High Yields at a Discount
Everyone likes a bargain. But it’s often difficult for investors to buy otherwise fundamentally sound stocks when they finally hit the bargain bin.
That’s because the circumstances that typically lead to bargain prices sow fear. And that causes investors to second-guess their strategy, even when their favorite stocks are selling at dream prices.
After all, some value plays can turn out to be value traps.
But what if there were a security that allowed you to buy a slice of assets at a discount to their current market price? And what if it also had a high yield?
That probably sounds too good to be true.
In fact, there is such a security. And it occupies an obscure corner of the investment world, so few investors know it exists.
Meanwhile, even the few savvy investors who do know it exists can find this security daunting to analyze, since its category includes a number of questionable offerings that basically function as legalized Ponzi schemes (those are the ones that are too good to be true).
Fortunately, it’s not too difficult to separate those who have the best interest of shareholders from those who do not. It just requires a little digging into publicly available information.
The Market’s One True Bargain
By now, you’re probably wondering what this mystery security is. I’m talking about closed-end funds (CEFs), a security created back in 1893, more than 30 years before the first mutual fund.
Like mutual funds, CEFs are actively managed pools of assets.
Unlike mutual funds, which can create an infinite number of shares to accommodate investor inflows, a CEF’s share count is generally fixed, with the shares outstanding only changing as the result of periodic tender offers or secondary issuances. Also unlike mutual funds, CEFs trade on public exchanges.
These two attributes can cause a CEF’s share price to dip below the net asset value per share of its portfolio. And that gives value-oriented investors such as ourselves an opportunity to buy a stake in a portfolio at a discount to its current market value.
There’s another key distinction between CEFs and mutual funds. Many CEFs use leverage to enhance their returns, which also gives a significant boost to their yield.
Avoiding the Dreaded Return of Capital
But here’s where you need to be careful. The investment companies that manage these assets know that a high yield helps attract investors.
Indeed, some CEFs sport absurdly high yields, otherwise known as distribution rates in CEF parlance. Thankfully, CEFs are required to report a detailed breakdown of the sources of their payouts, or distributions.
These sources include short- and long-term capital gains, interest or dividend income, and return of capital. The latter is the one for which investors should be wary.
In many cases, when a CEF returns capital to shareholders, it’s essentially giving them their own money back net of management fees. And if return of capital is a perennial majority of a high-yielding CEF’s distribution, then in my opinion that’s akin to a legalized Ponzi scheme.
However, the occasional return of capital is permissible, so long as a CEF doesn’t make a habit of it.
Since a number of CEFs are geared toward income investors, they know their shareholders depend on them for a steady payout. As such, many CEFs have instituted what are known as managed distribution policies, which smooth out what would otherwise be highly variable distributions.
That means there are some months when a CEF will under-earn its distribution, and a return of capital will, therefore, be a necessary component of its payout.
Again, this is perfectly okay, as long as it doesn’t happen too regularly. And there are some exceptions, such as when return of capital is derived from holding pass-through entities such as master limited partnerships (MLP) and real estate investment trusts (REIT), writing options, or maintaining a position in a security that has unrealized capital gains.
At Utility Forecaster, we’re primarily a stock-picking service. So we don’t write about pooled investment vehicles such as closed-end funds, mutual funds, and exchange-traded funds all that often.
But when we do, one of our longtime favorites is a closed-end fund that currently yields 6.6% and trades at a discount to its net asset value.
Equally important, many of its top holdings also happen to be among the top holdings in our own portfolios.
So this fund offers a quick way to gain exposure to a wide array of utilities, including a number of our favorites, all while offering a monthly payout with an extraordinary yield.
But only subscribers to Utility Forecaster will have a chance to learn what it is.