A brief case study in reaching for yield

I am often shocked at how much income investors will stick their neck out for yield. I spend most of my time looking at stocks so I often will note how I think investors are reaching for yield by going after utilities, REITs, etc… But if you really want to see extreme cases of reaching for yield look at some examples in the closed end fund (CEFs) world. Truly mind boggling. I thought I had come across a great example last night but this morning Jason Zweig at the WSJ wrote about a real doozy.

Jason’s example is the Cornerstone Progressive Return (CFP data here) closed end fund. This one is truly jaw dropping. The fund trades at an almost 12% premium to NAV and has a yield of 20%. Those two numbers should scream red flags to any investor right away but looking under the hood is even scarier. As the article states;

Most of the yield at Cornerstone, however, doesn’t come from its investments. In past years, it came from giving investors some of their original assets back. Now, it comes out of money the funds’ investors have just added.

In each of the past five years, the Cornerstone Progressive Return CFP +0.37% fund distributed more than 10 times as much in dividends and other payouts as it earned in net investment income.

In 2008 and 2009, for example, 93% of total distributions were return of capital—giving shareholders their own money back (after subtracting the manager’s fees, of course).

By the end of 2010, assets had shrunk to just $55 million from $132 million in 2007. At that rate, the fund would pay out its entire portfolio by 2014 or 2015—a kind of high-yield hara-kiri.

“If you keep throwing out more income than you can possibly make, someday your assets will go to zero,” says Mariana Bush, a closed-end fund analyst at Wells Fargo Advisors. “And so will your management fees.”

Wow! is all I can say. At least this is a miniscule fund. It has only $79M in assets. So I guess the good news is that not that many investors are getting duped. But there are many other less egregious examples out there that are still bewildering.

The example I was going to point out was the Pimco High Income Fund (PHK) with $1.3B in assets. In this case you have a fund run by maybe the best bond firm in the industry with probably the best bond manager of all time, Bill Gross. And it has a pretty darn good track record. So, we’re not talking about a low quality investment product. But that doesn’t mean it can’t get expensive. This CEF trades at a 70% premium to NAV and has a yield of 10%. And under the hood the outlook for maintaining its distribution is concerning. When looking into whether the distribution of a CEF is sustainable you need to look under the hood, specifically you need to look at its earnings per share. Here is the data for PHK.

The trend here is concerning. The fund is under earning its distribution, is returning capital (not necessarily a bad thing but a red flag), and has no income buffer as shown by its avg UNII per share. The risk here is if and when the fund lowers its distribution that big premium to NAV can vanish quickly leaving the investor with a large capital loss. PHK may well continue to perform but I don’t think its worth its price tag.

There are more prudent ways to get yield without going crazy. For example, in the taxable income world I like the ETF PCEF. It is an ETF of closed end funds that invests in CEFs when they are trading at a discount to NAV. The ETF is rebalanced quarterly. The ETF yields slightly over 8% today. Since its an ETF it always trades right around NAV. Granted its not the 10% yield of PHK but you’re taking a lot less risk here. I even think an investor is better off taking a smaller position in a higher income mortgage REIT, like AGNC or TWO, that yields 15% or so and trades at a 10% premium to NAV (book value).

The important thing to remember is that even if you want to reach for yield you always should think about capital preservation first. What’s the first rule of investing? Don’t lose money. What’s the second rule? See rule #1.

Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.

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6 Responses to A brief case study in reaching for yield

  1. Tony says:

    Have you ever look at Redwood Trust (RWT)? If the mortgage securtization market gets better, RWT should do better. Its PB, however, is above 1 now. Any comments about RWT?

    • libertatemamo says:

      Hey Tony. I’ve only looked at RWT a few times in the past and in not much detail. Yield looks PK and leverage levels are pretty low with not a lot of duration risk from repos. But I don’t think securitizations are coming back to any where near the level they were pre crisis so I don’t see much div growth potential there. But like I said I haven’t studied it too much. To get mortgage exposure I’d rather be in an mREIT. Currently I’m long TWO.


      • Tony says:

        TWO looks pretty interesting with a single family residential portfolio, although I don’t think it will make an impect on the overall portfolio anytime soon.

        Do you have any thoughts on CIM? It has not file its 2011 10K and 2012 first quarter 10Q. P/B is about 0.7 but the dividends have been reduced substaintially over the last couple years.

        • libertatemamo says:

          Tony, you are right that the residential portfolio won’t be material, at least for a while. I like that they have non-agency exposure. This will do very well with a bottoming housing market. Also, they are the most hedged to rising rates and their agency portfolio is very protected against pre-pays.

          I don’t like CIM. I owned them for while but got outlast year with a small gain after all dividends. Their non-agency portfolio hasnt done that well. They’ve cut their dividend the most of all mREITs and most worrisome they havent filed financials in 2 quarters. They says its nothing but that’s what they all say. Smells fishy to me. It could be nothing, and they could be putting in a bottom, but the risk is too high. I’ll take my 15% on TWO and be happy with that. I don’t own mREITs for capital appreciation.


      • Tony says:

        What is issue with the SEC concept release?
        You are right about CIM. It is a big unknown right now. They even changed auditor.

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