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Investors in search of high income had the rug pulled out from under them this past year. A frantic rush to buy Treasuries, despite obscenely low yields, undermined the value of other income-oriented investments, including junk bonds, mortgage securities, municipal IOUs and even some supposedly safe ultra-short-term bond funds. But as the headlines shift from the credit crunch to the timing of an economic recovery, income investors can exhale.
That's because in the hunt for yields of 8% or better, you'll have company. All those buyers will at least maintain, and perhaps push up, prices of income-oriented investments. "A lot of money in low-yield securities has to move out," says Bill Larkin, a fixed-income investor at Cabot Money Management, in Salem, Mass. What he means is that money-market funds at 2% and Treasury bonds at 4% cannot keep you square with the cost of living or preserve the purchasing power of your savings.
As if on cue, investors began exhibiting a greater appetite for risk this spring. They returned to medium-grade and low-rated corporate bonds, bank-loan funds and real estate investment trusts. They even started to nibble on leveraged closed-end funds. "All the stressed areas are up from their lows," says Bill Berno, who runs Aegis High Yield fund and has 30 years of experience looking for undervalued and unappreciated income securities.
From the perspective of the economic cycle, the recovery makes sense. Like stocks, many high-income securities tend to hit bottom in the middle of a recession. That's when forward-looking, patient investors get interested, as they anticipate better times ahead.
Meanwhile, the commodities boom continues to reward yield seekers. Oil and natural gas royalty trusts, pipeline partnerships and funds that focus on emerging-markets bonds (most issued by nations getting rich off of agriculture and natural resources) are protected from Wall Street's credit angst. Oil is overdue for a correction, so prices of oil-related income securities are falling from multiyear peaks. But even if crude, which fetched $126 a barrel in mid May, slips to less than $100, energy trusts will still pay high dividends.
We describe eight investing categories that produce good-to-great current returns. The categories are listed in descending order of risk. Bear in mind that in the world of income investing, risk is a slippery concept. Holding a 30-year Treasury bond is perilous, but not because the government could go bust. Rather, it's because the bond will lose value if inflation accelerates and interest rates rise (bond prices move inversely with interest rates and yields). REITs and junk bonds are up because bargain hunters have concluded that the worst of the credit crisis is over and that the economy will soon recover. If they're wrong, real estate and junk will give back recent gains, and then some.
Closed-end income funds
Since March, the share prices of many closed-end bond funds have leveled off after shedding as much as half of their value. This is a good sign. For example, look at First Trust Strategic High Income (symbol FHI), which borrows to invest in bank loans, mortgage-related securities and junk bonds. Its share price plunged from $20 in early 2007 to less than $10.50 eight months later, as its underlying assets fell victim to the credit crunch and the real estate recession. But the shares have rebounded to $12.25, and the fund's net asset value per share, now $10.38, has stopped crumbling (unless otherwise noted, all figures are to May 12).
But even as the fund was collapsing, it kept paying out 16 cents a month. Based on the current share price, the payout (which doesn't require borrowed money or represent a return of capital) comes to a yield of 15%. We generally don't recommend closed-end funds selling at 18% premiums to NAV, but First Trust's yield is too luscious to pass up.
The universe of closed-end funds is full of similar deals. If you don't think the credit picture is improving or that real estate, junk bonds or mortgages have seen the worst, the pickings are slim. But for an optimist or a contrarian, prices are cheap. At $18.28, Denali fund (DNY) (formerly Neuberger Berman Real Estate Income fund) trades at a 9.5% discount to its NAV. New management took over last year and has boosted the monthly payout from 11.5 cents to 19.5 cents, although the extra income comes from capital gains, not dividends. Denali is selling some long-held REIT shares as it converts from a real estate fund to a general, but leveraged, stock fund. But even at the 11.5-cent rate, Denali yields more than 7% and offers recovery potential. A year ago, the fund's shares traded for nearly $30.
Junk bonds
After a rough start in 2008, junk bonds rebounded smartly as the credit crunch eased and investors began to feel more confident that the economic downturn wouldn't be severe. The average high-yield corporate-bond fund returned nearly 3% in April and was up 0.5% year-to-date.
One plus for junk bonds -- those rated below BBB by Standard & Poor's and below Baa by Moody's -- is that they're relatively scarce in finance, housing and retail, the current trouble spots. Moreover, says Aegis manager Berno, prices of junk bonds are now benefiting from investors' renewed willingness to own lower-quality assets. Yet the yield gap between junk and Treasuries, six percentage points in mid May, is wide enough to suggest that the rally has more room to run.
Because defaults and downgrades are more common in high-yield than in other bond classes, you should use a fund to invest in this category. Metropolitan West High-Yield Bond (MWHYX), Payden High Income (PYHRX) and TCW High-Yield Bond I (TGHYX) are fine choices. Each boasts low expenses, is well diversified and yields 7.7% or better. And each is in the black so far in 2008.
POSTED BY: Mike (June 16, 2008 09:09 AM)
A tip: Don't own MLP shares inside an IRA. There are potentially nasty tax consequences. For energy trust and several other funds should have had some comments on the tax effects on investing in them.. Master Limited... etc.
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