Tuesday, July 6, 2010

Closed-End Funds: A Boring Play For A Bear Market

A recent New York Times article has called for the Dow 1000 based on some technical indicators, and there are times where I am almost fooled into believing it. Today, Tuesday July 6th, the Dow opened to substansial early day gains only to see them whittled away after the closing of European markets. There was essentially no reason for this, except for maybe a small increase in volume from people coming off their three day weekends. The oil spill has yet to be fixed. BP has ceased its dividend payouts. Diamond Offshore, a company that is not directly related to the spill, has cut its special cash dividend for fears of meager future cash flows. Europe is still a mess, and there is really no assurance that the upcoming earning season is going to impress.

With that being said, I’ve recently been watching some safer investments and analyzing how they could work within my portfolio. In this search I stumbled across a closed-end fund called the Western Asset High Income Fund II Inc (HIX). I’ll begin by discussing closed-end funds, since up until a month ago I wouldn’t have known what one was; and I should credit the majority of the following to www.closed-endfunds.com. Like an open-end fund, or mutual fund, closed-end funds, CEF’s from here, are professional managed and take a small management fee, though CEF’s fees are normally less expensive than mutual funds. What makes them different is that there are a fixed number of shares. An intial IPO raises capital, like any publicly traded stock, and then shares can be purchased through brokerages and not from the fund directly, as is the case with mutual funds. The benefit of this is that the fund does not need to bother with money coming into or leaving the fund and allocating positions accordingly. Instead, a large percentage of total capital, normally around 80%, is kept in positions, whereas a mutal fund would have much less. This has a clear drawback too, in that there is not always as much capital as you would like there to be available during bull markets. Fortunately, we won’t need to worry about that anytime soon.

CEF’s are asset backed, like a mutual fund, by securities, fixed income positions, cash, etc. The total value of all of these positions is called the Net Asset Value, or NAV. CEF’s can trade either at a premium, fund price is greater than the NAV, or at a discount, fund price is less than the NAV. These differences can be affected by any number of things including consumer sentiment or expected returns. CEF’s have an outlined objective, like capital appreciation or current income and can focus on specific countries, regions, or sectors. Also they can be bought and sold during the trading hours of whatever exchanged they are traded on, making them slightly more liquid than mutual funds.

With all of this in mind, let us examine the bond backed HIX, a current income CEF. Bonds have been relatively immune to the recent market currents and have been rather stable. The biggest risk in the bond market is a rise in the interest rate, and based on an article in today’s Wall Street Journal, this could be happening in the next year and a half or so. Luckily, based on the following graph, the price of HIX has not faltered too much over the past 12 years in relation to the Fed’s interest rate. The fund is comprised mainly of high yield corporate bonds in the BB to CCC range, making up 85% of the holdings, and with some rated higher or lower. Approximately 12% of all holdings are in emerging market debt and some is kept in currencies, but it is essentially an insignificant amount.

HIX is currently trading at $9.25 and has a 52 week range of $6.67 to $10.11. It has a NAV of $8.49, which means it is at an 8.48% premium. Now, you may be thinking that the opportunity on this has already set sale, but as the graph shows, as the price of the fund grows the monthly dividend is decreased, and vice versa. The current divident yield is slightly under 13%.

The Fed rate is shown in white, the price of HIX in orange, and the dividend yield of HIX in yellow. Judging by this it would be difficult to say what direction the price will take if and when the interest rated is raised. There is not much more to remark in regards to HIX, Bloomberg does not note any analysts following HIX and the only news available are quarterly reports releasing updated positions information. So again, there do not appear to be any apparent risks, and if there are please feel free to discuss them. There are certainly other riskier plays to be made and with a 13% dividend yield that is expected to decrease slightly for the following 9 months (the last 3 months experienced a drop from 9.5 cents to 9 cents per month) it would not be considered a buy by most analysts, but for a young investor looking to put away some money with minimal governance in a potential bear market this is certainly a good building block. Additionally, we all know the power of reinvested dividends over time and with this option available, HIX looks even more appealing.


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