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6 High-Yield Bond CEFs Trump ETFs Like HYG And JNK

Summary After a late 2014 sell-off, high yield bond funds currently offer very attractive mid- to high single-digit yields. Though they contain significant exposure to credit risk, high yield bonds have a relatively low sensitivity to rising interest rates. Investors interested in ETFs like HYG or JNK should consider the more than 30 closed-end funds that focus on high yield debt. Because of their unique structure, closed-end bond funds are able to generate substantially higher distribution income, sometimes with less credit or interest rate risk. High-Yield Bonds can be an important addition to a diversified taxable income-seeking portfolio, generating significant yields with less interest rate risk than alternatives including government or investment grade corporate funds. Accordingly, leading High-Yield Bond ETFs like SPDR Barclays Capital High Yield Bond ETF (NYSEARCA: JNK ) and iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ) have accumulated combined assets of more than $24 billion. However, investors – especially individual investors – in JNK and HYG should consider the closed-end fund alternatives for high yield bond income. This article will examine six closed-end funds that specialize in high yield bonds that provide superior yields with a similar risk profile. For an in-depth examination of the risks and rewards of high yield bond CEFs please refer to “In Search of Income: High Yield Bond CEFs Part I & Part II . Understanding the Closed-End Fund Structure Closed-End Funds (CEFs) are a form of mutual funds that have existed in the United States since 1893. While CEFs are actually the “original” type of mutual fund traded on US exchanges, they are far less common than the “open-ended” type of mutual funds that most investors associate with the term “mutual fund”. CEFs represent less than 2% ($298 billion) of the $15 trillion mutual fund market. CEFs are used for a variety of active strategies in both the equity and fixed income categories, and are most commonly associated with income generating strategies such as high yield bond investing. The closed-end fund structure is unique among market-listed fund structures because of its combination of three characteristics: Permanent capital – CEFs issue a fixed number of shares at IPO and do not subsequently create or redeem shares except in rare instances. This provides fund managers with permanent capital that is not subject to the whims of investor redemption requests. Continuous trading / market pricing – investors that want to transact shares of a CEF do so on the open market at any point during trading hours, buying from and selling to other individual market participants. Importantly, this leads to the existence of divergences between share price and share value NAV. Use of Leverage – CEFs frequently choose to use moderate amounts of leverage to enhance returns on investor capital. While this does also increase risk and volatility, this leverage can be attractive to investors because borrowing costs required to support it tend to be much lower than any alternative source of leverage financing accessible to individual investors. Closed-end funds and Exchange-Traded Funds are often compared to mutual funds because each type often focuses on a particular sector of the market. Perhaps because the mutual fund industry historically enjoyed high fees, sales loads and profitability the exchanged traded funds focusing on similar sectors have grown in popularity. However, the Closed-End Fund segment is often overlooked for investors interested in a specific sector. Advantages vs. ETFs – Exchange traded funds have exploded in popularity in the past two decades in part because they are exceptionally cost/tax efficient ways to get exposure to certain passive strategies. However, the CEF structure has several advantages over ETFs when investing in segments such as high yield debt. First, CEFs are actively managed, enabling seasoned fixed income portfolio managers to select specific attractive bond issues rather than “buying the market” as an index fund does. Second, CEFs have permanent capital not subject to redemptions which is of particular importance in sectors like high yield debt, where herd mentality can lead to investor redemptions at precisely the moment when bonds are least easily sold, and can make it hardest for ETF managers to “be greedy when the market is fearful”. CEF managers have ability to ride out – and capitalize on – these panics. Third, CEFs are able to employ low-cost leverage to enhance returns. Finally, because CEFs trade a prices significantly different (and typically lower) than their net asset values, savvy investors have opportunity to earn greater yields (earn the income on $100 of bonds with only $90 of investment) as well as potential for