Co-produced with Beyond Saving
At High Dividend Opportunities, our goal is to build a high level of current income through dividends. Dividends provide the flexibility to redirect the income into other profitable investments, or they are used by many as retirement income or spending money. To ensure stability, we encourage having a very diverse array of dividend-paying investments.
There are many types of investments that income investors can turn to – one structure that’s particularly favorable is closed-end funds or CEFs. These funds have a lot of great benefits for an income portfolio. They provide a high level of income and provide instant diversification, making the CEF a critical tool to have in your income-producing toolbox.
What Are CEFs?
A closed-end fund has many similarities to open-ended funds like mutual funds or exchange-traded funds (ETFs). All funds are run by an investment advisor that hires a management team to actually manage the investments. Funds will make income and capital gains distributions to shareholders and the advisor will charge a fee based on the amount of assets under management.
The key difference between a CEF and open-ended funds (such as Mutual Funds or many ETFs) is that a CEF raises capital at inception through an IPO. From then on, a fixed number of shares will trade on the secondary market. Open funds will issue new shares to investors and redeem or buy back shares, keeping their share price trading very close to the net asset value (‘NAV’) of their holdings. While CEFs can buy back shares in the open market or may do a secondary or rights offering, these are done in a manner similar to a publicly-traded corporation.
As a result, CEFs will frequently trade at a premium or discount to their NAV. We see CEF prices frequently influenced by the quality of the manager, the dividend paid (and the stability of the income), and the market’s outlook for the sector which the CEF invests in. Note that CEFs offer unique advantages and flexibility in investing and holding assets that are less liquid or not available to retail investors (such as many non-listed investments). Finally, most CEFs are actively managed, meaning that the investor is buying the management team’s expertise in addition to the fund’s assets. Therefore, a good asset manager will in most cases be able to beat other investments with a similar exposure. Having a good manager on your side is a great plus and can boost your returns.
There’s a lot of misunderstanding regarding the “expense ratio” that’s quoted by CEFs.
- First, the expense ratio is calculated independent of the dividend yield. It’s calculated by adding up the annual expenses of the fund and dividing by the net assets under management. Dividend yield is calculated by dividing the distribution by the current share price. The distribution is made after all expenses have been paid. In other words – you receive the full dividend yield – you don’t subtract the expense ratio from your dividends.
- Second, CEFs are actively managed. This means that the management team is making decisions day to day on which investments to buy, which to sell and how much leverage to use. Most ETFs are not actively managed, instead they follow a designated index and will buy, sell and weight investments closely following the index. Therefore, we typically see larger management fees for a CEF than an ETF and they are not really comparable. With a CEF, you are paying for the expertise of the manager, who will be hiring experts to do their due diligence and deep research. A much more labor-intensive task than simply following an index.
- Finally, CEFs frequently use leverage, borrowing money to increase the size of their assets, and improve returns. The interest expense is included in the expense ratio. This means that leveraged CEFs will have significantly higher expense ratios than funds that don’t use leverage. Since CEFs have the benefit of scale, they can frequently obtain leverage at much cheaper rates than retail investors can.
Leverage: Risks and Benefits
Leverage is a double-edged sword. It can greatly improve returns when investments are growing. However, when values collapse it will work against you and increase the size of losses.
Consider two of our favorite funds managed by Cohen & Steers. Cohen & Steers Quality Income Realty Fund (RQI) yielding 8.6% and Cohen&Steers Total Return Realty Fund (RFI) yielding 7.8%. These two funds have very similar holdings and are managed by the same management team. The major difference is that RQI uses leverage while RFI does not.
Here’s a look at how each performed based on NAV in 2019:
RQI’s leverage worked in their favor during a bullish year and returned more than 35% compared to 28% from RFI. However, that dynamic flipped in 2020 when COVID-19 ravaged REITs.
RQI is down 13% year to date while RFI is down about 8%.
So we can see how using leverage can improve returns in the good times but has a higher risk when markets are falling. When considering whether to go with a leveraged fund or one that’s not leveraged, investors should consider current market conditions and their own risk tolerance. Having a view on the sector you are investing in is very important. Are you bullish or bearish on this sector? In the case of RQI and RFI, the sector in question is Property REITs.
Top 3 High-Yielding CEFs
Our top three CEFs today are:
Pick #1: Cohen & Steers Quality Income Realty Fund – Yield 8.6%
We are very bullish on the property REIT sector for the next few years for many reasons which include current low attractive valuations and the inflation hedge that this sector provides. With all the money that’s being printed by central bankers across the globe, someone will have to pay. This cost will most likely be partly paid by higher inflation which is an indirect tax that impacts every one of us. Property REITs invest in real estate, and we know that real estate prices tend to go up as inflation hits, so it’s one great way to hedge your portfolio.
RQI invests in the property REIT sector, which is currently oversold. On top of that, RQI is trading at an 8% discount to NAV. This means that we can buy REITs through RQI cheaper than if we bought the REITs directly.
