Michael Fabian: Although often overlooked by individual investors thirsty for yield, many closed end funds (CEFs) have built notorious reputations for returning large amounts of principal to their shareholders. For investors in this small corner of the market, it’s more important than ever to understand the inner workings of fund management and distribution policies. A great way to start is evaluating a funds distribution history alongside its portfolio’s earnings, which will immediately shed insight into a sponsor or board’s management practices. By analyzing a fund’s semiannual or annual report an investor can glean fine details such as undistributed net investment income (UNII) alongside any changes in portfolio holdings and prospects for dividend coverage.
The key to this strategy is to uncover and then focus on funds that use their leverage from borrowings productively, and avoid funds that have excessively high stated distribution policies. I would prefer to own a fund that pays a special dividend each year for the purpose of balancing its tax liability because of an over earning portfolio than a fund struggling to make ends meet. It offers additional peace of mind to investors that a dividend cut isn’t looming, which in turn can cause erratic price volatility.
In addition, given that CEFs are active and need room to adapt to changing equity and interest rate environments, portfolio yields are constantly changing thereby lending further proof to the benefit of a healthy UNII buffer. My top three funds include selections from managers that have long histories of generating excellent returns and providing their shareholders with a nice cushion of investment income in excess of distributions.
PIMCO Dynamic Income Fund (PDI)
The PIMCO Dynamic Income fund is truly a dominant force in the multi sector/MBS category. The fund, which is managed by fixed income genius Daniel Ivascyn commenced operations in May 2012 and has generated significant amounts of UNII ever since posting its first annual report.
The strategy the team is implementing relies heavily on the discounted pricing of mid-late 2000’s vintage non-agency mortgage backed securities. By pairing written down packages of loans with other high yield and emerging market fixed income then leveraging the portfolio by roughly 45%. He was able to out-earn the fund’s distribution policy of 19.1 cents per month by a margin of roughly 10 cents through the last reporting period. In addition, the portfolio management team implements hedging strategies using interest rate and credit default swaps to control volatility.
Although non-agency mortgage backed securities are essentially a shrinking market due to lack of issuance following the financial crisis, I believe Ivascyn as demonstrated an amazing ability to seek out undervalued sectors of the fixed income market to keep income flowing to his shareholders. PDI’s track record since its inception is nearly unrivaled by other CEFs, and I believe superior expertise of management will allow it to continue well into the future.
The Pioneer Diversified High Income Fund (HNW)
Pioneer’s diversified high income fund is designed to seek a high level of current income through investments in various sectors of the high yield bond market. More specifically, the fund specializes in global credit, with the majority of its portfolio allocated to U.S. high yield, senior loans, event-linked securities, and emerging markets. With the exception of the catastrophe bond sleeve, the stated portfolio mix is not uncommon in the CEF market place.