Summary

• Many retirees have income needs that exceed the 2-4% one might expect from dividend stocks.
• Higher income yields can be had from several other asset classes including MLPs, BDCs, REITs and high-yield bonds.
• An alternative — or complement — to these investment vehicles is a diversified portfolio of closed end funds which can provide income in excess of 7-8%.
• One tool managers use to generate those yields is leverage, which I discuss here.

In a previous article (found here ) I presented the argument that a portfolio built around closed end funds can provide the high yields many retirees are finding they need. With careful choices, it can do so while providing the broad asset-class diversification that can mitigate the risks that comes with those high yields. In this and subsequent installments, I will be discussing some key considerations that go into investing in closed end funds. Today, I’ll focus on leverage, which is a common tool used by CEFs to enhance yields. I’ll follow up with consideration of discounts and premiums. Then, in part 4, I plan to begin a discussion of building and maintaining a high-yielding CEF income portfolio.

Closed End Funds Are Not an Asset Class

Let’s understand before we start that closed end funds are not an asset class. This is despite the fact that I see several authors on Seeking Alpha considering them as such. Like ETFs or mutual funds, any given CEF is a wrapper that contains investments in an asset class or asset classes. One can get exposure to most asset classes — particularly income asset classes — through closed end funds. There are CEFs for myriad varieties of fixed-income investments. There are equity CEFs that cover the US domestic market, several sectors, and the global markets in all its permutations. Other CEFs cover such asset classes as preferred stocks, real estate, MLPs, commodities, energy and resources, basic materials, and probably several others I’m leaving out. As I pointed out at some length previously, a large part of the appeal of CEFs is that one can diversify a high-yield income portfolio across asset classes by using them.

Let me briefly note here how CEFs differ from other funds for the sake of readers who are new to the category. The key is the word closed which means that the assets of the fund are fixed at their IPO. One important consequence is that managers do not have to concern themselves with having to sell assets in order to redeem shares when investors decide to pull out of the fund. This is especially important in some of the more illiquid asset classes which are strongly represented in the CEF universe.

Remember the taper tantrum of last year? Investor panic over the specter of rising interest rates generated a massive outflow in fixed-income and rate-sensitive funds of all sorts. Managers of open-end mutual funds were forced to sell assets to meet the demand for redemptions at a time when the wiser course of action might have been holding those assets, if not actually buying bargains. This was not the case for closed end funds where managers could stay the course or even take advantage of those bargains on the market. Of course, the investor panic still affected the funds but they behave more like stocks so the sell-off reduced the market value of the funds relative to the true value of their assets much as a sell-off in stocks might do. Discounts increased, presenting buying opportunities for investors.

Closed End Funds Are All About Income

Why CEFs? you ask. The short answer is that, with few exceptions. CEFs are all about income — typically high-yield income — making them an attractive investment for the retiree especially. The emphasis on income is evident from the large number of managed distribution funds found in the CEF universe. Such funds have a commitment to shareholders to provide a predictable, although not guaranteed, level of cash flow. The typical managed distribution fund provides regular (quarterly or monthly) fixed cash payments or, less commonly, payments based on a percentage of assets. In a report on managed distribution policies. Gabelli asserts that managed distributions tend to have less volatile market prices and tend to trade at smaller discounts than their unmanaged peers. I plan to discuss managed distribution funds in more detail in a later article in this series.

Because closed end funds are income-payers, one must pay particular attention to total return when making comparisons to other categories of investment within asset classes. For an example let’s look at one equity CEF that has a reasonably clear comparable ETF. NASDAQ Premium Income & Growth Common (NASDAQ:QQQX ) is a CEF that tracks the NASDAQ 100 index and writes call options on that index. It pays regular distributions. One can compare QQQX with its peer ETF, the NASDAQ index ETF (NASDAQ:QQQ ) which tracks the index but pays minimal distributions. When doing a comparison, most sources will return only share price. By this measure QQQX does not fare particularly well (see top chart below). But factor in QQQX’s current distribution of 7.2%, and a different picture emerges as seen in the lower chart.

