How to Supercharge Your Returns with CEF s

How to Supercharge Your Returns with CEF s

How to Supercharge Your Returns with CEFs By Charles Sizemore AS Rodney explained in the webinar you just watched, closed-end municipal bond funds can be a fantastic way to add a consistent and tax-free stream of income to a portfolio. In a world where savings accounts and CDs offer zero in the way of returns, a tax-equivalent yield of close to 10% is almost too good to be true. But while the closed-end fund (CEF) world tends to be dominated by muni bond funds, CEFs cover a lot more than just muni bonds. There are CEFs that specialize in taxable corporate bonds, bank loans, preferred stock, real estate investment trusts (REITs), oil and gas master limited partnerships (MLPs) and even good, oldfashioned common stocks. In fact, most people don t know this, but the very first stock mutual funds started in the early 1800s were actually closed-end funds. Mutual funds as we think of them today didn t come around for another hundred years. But while a CEF can hold virtually any investment asset under the sun, nearly all have one thing in common: a focus on current income. While some CEFs have more emphasis on capital gains than others, nearly all pay high monthly or quarterly dividends and cater to investors wanting yield. A Nightmare You Can Avoid The non-muni CEFs offer the same basic benefits as the municipal bonds that Rodney described. The fund issues a set amount of shares in an IPO, and those shares trade on the New York Stock Exchange like a stock. Unlike regular mutual funds, however, CEFs don t have to worry about investors panicking in a bear market and pulling their money out. The nightmare of every mutual fund manager is that, due to redemptions from their investors, they ll have to sell their best stocks at lousy prices during a bear market. A CEF manager doesn t have that problem since the number of fund shares is fixed, and they have the flexibility to hold a high-conviction stock even if it s small and thinly traded without fear of redemptions. Also, as with their cousins in the muni CEF space, these non-muni CEF managers have the ability to borrow, using a little leverage. By borrowing, a manager can often turn a portfolio that yields 6% or 7% into an income stream of 9% to 10% for their investors. Not too shabby! There are other benefits too, including tax benefits. While all mutual funds, including CEFs, are required to distribute 98% of realized capital gains and 90% of income to their investors every year, CEFs are still a lot more tax efficient. Think about it. If a manager is forced to sell stocks to meet shareholder redemptions, that creates taxable sales for all investors, even those that stay in the fund. Well, since a CEF never has to face redemptions, this isn t a problem for CEF shareholders. You ll never get stuck with a tax bill because of the emotional trading moves of another investor. 1

Making Money in CEFs All closed-end funds have three potential sources of return: 1. The current dividend 2. Changes in the value of the portfolio 3. A shrinkage of the discount to net asset value (NAV), or an increase of the premium to NAV in some cases The first bullet point requires very little explanation. We ve dedicated Peak Income to generating current income in a low-yield environment, and nearly all CEFs deliver on that count. Depending on how much risk you re willing to take, yields of 7% to 10% can be common. But when you re venturing outside the conservative world of muni bonds, capital gains are a real consideration too. Just as with any mutual fund, the net asset value of the CEF grows as the value of the investments it owns grow. But that final bullet point is where it gets really interesting. Because CEFs trade in the market like stocks, the price of the CEF will often move independently of the investments it owns. This means that on any given day, you could pay 90 cents for a dollar s worth of assets or $1.10 for a dollar s worth of assets. Now, I can t think of too many reasons why I d want to pay $1.10 for a dollar s worth of assets. I wouldn t pay $110,000 for two cars worth $50,000 each, so why would I view stocks or other investments any differently? Sure, I suppose there might be some extraordinary exceptions. Certain stocks like MLPs can be a real headache to own due to complex tax reporting, and a CEF structure can eliminate that headache. That might be worth paying a modest premium. And CEF fund managers can borrow a lot more cheaply than you or I can, so I suppose in some cases it might make sense to pay a very small premium in order to get access to the CEFs cheap leverage. But all the same, I d much rather buy at a discount. And that s where CEFs get fun. It s not uncommon to see CEFs trading at discounts of 10% or more; I ve even seen discounts of 20% or 30% before. There aren t too many stocks I wouldn t want to own at 70 or 80 cents on the dollar! Sticking With the Safe Bet Let s take a look at some stocks that currently trade at steep discounts. Legendary stock mutual fund manager Mario Gabelli runs the Gabelli Dividend and Income Fund (NYSE: GDV). This is a conservative fund that owns widow and orphan stocks in stable sectors like utilities and telecom. Today, GDV trades at a 14% discount to NAV. That means you re getting a portfolio of some of the most stable, dividend-paying stocks in America for just 86 cents on the dollar. And it pays a fat 7.4% dividend. If you re going to have exposure to the stock market, this would seem like a pretty smart way to do it. Another great example actually comes from a stock that I recommended in the March issue of Peak Income. This particular fund hits all three of our sources of return, so I didn t want those of you just signing up for the service to miss out on a stock that I see being a great deflation hedge in the months to come. With that said, the Cohen & Steers Quality Income Realty Fund (NYSE: RQI) is a solid CEF that invests in the common and preferred stock of publically traded REITs. It sports a hefty 8.1% yield and has been gradually raising its payout since 2009. Take a look at the chart at the chart on the next page. RQI is well diversified, with about 16% of the portfolio invested in preferred stock. If you re unfamiliar with 2