capital appreciation. Advantages vs. Mutual Funds – Standard Mutual funds, technically classified as “open-end mutual funds”, offer tremendous variety of both active and passive strategies. However, closed-end funds have several advantages on them as well. In addition to the permanent capital, leverage, and discount pricing described above, CEFs offer continuous liquidity and the ability to control price at which you buy and sell with limit orders, rather than once daily trading after market hours at “blind” prices. Comparing Investment Options With those structural differences in mind, we’ll compare two of the largest high yield bond ETFs, iShares iBoxx $ High Yield Corporate Bond ETF and SPDR Barclays Capital High Yield Bond ETF , to six leading high yield closed-end funds ( AWF , GHY , HIO , IVH , NHS , and HYI ). While the selected funds represent only 6 of 33 CEFs in the High Yield category, they provide a good cross-section of fund sponsors, sizes, and risk metrics. (click to enlarge) Income Generation The principal motivation for owning high yield bond funds is, unsurprisingly, high yield. Many high-yield ETF investors may be surprised to find that CEF offerings in the High Yield Bond segment offer substantially higher risk adjusted yields than their ETF counterparts. While there are many factors to consider in comparing the opportunities and risks presented by ETFs and CEFs, the 250+ basis point difference in yield is hard to ignore. (click to enlarge) Note that, because they are actively managed, closed-end fund distributions at times the include return of capital, long-term capital gains or short-term capital gains. However, for the funds we are examining, those factors are virtually insignificant, as shown in the below table. (click to enlarge) Price to Value (aka the closed-end discount) As mentioned above, a core feature of closed-end funds is their tendency to trade at prices that vary considerably from their underlying value, or NAV. This difference is commonly referred to as the premium (or discount) to NAV. When prices are below NAV (which historically has been the case about 90% of the time), the discounts created create two major advantages for CEF investors. First, purchasing at a discount enhances yields since an investor can own the rights to the income generated from a hypothetical $10 of net assets with only $9 of investment. Second, for investors willing to actively manage their holdings, funds purchased at particularly wide discounts can be sold at narrower discounts – or even premiums – for capital gain treatment that enhance the after tax returns from a fund. High yield bond CEF discounts are currently in the 10% range, though wide variation exists. ETFs rarely have meaningful or sustained discounts to NAV. (click to enlarge) Risks Return potential from an investment must be viewed in the context of the risk investors are taking. Bond investors are primarily exposed to two types of risk: (1) default risk, as measured by credit rating, and (2) interest rate risk, as measured by “duration”. The high yield bond sector generally carries moderate to high default risk (the “junk” in junk bonds…) but tend to have low durations, and thus low interest rate risks. As many investors are concerned about the specter of interest rate increases, the shorter duration of all funds – CEF and ETF alike – in the category is attractive to many. Comparing across funds, CEFs are generally equivalent on credit rating and superior on duration, in many cases even when the amplification effect of leverage is considered. (click to enlarge) Expenses Because CEFS are actively managed, adjusted expense ratios typically exceed ETFs by 50-100 basis points. While index ETF fees are 0.4 to 0.5%, CEFs range from a little less than 1% to little more than 1.5%, after adjustment for cost of leverage. (click to enlarge) * According to Morningstar: “By regulation, closed-end funds utilizing debt for leverage must report their interest expense as part of expense ratio. This happens even if the leverage is profitable. Funds utilizing preferred shares or non-1940 Act leverage are not required to report the cost of leverage as part of expense ratio. To make useful comparison between closed-end funds and with both open-end funds and exchange-traded funds, the adjusted expense ratio excludes internal expense from the calculation. In addition, we adjust the calculation’s denominator, basing it on average daily net assets.” Conclusion The high yield bond sector is interesting at current – regardless of investment vehicle chosen – because of its relative lack of interest rate risk and its recent re-pricing in response to the falling price of oil. Investors considering high yield ETFs should give a close look at the CEF alternatives, primarily for the enhanced income distributions and secondarily for the potential gain from a narrowing price discount.