In our opinion, Cohen & Steers is the best fund manager in the REIT sector, and has managed RQI through the worst of the worst for REITs. First the Great Financial Crisis and now COVID-19. Despite those stumbling blocks, RQI has rewarded shareholders with returns that beat the S&P 500 index (SPY).
RQI offers two upside potentials: First as the gap between NAV and share price closes, and the second as the REIT sector recovers. This is one of our favorite sectors right now and RQI is a fantastic investment to get broad exposure to property REITs and get paid high dividends in the process.
Pick #2: Highland Income Fund (HFRO) – Yield 10%
HFRO invests in a wide variety of investments. From debt tranches of collateralized loan obligations (CLOs) to preferred equity in publicly-traded and non-public investments and even some direct-owned real estate. So HFRO has a fairly diversified portfolio.
What makes HFRO particularly notable is that the price of their shares has tanked, while their NAV only declined moderately from COVID-19.
While HFRO has seen some recovery in their price over the past month, they are still trading at an incredible 28% discount to NAV. This provides a very large margin of safety for investors and we can collect a very large dividend while we wait. One reason for such a high discount is that this is a smaller CEF with little analyst coverage, and therefore can go “under the radar.” This large discount has boosted the yield which now provides a significant amount of income to investors.
In addition to continuing to provide a double-digit yield, the values of senior loans, CLOs and preferred equity positions are continuing to recover from March lows as actual defaults have been much lower than the market had initially feared. We covered HFRO more in depth in this article.
Pick #3: PIMCO Dynamic Credit Income Fund (PCI) – Yield 11%
PCI is managed by PIMCO, an elite management team that invests in the debt markets. PIMCO has a well-earned reputation as a world-class manager, and that reflects in the values of their funds.
Among the three picks discussed in this report, PCI is the only one trading at a premium to NAV. They are currently trading at a 3% premium, and that premium is worth every penny. In fact, by PIMCO standards, PCI’s premium is very small. Many PIMCO funds trade at 20%+ or even 30%+ premiums.
Not only does PCI provide an elite management team, but this CEF also invests in areas that are very hard for retail investors to invest in. The bulk of their holdings are residential mortgage-backed securities (‘MBS’). PCI was formed by PIMCO to buy MBS that were trading well below face value in the wake of the mortgage crisis.
Mortgage fundamentals have remained very strong despite COVID-19, providing opportunities for outsized returns. Historically, mortgages have performed very well in recessions because people prioritize paying their mortgage over most other bills in their lives. The mortgage meltdown was the exception, in part caused by the historical strength of mortgages. Today, mortgages are performing more in line with what we saw in recessions pre-2009.
One unique feature of the COVID-19 crisis is that most lenders are offering forbearance. Borrowers impacted by COVID-19 can have their payments delayed, usually added on to the end of the loan. In June and July, we have seen the number of loans in forbearance decline as borrowers resume payments.
Currently, 7.5% of mortgages are on a forbearance plan. Some portion of those will become delinquent, but many have been transitioning back to regular payments. To put that in perspective, during the mortgage crisis more than 10% of all mortgages were delinquent. Heavily influenced by the experience from the last recession, the market panicked and sold off mortgages in March assuming the worst. Many projections called for 30% or more mortgages going into forbearance. When the market overestimates the risk, that’s a buying opportunity.
PCI offers one of the best options (if not the best) to take advantage of the market’s fear for mortgage REITs. PCI offers today not only a juicy yield, but also a good upside potential.
The CEF structure is our preferred structure when investing in funds in order to achieve a high level of income. Active management means that an expert is making investment decisions and not just blindly following an index. Where an ETF sets out to match an index as closely as possible, a CEF sets out to beat the indexes in their sector.
Since the shares trade independently of their respective Net Asset Value, CEFs often provide investors with an opportunity to invest at discounts. In uncertain times, those discounts can become quite large and provide a great opportunity. Like HFRO trading at nearly a 30% discount!
CEFs are also a great vehicle for investing based on your outlook for a sector. We are very bullish on REITs and hold quite a few in our portfolio. RQI holds over 140 REITs, provides leverage at a much cheaper price than we could obtain and is trading at a discount to NAV. This makes RQI a great complement to our strategy.
PCI invests in bonds and MBS, investments that are difficult to manage on a small scale and are not easily accessible to retail investors. You could spend every waking hour deciding which MBS to invest in among the thousands of options, or you can invest in PCI and let people who live and breathe MBS daily make that decision.
CEFs provide instant diversification, a high level of income and can help provide a portfolio with stability. That is why we recommend that income investors maintain a healthy allocation to CEFs. I’m personally long the above three high-yield CEFs in my retirement portfolio, and plan to hold them for the very long run.
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Disclosure: I am/we are long PCI, HFRO, RQI, RFI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Treading Softly, Beyond Saving, Trapping Value, PendragonY, Preferred Stock Trader, and Long Player all are supporting contributors for High Dividend Opportunities.