, occurring less than 2.25% of the time. However, in today’s environment, there are over 150 CEFs that have one year Z-scores more negative than minus 2, which illustrates the current lack of demand for these CEFs. There were too many CEFs to analyze so I reduced the sample size by using the following selection criteria: A Z-score more negative than minus 2.9. This will occur (assuming a normal distribution) less than 0.2% of the time. A history that includes October 12, 2007 (the beginning of the 2008 bear market) A daily average volume greater than 100,000 shares A market cap of at least $100 million. A distribution of 6% or higher The following CEFs satisfy all these criteria. Clough Global Opportunities Fund (NYSEMKT: GLO ). The CEF sells at a discount of 16.7% and has a Z-score of negative 3.59. This CEF has a “go anywhere” philosophy and has a portfolio of 167 securities, with 60% allocated to the equities, 28% to cash alternatives, and 7% to bonds. The fund may also use an option strategy to increase income. The fund uses a high leverage of 52% and has an expense ratio of 2.2%. The distribution is 10.7%, consisting primarily of gains and Return of Capital (ROC). Over the past year, ROC has been used 50% of the time, with the amount of ROC ranging from 30% to 100%. Invesco Credit Opportunities Fund (NYSE: VTA ). This CEF sells at a discount of 15.3% and has a Z-score of negative 3.59. It has a portfolio of 610 securities invested primarily in senior loans (76%) and high yield bonds (18%). The fund uses 33% leverage and has an expense ratio of 2.5%. The distribution is 8.2% with no ROC. Madison Covered Call and Equity Strategy Fund (NYSE: MCN ). This CEF sells at a discount of 15.1% and has a Z-score of negative 3.3. The portfolio consists of 47 securities, with 78% in equities and 20% in short-term debt. The fund does not use leverage and has an expense ratio of 0.8%. The distribution is 9.7% with no ROC. LMP Corporate Loan Fund (NYSE: TLI ). This CEF sells for a discount of 13% and has a Z-score of negative 3.25. The portfolio consists of 268 securities invested primarily in senior loans (87%) and high yield bonds (8%). The fund uses 33% leverage and has an expense ratio of 1.8%. The distribution is 8.4% with no ROC. Macquarie Global Infrastructure Total Return Fund (NYSE: MGU ). This CEF sells for a discount of 16.9% and has a Z-score of negative 3.09. The fund is concentrated with 51 holdings in infrastructure companies (89%) and 6% in master limited partnerships. The fund uses 30% leverage and has an expense ratio of 2.2%. The distribution is 7%, paid from income and capital gains with no ROC. Calamos Convertible Opportunities and Income Fund (NASDAQ: CHI ). This CEF sells at a discount of 11.2% and has a Z-score of negative 3.04. The portfolio consists of 287 securities, with 57% in convertible bonds and 38% in high yield bonds. The fund uses 28% leverage and has an expense ratio of 1.5%. The distribution is 10.8% with 2 months of ROC during the past year. MS Emerging Markets Debt Fund (NYSE: MSD ). This CEF sells for a discount of 18.3% and has a Z-score of negative 2.95. The portfolio consists of 115 emerging market holdings, with 41% investment grade bonds and the rest in high yield bonds. The fund uses only 8% leverage and has an expense ratio of 3.5%. The distribution is 6.6% with no ROC. GDL Fund (NYSE: GDL ). This CEF sells for a discount of 18.1% and has a Z-score of negative 2.9. The fund seeks total return by using arbitrage transactions and investing in reorganizations and spinoffs. It has 159 holdings, with 75% in equity and 21% in Government bonds. It uses 35% leverage and has an expense ratio of 3%. The distribution is 6.5% with only a small amount of ROC over the past year (the distribution for one quarter had 25% ROC). Based on the Z-score, these high income CEFs appear to be bargains, but Z-score is only one metric to consider. I also like to look at the reward-versus-risk over different time frames. In my mind, the best fund is the one that delivers the highest reward for a given level of risk. This article will analyze these CEFs in terms of risk-versus-reward to help you determine which may be right for your portfolio. 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 bear-bull cycle (from October 12, 2007 to August 28, 2015). The risk free rate was set at 0% so that performance could be easily assessed. This plot is shown in Figure 1. Note that the rate of return is based on price, not Net Asset Value (NAV). I used the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ) as a reference. (click to enlarge) Figure 1. Risk versus Reward over the bear-bull cycle The plot illustrates that these CEFs 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 1, 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. Some interesting observations are evident from the figure. High Z-score CEFs are substantially more volatile than HYG. This is not surprising since CEFs can sell at discounts and many use leverage. With the exception of VTA, the CEFs had larger absolute returns than HYG. However, when volatility is factored into the calculation, only 4 CEFs (GDL, GLO, MGU, and MSD) beat HYG on a risk-adjusted basis. Two other CEFs (TLI and MCU) had risk-adjusted performances similar to HYG. Among the CEFs, MSD was the best performer followed by GLO, MGU, and GDL. The worst performer on a risk-adjusted and absolute basis was VTA. These funds utilized different investment strategies, so 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. For reference, I also included the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as a proxy for the overall stock market. The results are presented in Figure 2. (click to enlarge) Figure 2. Correlation over the bear-bull cycle 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 VTA to the right for three columns, you will see that the intersection with GLO is 0.650. This indicates that, over the past bear-bull cycle, the price of VTA and GLO were 65% 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 were not very correlated with HYG or among themselves. The highest correlation was between SPY and GLO, which was expected since GLO contained a large position in equities. The overall conclusion is that you can obtain diversification by purchasing more than one of these funds. Next, I wanted to see how these funds fared during more recent times so I used a 5-year look-back period. The results are shown in Figure 3 and what a difference a few years made. The CEFs are still more volatile than HYG, but HYG now beats all the CEFs in terms of risk-adjusted performance. MSD fell from being the best performer to the worst, and VTA moved up from being at the bottom to the third best. MGU had by far the best risk-adjusted performance among the CEFs, with GLO coming in second. GDL was again the least volatile but also did not have a high return. (click to enlarge) Figure 3. Risk versus reward over past 5 years My final analysis used a 3-year look-back period, and the results are shown in Figure 4. During this period, GLO, MGU, and MCN were the top performers on a risk-adjusted basis. These CEFs outperformed HYG on both an absolute and risk-adjusted basis. MSD continued its poor performance, booking a negative return. (click to enlarge) Figure 4. Risk versus reward over the past 3 years Bottom Line These large Z-score CEFs had a wide range of performance relative to each other and to HYG. All of these CEFs are much more volatile than high yield bonds so they would only be suitable for risk tolerant investors. These CEFs are at historically wide discounts and may be bargains in terms of discounts but their overall performance left something to be desired. If you want to take a gamble on these funds, I would recommend MGU. GLO could also be considered, but I am a little cautious of this fund’s ROC. No one can predict the future, but based on the past, these two CEFs have consistently outperformed their peers on a risk-adjusted basis. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MGU 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.

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.