How To Design A Market Neutral Portfolio – Part 3

Summary How to build a robust long side. Which ETF on the short side. How to make it IRA-compliant. The first article of the series described the investor profile to hold a market neutral portfolio, some characteristics of this investing style. The second one explained the benefit of sector diversification, with examples. This one simulates solutions for the hedging position with various ETFs: leveraged and non leveraged, inverse and regular. People implementing an equity market neutral strategy usually have two balanced sets of individual stocks on both sides (long and short). Before going to the point, I want to come back on the reason why I prefer a single index ETF position on the short side. My opinion is that ‘Market Neutral’ is for risk-averse investors. Therefore it is also better to avoid a potentially unlimited risk that is not related to the market: being trapped in a short squeeze. People who think that this risk is limited to penny stocks and small caps have a short memory, or don’t know some cases. My preferred example is the ‘mother of all short squeezes’ that happened in 2008 when Volkswagen AG became briefly the highest capitalization in the world after its share price was multiplied by five in 2 days. Then it fell back to its initial level even more quickly. In the interval, investors and traders on the short side covered their positions at any price with huge losses, in panic or forced by their brokers. Whatever the reason (in this case a corner engineered by a major shareholder), and the consequences (at least a suicide has been attributed to that), I prefer avoiding by design this kind of event. Even absorbed in a diversified portfolio, such a shock hurts and may trigger a margin call for leveraged investors. On the long side… The quantitative models used for the long side of my real market neutral portfolio will not be disclosed here. However, I want to share some of its characteristics that may be reused by readers in another context. The portfolio is based on 5 different models: 2 with defensive stocks, 2 with cyclical stocks, 1 based on growth and valuation with no sector limitation. All models are based on rankings using fundamental factors. 24 stocks are selected: 14 in the S&P 500 index, 5 in the Russell 1000 index, 5 in the Russell 3000 index. The number of stocks has been chosen to limit the idiosyncratic risk. The sector diversification pattern should help beat the hedge in most phases of the market cycle. The diversification in rankings across models should limit the risk of over-optimization. The focus on large capitalizations is a choice of comfort (for myself) and ethic (for subscribers). Russell 3000 stocks are filtered on their average dollar daily volume. The portfolio is rebalanced weekly, but backtests show that a bi-weekly rebalancing doesn’t hurt the long-term performance. However, the hedge should always be rebalanced weekly. The next chart shows the simulation of this 24-stock portfolio (long side only) since 1999, with a 0.3% transaction cost and a 2-week rebalancing: (click to enlarge) Past performance, real or simulated, is never a guarantee of future returns. However, for a diversified portfolio like this one, it gives some clues about the robustness. Especially when robustness has been integrated from the design process, not just as the result of backtest optimization. On the short side… Some readers will be scared if I tell them abruptly that I use a leveraged 3x inverse ETF. Most people who are afraid of leveraged ETFs don’t really understand where their ‘decay’ comes from. If you exclude the management fee (under 1% a year), the decay has two names: roll-over cost and beta-slippage. The holdings of leveraged S&P 500 ETFs (inverse and regular) are swaps for the biggest part, and futures in second position. Rollover costs are close to zero for such contracts on the S&P 500. For beta slippage, some of my old articles have already explained what it is , and why I don’t fear it on S&P 500 leveraged ETFs. In short: most leveraged ETFs are harmful as long term holdings, but not all of them. The next table is a summary of backtests for the portfolio with different hedges, period 1/1/1999 to 11/29/2014 (weekly rebalancing). The ETF used are the ProShares Short S&P 500 ETF ( SH), the ProShares UltraShort S&P 500 ETF ( SDS), the ProShares UltraPro Short S&P 500 ETF ( SPXU) and the ProShares UltraPro S&P 500 ETF ( UPRO). For most cases it shows the performance without leverage, and with a leverage factor corresponding to holding the stocks on capital and the hedge on margin. Price data are synthetic before the