Getting Fat Yields by Casting a Wide Net
Can high-yield funds continue rolling? Maybe. But the risks are growing as the share prices rise. High-yield bonds are rated below-investment grade, so they pose default risks. A crisis in Washington could send the low-quality bonds into a tailspin. To limit risk, consider a broadly diversified income ETF. Besides owning high-yield bonds, the diversified choices also hold high-quality assets. If junk bonds sink, the high-quality issues should help to stabilize the portfolios.
An intriguing choice is PowerShares CEF Income Composite (PCEF) , which yields 7.4% and returned 15.9% in the past year. A new diversified ETF is iShares Morningstar Multi-Asset Income Index (IYLD) , which yields 7.0%.
The PowerShares fund currently has 19% of assets in high-yield bonds, 42% in higher-quality issues, and 37% in stock strategies that use options to generate income. The different holdings are selected to complement each other. If the economy expands and interest rates rise, high-quality bonds can sink as investors dump existing bonds with low yields. But prices of junk bonds could be resilient at a time of rising rates because investors would worry less about defaults as the economy grows. The stock strategies can also thrive when rates rise.
To implement its diversified approach, the PowerShares fund follows an unusual strategy, investing in a broad portfolio of closed-end funds. Because of their structure, closed-end funds can yield more than traditional mutual funds. Like mutual funds, closed-ends invest in portfolios of stocks and bonds. But shares of closed-end funds trade on stock exchanges. When investors are bullish, the shares can trade at premiums to the value of the assets. The funds can slip to discounts when the market is less ebullient.
The best time to buy is when closed-ends sell at discounts. The PowerShares portfolio currently has an average discount of about 3%. So investors can obtain a dollar of assets for 97 cents. When you buy at a discount, you get a higher yield and more income for each dollar invested.
Closed-end funds can also boost yields by using leverage. In a typical arrangement, a fund might raise $100 million from investors and use the cash to buy bonds. Then the portfolio manager borrows another $30 million against the assets. The manager takes the proceeds of the loans and buys more bonds.