preferred stock, think of it as a hybrid between a stock and a bond. Preferred stock ranks behind bonds in the event of company liquidation and income payments. In other words, bondholders get paid first then preferred stockholders and then the regular, common stockholders. For most healthy companies, the value of their preferred stock doesn t tend to move a lot. Preferred stock tends to trade fairly close to its par value, which is usually priced at $25 (note that changes in market bond yields will move the price). When bond yields rise, preferred stock prices fall, and vice versa. Given our view on what to expect for bond yields, preferred stock would seem like a safe bet. The remaining 84% of the portfolio is invested in high-quality real estate throwing off consistent, regular rental income. Real estate got hit in 2015 when investors started to worry about Fed rate hikes. The result was that investors sold first and asked questions later which created some fantastic pricing for us: RQI trades near the deepest discounts to NAV since the 2008 financial crisis and its aftermath, at about 13%. Between the current yield, the expected appreciation of real estate stocks, and a shrinkage of this massive and undeserved discount to NAV, I believe we could see total returns in the ballpark of about 20% in a little over a year that is, if you act now. A Welcome to the Newcomers RQI s Trading at a Ridiculous Discount I wanted to quickly say thank you for signing up for Peak Income. The world has become a scary place as of late, with slowing economies, negative interest rates, and our own Federal Reserve proving time and again that they re out of touch with, well just about everything. That s why Rodney and I created this newsletter: to help investors find steady, reliable income in a market that s gone topsy-turvy. You ll be hearing from us on alternating months, and we ll each come at this topic from our own areas of expertise so while I tend to focus mainly on stocks, Rodney has decades of experience as a bond trader, and he ll cover the bond market. Together, we ll show you that there s still yield to find in a low-yield environment if you know where to look. 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% RQI Quarterly Dividends $0.25 $0.23 $0.21 $0.19 $0.17 $0.15 $0.13 $0.11 $0.09 $0.07 $0.05 2009 2010 2011 2012 2013 2014 2015 RQI s trading at its deepest discount to NAV since the 2008 crisis and aftermath -35% 2002 2004 2006 2008 2010 2012 2014 2016 3

Financial Guidance from Someone You Can Trust Charles Sizemore has worked closely with Harry and the rest of the Dent Research team for years. He s the current Portfolio Manager for Boom & Bust, and has his own newsletter called Dent 401K Advisor, which focuses on protecting and growing your retirement fund. He formerly managed around $30 million in 401(k) assets while at HS Dent Investment Management, and has provided recommendations for Harry s publications for over a decade namely The Great Depression Ahead. Charles has also been a feature contributor for Barron s magazine, The Wall Street Journal, Forbes and The Washington Post, to name a few. He holds a Master s Degree in Accounting and Finance from the London School of Economics. 4

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