The Aleph Blog » Blog Archive » Let Them Eat Yield!

Let Them Eat Yield!

An article in Friday’s Wall Street Journal described the creation of new closed-end funds dedicated to the production of yield. I am simultaneously horrified at the concept, and yet wondering whether I couldn’t create one with multiple strategies to smooth out the difficulties of single strategy yield creation. I could buy:

  • unusual bonds with high yields.
  • certain fixed income closed end funds at a discount.
  • dividend paying stocks, and occasionally (ugh) preferred stocks.
  • non- or low dividend paying stocks that fit my eight rules, and sell out-of-the-money calls against them.
  • lever the fund by borrowing at LIBOR.
  • Use my mean reverting REIT, utility, LP strategy. Backtests have it generating a 20% return annually, and I haven’t tweaked it.

The thing is, though, yield is a conceit. People like to think that they are merely scraping the income off of the portfolio, when in many cases, they are truly consuming capital, but the accounting doesn’t make it look that way. Think of a high yield fund with a single-B average credit quality. During good times, the full yield, and maybe a tiny amount of capital gains comes into income. During bad times, the yield shrinks, and capital losses get passed through. Over a full cycle, the NAV of a high yield fund shrinks.

Logical people would not invest in income vehicles like that, but invest they do. Two parting bits of advice. One, there is no reason to ever invest in a closed-end fund IPO. Closed-end funds should trade at a discount equal to the annual fee times five (or so). Two, be conservative in yield investing. It is little known that lower yielding REITs tend to outperform higher yielding REITs. The only time to stretch for yield is when everyone is scared. Even then be careful; make sure the yield that you are getting is secure.






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10 Responses to Let Them Eat Yield!

  1. James Dailey says:

    Hello David,

    I was curious how you derived the 5x’s rule for closed-end fund discounts to NAV?

    With generationally low interest rates, I’ve seen SO many older retail investors who’ve been sold these products by brokers and who have little idea how much risk they are taking. Just like mortgages have been sold based on unsustainable monthly payments, these funds have been sold purely based on monthly income to seniors starving for income. Unfortunately, I fear that the people most hurt by the inevitable will be those who can least afford it.

  2. Peter Shaw says:

    The time is ripe for a properly structured, diversified income fund. Market it to high net worth individuals, who have been shown to crave safety and yield. Avoid the constraints and benchmark chasing of the high yield bond crowd, don’t get forced into a style box for the consultants, and provide some tax advantages through the exposure to qualified dividends in the mix.

    Unfortunately, the average senior is deluged with inappropriate yield investments showing a complete disregard for total return. Reg D offerings with 10% commish to the rep and another 8% in O&O for the syndicator, high coupon long paper with a few years to maturity trading at significant premium and 3 points to the broker, etc.

    I saw it all in my days in retail brokerage…

  3. Ben Williams says:

    1. As for 5x expenses, many years ago an academic paper found that something like 10x expenses, or perhaps 10x “excess expenses” of CEFs explained the discount. Excess expense would be the difference in cost of a CEF over competitive, open end or index fund expenses in that category. (Apologies for not having the reference available, and possibly mis-remembering the conclusion.)

    2. Note that the style for the past few years has been buy-write funds rather than (leveraged) high-yield funds. Sell some of the upside semivariance for a higher mean return, but keep the downside semi.

    3. Hey, you can always return capital and call it ‘yield’ . . .

  4. Paul in Kansas City says:

    I’m constantly being asked for 6% to 7% income yields with safety of principal. If I can attain 4% being diversified I’m happy; but forget principal stability. My approach (for good or bad) is to mix dividends with interest generated from “floating rate” or “strategic income” type portfolios. Mix this with money market/tbills and I’ve also shifted some assets into non-us dollar debt; usually i try to set aside enough cash/money market that these assets can function a minimum of 5 years without selling shares.

  5. James – My 5x is a compromise between the theoretically correct value for a buy-and-hold investor, which is around 10x, and the force of arbitrage that threatens to open end the funds if they get too far away from the NAV.

    Peter — Agree entirely. I have seen too many people sold inappropriate income trusts in my time. When I was a corporate bond manager, one investment bank (who will remain nameless) would beg to buy my century bonds. Occasionally, I would sell him some, when the bid got outrageous enough. I asked him why he was willing to pay so much, and he told me that they dropped the bonds into income trusts with a five year par call feature. People lined up for the income; whoops, 2007 is the call date, and rates are low. Bye, high yield.

    Also, I have had regional brokers beg me to buy marginal investment grade bonds at prices above what the street would pay. The high yield manager and I would comment after we sold them some, “Jamming retail, are we?” They were pigs to the degree that they would call us back for more, in spite of the insult.

    Ben — good comments. Buy-writes can be a way of distributing capital and calling it income. Nothing magic there, unless one is a sharp options writer.

    Paul — What can we say? People undersave, and then they try to make it up on the yield rate. The bond portion of my balanced mandates yields in the 4-5% region, with the stock portion in the 2% region, split 50/50. The bonds are interesting — TIPS, foreign (including yen, what a drag on yields), bank loan funds, and cash. I probably have a 3%+ yield overall, which is an aid to overall performance, but the portfolio is so eclectic that if a fund consultant looked at it, they would faint over the tracking error.

    All — Very good comments. My bond portfolio is over at Stockpickr.com. As an aside, my macro philosophy of fixed income management is when nothing looks good, forsake yield for safety, and add foreign bonds and inflation protection. That is the situation that we are in now.

  6. Paul in Kansas City says:

    David; your comments have helped me VERY MUCH on income distribution straetegies for clients. I’ll also give credit to Howard Simons on Real Money; he had written about junk bonds in late 2001 and repeated in late 2002 to overweight and I did so with spectacular results (for income portfolios in particular). David at the time was one of Jim Cramer’s sources. Thanks!

  7. I took a slightly more in depth look at the latest crop of closed-end funds, specifically dividend capture funds. My story was posted Thursday and appeared in BW’s issue on Friday. Coincidence? ;)

    -Aaron

  8. Aaron, it is an pleasure to have you post here. I miss your perspective over at RM, much as I like those who fill your function there now.

    Coincidence? Well, great minds think alike, and fools seldom differ. ;) My concern boils down to what my old boss at Mount Washington Investment Group was fond of saying, “You can add yield to any portfolio.” Then he would go into the myriad ways that by taking incremental risk one can add yield. None of the strategies were free lunches… many involved substantial risks. We rarely used them, because we wanted to keep the insurance companies that we served safe.

    This was impressed on me back in the early 1990s, when high yield bond funds were trading at 20% discounts. Economically, much of every dividend should have been considered a return of capital, because you expect a certain amount of junk to go belly up. The accounting treatment makes it income though, and only later, when you take the capital loss upon sale, is the true value realized from a taxation standpoint.

    As Will Rogers’ logic went, we should be more concerned with the return of our money than the return of our money. As the Baby Boomers gray, I’m afraid we’re going to see more and more dubious income vehicles trotted out. In most cases, better that they should buy an inflation indexed immediate annuity. But that’s too simple (and illiquid).

    Drop by again, Aaron.

  9. Igor Y says:

    Hi David,
    You mention in your article “mean reverting REIT, utility, LP strategy”.
    What is it ? Wher can I find more info about it.

    Thank you,

    Igor

  10. Igor – I haven’t written about that one yet. It’s a simple strategy that plays off the yield illusion of retail investors. Extreme price moves in yieldy stocks tend to mean revert. That’s all I can share for now.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


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