inception dates (calculated by data provider). Hedge Leverage An.Ret. (%) DD (%) DL (weeks) K (%) No no 28 36 103 24 SH no 10 10 54 25 SH 2 23 23 54 25 SDS no 14 12 54 28 SDS 1.5 21 17 54 28 SPXU no 15 9 54 30 SPXU 1.33 21 11 54 30 UPRO (short) no 16 8 51 33 UPRO (short) 1.33 22 10 51 33 SPXU 50% no 20 17 51 34 SPXU 50% 1.167 24 19 51 34 SPXU 75% no 17 11 49 33 SPXU 75% 1.25 23 14 50 33 SPXU Timed no 25 15 50 34 SPXU HalfTimed no 20 10 48 36 SPXU HalfTimed 1.33 28 13 49 36 An.Ret.: annualized return DD: max drawdown depth on rebalancing (it may be deeper intra-week) DL: max drawdown length K: Kelly criterion of the weekly game, an indicator of probabilistic robustness The ‘Timed’ version uses a signal based on the 3-month momentum of the aggregate S&P 500 EPS and the U.S. unemployment rate. ‘Half Timed’ means that 50% of the hedging position is permanent, the other 50% is timed. Among the 100% market neutral versions, shorting UPRO looks better at first sight… but it is not after taking into account the borrowing rate (4.48% last time I had a look at UPRO properties in InteractiveBrokers platform). As it represents 25% of the total portfolio, the drag on the portfolio annual return is about 1%, which gives the same performance as with SPXU. I prefer buying SPXU and eliminating the inherent risk of short selling. Moreover, U.S. tax-payers can implement this kind of strategy in an IRA account if they use SPXU. Such a portfolio can be traded without leverage, but cash and IRA accounts usually have a 3-day settlement period. It is recommended trading at a broker offering a limited margin IRA feature waiving the settlement period and the risk of free-riding. It seems that Interactive Brokers and TD Ameritrade do that (and maybe others). Inform yourself carefully. Data and charts: Portfolio123 Additional disclosure: Long SPXU as a hedge.

Relative Value The Reason To Keep Buying Munis And Long Bond ETFs

Two-and-a-half years back, the U.S. Federal Reserve, placed that percentage at 2%. Yet the U.S. has failed to hit the bulls-eye. In spite of the media hype that surrounds the notion of imminent Fed rate hikes, history suggests that the Fed will need to remain exceedingly “patient.” As much as the Fed might like to get us all off the drug of ultra-low borrowing costs, there are other risks with raising rates too soon. Since the Reserve Bank of New Zealand first formerly targeted inflation rates roughly 25 years ago, other central banks around the globe have followed suit; that is, many banks have been setting medium-term rates that prices should rise on an annualized basis, and then presenting those percentages publicly. Two-and-a-half years back, the U.S. Federal Reserve, placed that percentage at 2%. Yet the U.S. has failed to hit the bulls-eye. Trillions in electronically created dollars over 30 some-odd months, coupled with zero percent overnight lending rates during the Fed’s inflation targeting period, and the U.S. is still a long way from the stated goal. In spite of the media hype that surrounds the notion of imminent Fed rate hikes, history suggests that the Fed will need to remain exceedingly “patient.” In the quarter century of inflation targeting (at least as far as I have been able to determine), the Fed has never kicked off a rate tightening period when inflation sat below 2%. In truth, the Fed is not oblivious to the fact that dogged determination to move towards the normalization of overnight lending rates is more likely to hinder economic progress than ensure price stability or advance employment objectives. Who but a few members of Congress will grumble at Janet Yellen’s Fed deciding to push back into Q3 or Q4? After all, haven’t we already lived with zero percent rate policy (ZIRP) for six-plus years? As much as the Fed might like to get us all off the drug of ultra-low borrowing costs, there are other risks with raising rates too soon. With both Japan and Europe injecting trillions of QE dollars in an effort to boost inflation and improve economic prospects abroad, the money inevitably finds its way into market-based securities of relative value. The German 10-year? 0.35%. Spain? 