How To Boost Your Yield With Bond Funds

Written By Vita Nelson

Vita Nelson’s The Moneypaper specializes in direct investing through dividend-reinvestment plans, or DRIPs. However, this month Nelson also provided subscribers with some helpful advice for investing in fixed-income instruments in today’s low-yield environment, and explained the pros and cons of various types of bond funds.

“Federal Reserve Chairman Bernanke has promised to keep interest rates near zero for the next two years. That’s good news for borrowers; you have time to buy a home or refinance a mortgage at historically low rates. On the other hand, low rates are unappealing for yield-oriented investors. While it makes sense to keep some money in the bank or in money market funds for a cash reserve, if you are keeping major positions you are forfeiting any chance for a meaningful return. If you decide to move out of cash and into the bond market, where can you go?

In the past, I’ve advised investors to own individual bonds because they come due at par. You know what you’ll get and when and you can rely on a certain income in the meantime. Now, with yields so low, it may be wise to use bond funds. An experienced bond manager can buy a diversified mix of high-yield (‘junk’) issues and lesser-known fixed-income vehicles that you might not want to own individually, delivering decent returns.

For your taxable account, consider a municipal bond fund. Chances are that income tax rates will go higher, especially for high-income taxpayers. If you live in a high- tax state, an in-state muni fund might be a good choice to avoid federal, state, and even local income taxes. Of course, you’ll want taxable bond funds for your IRA and other retirement plans. Look for managers with a track record of avoiding or minimizing losses in the past, when the bond market turned down (and rates turned up).

Moreover, don’t limit yourself to traditional mutual funds. Consider closed-end bond funds as well. Closed-end funds often sell at a premium or a discount to the net asset value (NAV) of their underlying bonds. That is, a fund with 1 million shares outstanding might own $10 million worth of bonds, for an NAV of $10 per share. With a traditional (open-ended) mutual fund, shares will always be priced at or near $10 in this hypothetical scenario. That’s the price the fund will charge to investors buying new shares and the price the fund will pay to investors redeeming shares they previously bought.

“Closed-end funds are different. They issue a fixed number of shares, which then trade like stocks. Investors buy and sell those shares from and to each other. One month, investors might be willing to pay, say, $9.60 a share—a 4% discount. The next month, $10.50 a share—a 5% premium. If you track an attractive closed- end bond fund, you can see the range of its premiums and discounts over time. By buying when the discount is at or near its peak, you can boost the yield you receive from this fund. What’s more, some closed-end bond funds employ leverage—they borrow money at today’s low rates to buy more bonds with higher yields. Some leveraged closed-end high-yield bond funds now offer double-digit yields. It’s true that leverage cuts both ways: funds can lose heavily if interest rates rise and bond values sink. Therefore, if this idea interests you, you should look for a fund where the manager has a long tenure and a good long-term record.

“Emerging markets bond funds also may deliver high yields now. Issues from developing markets may offer good value these days relative to issues from industrialized nations. Again, you can choose from traditional mutual funds, as well as closed-end funds. While you’re thinking about emerging markets, consider dividends as well as bond yields. Many companies based in the emerging markets pay dividends, and some have hiked their payouts substantially in the past year or so. Some exchange-traded funds (ETFs) now focus on dividend-paying stocks from the emerging markets. Again, these funds may provide an interesting alternative to global funds that may hold dividend- paying funds with shares in European banks, which are under pressure because of debt problems. Emerging markets dividend-paying ETFs hold shares from, say, Taiwan and Malaysia, instead of Europe. Emerging markets stocks not only pay dividends, they also have the potential for hefty appreciation. While developed countries struggle with various problems, emerging markets have growing populations and an emerging middle class. No one knows where the greatest growth will be, so you should have exposure to many potential hot spots. So be sure to look ‘under the hood’ before investing in an emerging markets stock fund, whether or not it focuses on dividends. See if the fund really has a diversified approach or if it’s placing its chips on one or two regions.

“As always, you should also consider expense ratios when you research these funds or ETFs. While some of the largest domestic ETFs may change just 0.10% or 0.20% of assets, you may have to pay 0.50% or 0.75% for an emerging markets ETF.

“In recent months, we’ve also mentioned alternatives like MLPs (Master Limited Partnerships) and REITs (Real Estate Investment Trusts) for high yield. Keep in mind that, because of their tax structures, you have to be thoughtful about whether or not to hold them in retirement or taxable accounts. MLPs may throw off income from operations that would disqualify your retirement account. What’ s more, the return of capital they throw off would result in eventual capital gains (at lower tax rates) in a taxable account. On the other hand, the high dividend income that passes through to you from a REIT is considered ordinary income for tax purposes, so they might best be held in your retirement account—except that you’d also pay ordinary rates (on withdrawal) even on capital gains distributions or return of capital. So it’s a good idea to look at the historical distributions of any REIT that you’re considering. Those with little or no capital gains distributions or returns of capital would be a better fit in a retirement account.”

Vita Nelson, Vita Nelson’s The Moneypaper. 12/11