Image Source: Giorgio Trovato
If someone offered you a dollar for just 90 cents, you would think it is too good to be true. Interestingly, there is a dedicated class of quality financial instruments where such bargains are very common. CEFs (Closed-End Funds) are a fantastic vehicle for income investors due to two primary reasons.
These funds provide significant diversification, including income-oriented exposure to asset classes like healthcare and technology that aren’t generous with their dividends.
CEFs have a legal requirement to pay out a majority of their income and realize capital gains as distributions.
The primary source of returns from a CEF comes from income, not price appreciation, and since the investment strategy involves active management, it is quite likely that the top holdings of a CEF will look very different after a year, with significant noticeable changes each month.
As a result, there are a few core strategies that CEF managers use to determine their distributions:
Distribute a fixed amount that matches the long-term expectation. In other words, the CEF will overpay some years and underpay others, but over long periods, it should average out to approximate the dividend. The manager will adjust the dividend when their view of the long term is that the current distribution is over or under the portfolio's long-term potential.
Distribute a low fixed amount with the intention of paying out a special when taxable income requires it. This is a strategy used by PIMCO. As noted above, with debt investments like the PIMCO funds we invest in, the debt can be repaid at the option of the borrower. When this happens, it creates taxable events. So we often see PIMCO pay a flat monthly dividend, and in years where excess taxable income is produced, they pay a special distribution.
Distribute a variable amount based on NAV. This strategy means that the distribution changes frequently as NAV goes up or down. The distribution is adjusted frequently and will directly follow NAV. So, if NAV declines due to a recession, these distributions will be reduced. Yet shareholders can have confidence that when the portfolio performs better, they will get the rewards.
While there will be differences in the volatility of distributions based on the chosen strategy, at the end of the day, the distribution of any CEF is dependent upon the performance of the underlying portfolio. If a CEF adjusts its distribution, it is most likely due to management's changing outlook for the sector.
Due to their leveraged nature, a tailwind that will benefit many CEFs is declining interest rates. Many CEFs use leverage, so declining interest rates will directly lead to a lower cost to borrow, which is a positive for all CEFs that use leverage.
CEFs are an excellent utility for an income investor, but investors often overlook this instrument class due to the misunderstanding of “expense ratios” and the fact that they utilize leverage. Many well-managed CEFs that operate with leverage have delivered terrific long-term returns.
Without further ado, let's dive into our top CEFs, which, due to their discounted valuation, let you buy more for less.
Pick 1: THQ – Yield 10%
abrdn Healthcare Opportunities Fund (THQ) is diversified across 113 healthcare holdings, with some of America’s largest and most prominent biopharma companies representing its top positions.
THQ’s top positions represent ~45% of the CEF’s assets and continue to deliver robust earnings, with the special mention of Eli Lilly, which reports robust sales of its weight-loss drug, Zepbound, demonstrating the commercial promise of GLP-1 drugs.
THQ operates with a ~20% leverage (at a cost of 1.48% of net assets) to boost returns from its holdings. The CEF trades at a ~7% discount to par and offers a 10% annualized yield with monthly distributions of $0.18/share.
Healthcare prices and overall health spending have historically outpaced the rest of the economy. As the American population continues to age, health costs form a growing share of the gross domestic product, and families are seeing the cost of services, drugs, and insurance premiums grow much faster than household income. THQ presents a solid investment to benefit from this tailwind while collecting generous monthly distributions.
Pick 2: DFP – Yield 6.7%
Flaherty & Crumrine Dynamic Preferred and Income Fund (DFP) is a closed-end fund that invests in preferred shares issued primarily by banks and insurance companies.
Over 50% of the CEF’s portfolio is investment-grade, making it a stronger asset class amidst a weakening economy. Since rates peaked, DFP's portfolio NAV has been on a steady climb. The CEF stands to directly benefit from rate cuts due to two reasons:
Lower leverage costs, resulting in reduced fund expenses, implying that higher earnings will be available for distribution.
The price performance of fixed-income securities is inversely correlated with interest rates. This asset class is well-positioned to appreciate with rate cuts.
We have already seen the effect of this with DFP’s NAV rise over the past year.
We expect the fund to progressively raise distributions in the upcoming quarters, fueled by rate cuts. DFP trades at an 8% discount to par, allowing you to buy an already undervalued asset class at an even greater bargain.
Conclusion
Both CEFs discussed today have experienced steady NAV rises over the past year. THQ has delivered a massive distribution hike, while DFP’s payments have risen modestly this year. These indicate management’s confidence in the strength of their underlying assets in current market conditions.
CEFs are often misunderstood and overlooked because many investors shy away from securities with minimal long-term price appreciation and tend to avoid investments involving leverage. But these regulated instruments tend to pay generous distributions, factoring into strong total returns, often resulting in the CEF beating a passive ETF focused on the same sector. We see this to be the case with both THQ and DFP.
Slow and steady wins the race, and with CEFs, you can build a winning retirement, one paycheck after another. This is the beauty of the Income Method.
We're offering a limited-time 30% discount on our annual price of $599.99 via this link only:
Are you ready to become an income investor?
We can't say it better than our members:
Stop wondering if you will have the income you need in retirement; start growing your income stream now. We are the largest community of income investors and retirees, with over 8,000 members. Our "Model Portfolio" targets a +8% yield, with the highest and safest dividend stocks, preferred stocks, and bonds. This service is ranked #1 in dividends, income, and retirement. If you are looking for high, sustainable income, you have come to the right place!
Commentaires