1.3%. What overseas institution or money manager would not look at those 10-year yields and consider the safety of U.S. 10-year treasury bonds at 1.8% instead? Or our ultimate safe haven prospect, the 30-year at 2.37%. Granted, those are obscenely low yields that barely compensate for historical cost of living. On the other side of the ledger, though, the U.S. bond market has plenty of room to run on price before comparable yields match those of overseas sovereign debt securities. Yet these facts epitomize the Fed’s dilemma. The 30-Year (TYX):10-Year (TNX) spread has moved from 0.90 one year earlier to 0.57 today; the spread between the 10-Year and the 2-Year has shifted from 2.43 to 1.28. The yield curve continues to compress, and may get close to partial inversion if the Fed fails to exercise patience. Inverted yield curve? Partial inversion? What’s the big deal? Well, you’re talking about a circumstance where the odds of a domestic recession increase dramatically. Inverted yield curves have a near-perfect record of forecasting recessions in the U.S. For that matter, raising local rates before determining whether Europe, Japan and the rest of the world are capable of escaping respective recessions and stagnation is akin to suggesting the U.S. is self-sustaining island. Decoupling theories notwithstanding, the well-being of the United States is still very much dependent on what happens on the world stage -from China to Russia to Germany to Saudi Arabia. The investing implications may be as simple as supply and demand. Wouldn’t intermediate and long-term rates naturally go higher if demand for government bonds were waning? Similarly, with prominent proxies like the German 2-year heading further and further into negative returns, why on earth would foreign institutions and/or wealthy foreigners stop buying U.S. debt? The Vanguard Long-Term Bond ETF (NYSEARCA: BLV ) is still a winner when it comes to the probability of price gains. Meanwhile, if you’re looking to ensure higher monthly distributions, munis still offer relative value. The SPDR Nuveen Barclays Municipal Bond ETF (NYSEARCA: TFI ) works, and for those who welcome a little leverage and are not afraid of some volatility in the space, consider closed-end muni bond funds like the Nuveen Municipal Opportunity Fund (NYSE: NIO ) or the Eaton Vance National Municipal Opportunities Trust (NYSE: EOT ). As much as U.S. investors would like to believe in the miraculous, never-say-die, resilience of the U.S. economy, the facts about our “low” unemployment rate and our “accelerating” gross domestic product (GDP) are entirely misleading. Only 46% of 16-54 year olds are working; it was closer to 52% at the eve of the Great Recession in December 2007. Tens of millions of retirees in the early 50s? Not bloody likely. And what about the acceleration of GDP in the last few quarters? It is primarily due to an undesirable increase in household debt. Here is a brief history lesson. Americans held $6.3 trillion in household debt in June of 2002. Due to the housing bubble in which anyone could borrow any amount to get rich quick, that number swelled to $12.6 trillion by June of 2008. The Great Recession required that consumers had to deleverage, refinance or default, but total household debt only dropped to $11.3 trillion by December 2012. Perhaps ironically, the reamarkble stock gains that occurred in 2013 and 2014 are partially attributable to household debt climbing back up once more, up to $11.7 trillion at the latest figures of September 2014. Some argue that this proves that U.S. consumers have been happily consuming. Well, yes… on borrowed dollars. After all, real wages have been declining and are actually lower than they were in December of 2007. Isn’t it true that the lower interest rates make the cost of servicing $11.7 trillion in September 2014 much more sustainable than the cost to service debt back in June 2008? Absolutely. Unfortunately, this notion of debt servicing costs being the only important factor means interest rates need to stay permanently lower for U.S. consumers to borrow-n-spend. If rates go higher, the only way that picture does not get ugly is if Americans start earning a whole lot more from their employers. In other words, either rates have to stay exceptionally low for households and the U.S. government to service the monstrous debts, or households and the U.S. government need to earn a whole lot more than they’ve been earning. Which scenario do you see as most probable – employers paying workers higher real wages in the months and years ahead, or the Federal Reserve barely touching the overnight lending rate? In 15 years, the Bank of Japan (BOJ) has not been able to get their overnight lending rate above 0.5%. When you combine the reality of low rate addiction/necessity with limited supply/extraordinary demand for longer-term sovereign debt, you conclude that yields will keep falling. Investment possibilities should include: BLV, TFI, NIO, EOT, as well as the Market Vectors Long Municipal Index ETF (NYSEARCA: MLN ) and the SPDR Nuveen S&P High Yield Municipal Bond ETF (NYSEARCA: HYMB ). Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.