Here’s another example, this from the fixed-income, high-yield category. For this example I’ll use the largest (by AUM) CEF in the category, BlackRock Corp High Yield (NYSE:HYT ) and compare it to high-yield fixed-income ETFs, (NYSEARCA:JNK ) and (NYSEARCA:HYG ). I should note that the ETFs are not strictly comparable; they have relatively less credit risk in their portfolios and different exposures to high-yield asset classes. But, for illustrative purposes, they are reasonably comparable. Unlike the equity example, each of these funds pays out distributions. Typical of CEFs, HYT pays an appreciably higher distribution than the ETFs (currently 7.88% for HYT vs. 5.6% for the ETFs). This higher distribution rate has profound implications for total return as seen here for one year:

Or five years:

Finally, let’s look at what happens if we emphasize the effects of the mid-2013 anxiety over rate increases in these 18 month charts:

It should be clear that HYT has solidly outperformed the ETFs. The cost of doing so has been somewhat increased volatility (beta = 0.65 vs. 0.48 for the ETFs; standard deviation = 7.84 vs. 7.35 for the ETFs), but for one invested in HYT instead of the ETFs the rewards are obvious.

Distributions Tend to Equilibrate within Asset Classes

Investors tend to sustain yield equilibrium within CEF asset classes and categories through market activities affecting discounts and premiums. It is not uncommon to see funds within an asset class returning comparable yields on their market values based on quite different returns on net asset values. For an example, I just ran a quick screen in cefconnect.com for high-yield fixed-income funds. The five highest yielding funds have a distribution-rate range of 20 basis points (8.87% to 9.07%) based on market prices. Contrast that with the distributions rates based on NAVs which range over 300 bps (from 8.23% to 11.60%).

The discrepancies between yield at market and yield at NAV follow from the funds’ discount/premiums. For this group the discounts/premiums range from -7.15% to 29.40%. Funds with higher NAV returns sell at a premium to their net assets value and those with more modest NAV returns sell at a discount. This phenomenon generates and sustains discount/premiums within the asset class. Looking at the example of HYT, which I discussed above, we find that falls in about the middle of its asset-class pack on yield (7.9% for HYT vs. a median of 8.04% for the category) and carries a discount currently at -9.32%, which is well below the category median value of -6.56%.

I’ll be discussing discounts and premiums in more detail in a future installment.

Leverage

Clearly these funds are providing outsized yields. The high-yield fixed-income group referenced above is yielding almost 60% more than the high-yield fixed-income ETFs (JNK and HYG with current yield of 5.70%). How do they do that? Well, a big part of the answer is leverage; those five top-yielding funds carry an average leverage of 27%. Although there are exceptions (discussed below), CEFs commonly use leverage to achieve their high distribution yields. This is especially the case for fixed-income funds where all but a handful of CEFs are leveraged. But leverage alone does not guarantee high yields. Evidence is found in the chart below which looks at the 33 funds comprising the high-yield fixed-income category (data from cefconnnect.com. chart by author).

This chart plots distribution rates (market and NAV) against effective leverage. The solid blue markers represent market yield and the open red markets represent NAV yield. (Note that for fixed-income CEFs the regulatory limit for leverage is 33%.)

The fitted trend lines are based on polynomial (second order) regressions (which generated the best fits —based on r 2 — of the standard regression types). What’s important to see is that there is only a trivial correlation between leverage and yield, with r 2 values of only 0.14 (market yield) and 0.05 (yield on NAV). For this set of funds there’s a sweet spot for leverage in the mid to high 20 percent range (orange oval). Further, the funds with the highest leverage tend to do less well than funds with more modest leverage. The message? Leverage is an effective tool for enhancing yield, but good management is paramount.

Note that there are two funds clustered at about 10% leverage and 8% market yield (blue oval). Both of these sell at a small premium to their NAVs. They are Babson Capital Participation Investors (NYSE:MPV ) and Babson Capital Corporate Investors (NYSE:MCI ). Both have long histories of consistent returns and modest volatility. As such, they may be worth a close look for anyone considering exploring this space.

I submit that it is critically important to pay attention to the extent of leverage relative to peers when one selects a closed end fund. Leverage is, of course, the classic two-edged sword; it will enhance returns when the going is good but this comes at the cost of increased downside risk when the market turns. Thus, those two modestly levered, Babson funds returning 8% or so may well justify their premium valuations, particularly as we look at uncertain times ahead for fixed-income investments.

Nearly all fixed-income CEFs are levered. This is not the case for equity CEFs where some are and some are not. One category of equity CEFs that generally does not employ leverage as a strategy is the covered-call or buy-write funds. Of 29 US equity covered-call funds listed on cefconnect.com only three use leverage. The average distribution yield for these funds is 8.41%, ranging from 6.34% to 10.77%. Leverage adds little to distribution returns here. Of the three levered funds, one is at the high end of the distribution scale, one is at the bottom and one is in the middle. On a total return basis, however, each of the three has outperformed the category.

In the general-equity and tax-advantaged equity categories, about half of the funds are levered. Leverage percentages are typically modest, with most of the levered funds having effective leverage in the mid-teens. But, how effective is that leverage in driving enhancement of returns? Let’s look. Here’s a chart of 1 and 3 year returns vs. effective leverage of domestic equity CEFs for the general equity and tax-advantaged equity categories from cefconnect.com:

By this analysis there is little advantage to leverage for equity funds in these categories. I’ll add as well that the unlevered funds from the covered-call equity category fare well by comparison. This group of leveraged domestic equity funds returned a one-year average of 22.51% with an average distribution of 5.24% for an average total return of 27.75%. The unlevered covered-call funds returned an average of 20.74% on price with an average distribution of 8.39%, giving an average total return of 29.12% for the past year. Add to that observation the fact that the option-income funds are less volatile than the levered funds making them more defensive and more suitable for less bullish market conditions.

Among sector funds, funds that focus on health care and commodities tend to be unlevered. For other sectors (real estate, utilities, energy, resources, MLPs, finance) leverage is the general rule.

Closing Thoughts

I’ve had a look here at two categories of closed end funds, fixed income and domestic equity, with an eye to evaluating the effectiveness of leverage on returns. For high-yield fixed-income funds leverage is shown to be a powerful tool for enhancing return, at least up to a point. At higher levels of effective leverage, the impact on enhanced returns tends to fall off somewhat. It may be possible that this is due to underperforming managers extending themselves or playing catch-up by increasing the effective leverage of their funds.

For equity funds, the results shown here tend to indicate that there may be little real advantage to increasing leverage (with the exception of those 3 levered covered-call funds, perhaps). The income investor will want to be extremely cautious before venturing into levered equity funds.

It is not my purpose in this series to recommend individual funds, but some of the examples used here may be worth exploring for someone interested in entering the CEF income arena.

In the high-yield fixed income category, I consider the two Babson funds (MPV and MCI) to be worth a hard look. They have shown steady and solid returns over a long time frame, use only a modest level of leverage to achieve those returns and are priced at a not unreasonable premium. MPV appears to be the stronger buy of the two today with its premium under 2% and a yield just over 8%.

Then there’s the Blackrock fixed income fund, HYT, with its 7.9% yield and outsized discount relative to its own historical premium/discount status and the prevailing discounts for its peer group.

Finally, let me close with a bit of tip. QQQX is a solid index income fund that has provided outstanding returns. If one considers that the NASDAQ will continue to outperform, this fund provides an alternate, income-producing, exposure compared to QQQ. If you find QQQX an intriguing prospect and decide to look more closely at investing in the fund, I’ll point out that another Nuveen fund, Equity Premium Advantage Fund (JLA), is proposed to merge into QQQX sometime this fall. The merger as proposed will be on a straight NAV basis. Currently JLA is priced at a -6.24 % discount while QQQX is priced at -0.21% to NAV. For anyone looking to invest in QQQX today with the intention of holding for several months or more, doing so via buying JLA in anticipation of the merger should prove to be an excellent strategy. I discussed the Nuveen funds’ merger in more detail in a previous article (found here ).

As always, I remind readers that I am an individual investor, not an advisor or analyst. Nothing here should be taken as investment advice and every individual will, of course, want to do complete due diligence before investing.

If you have any thoughts, additions, objections or any other responses to this article, I and other readers welcome your comments, so please join the discussion.

Disclosure: The author is long JLA, HYG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.