Retirees should be (and usually are) interested in income. Your salary isn’t easily replaced, so having a healthy payout from an investment helps finance both your monthly expenses and the bigger-ticket items you look forward to (that trip to Thailand, the cottage in the mountains).
For this reason, financial advisors frequently recommend that retirees build a laddered portfolio of bonds. Each bond (or, more typically, group of bonds) has a different maturity date—2020, 2021, 2022—to meet a different income goal. As the nearer-term bonds mature, you can spend that cash or reinvest it in longer-dated, higher-yielding securities to form another rung on the ladder. This strategy, however, requires a hefty investment.
There are exchange-traded funds—such as Invesco BulletShares 2025 Corporate Bond (BSCP)—that offer diversified bond portfolios that mature, or liquidate, on specific dates, just like individual bonds. But interest rates are still low, and most such ETFs yield only 3% to 4% annually. One way to increase that payout is to buy an ETF focused on high-yield bonds, such as Invesco BulletShares 2025 High Yield Corporate Bond (BSJP), which yields 6.9%, but ramps up credit risk.
A much-overlooked investment addresses all of these challenges: a closed-end fund with term limits. Closed-ends often frustrate inexperienced investors because they can trade at discounts to their underlying portfolio’s net asset value (NAV)—and the discounts can persist indefinitely. So, you might never get the full value of your investment. But “term trust” closed-ends solve the problem because they liquidate their holdings at market prices on specific maturity dates. The discounts disappear and investors get the full portfolio return. (Conversely, if such a fund were bought when it was fetching a premium to NAV, the buyer would be hurt at liquidation.)
I like this strategy enough that I invest in such closed-ends myself. Say, instead of buying Invesco BulletShares 2025 High Yield, you bought Western Asset High Yield Defined Opportunity (HYI), which I own. It also is maturing in 2025—on Sept. 30. But as of Jan. 25, it was trading at a 13.2% discount—with a share price of $13.68 and an underlying NAV of $15.76. If the fund were maturing now, that $13.68 share price would rise to $15.76 as the fund liquidates—a gain of 15% above whatever income the fund is already paying from its underlying bond portfolio. Since the fund matures in 6.7 years, the discount closing will amount to two percentage points of additional return a year above the underlying portfolio’s return.
It gets better. Discounts amplify the underlying portfolio’s yield. Consider that $1 paid out of a fund with a $10 NAV and $9 share price, i.e., a 10% discount, increases the yield to the shareholder buying at $9 from 10% to 11%. In Western High Yield’s case, the underlying portfolio currently yields 6.7%, based on the fund’s most recent payout. But factor in the discount and that yield jumps to 7.7%—an extra one percentage point a year. In total, you get three percentage points of added gains annually if you hold until liquidation. Even better, two points of those yearly gains have little to do with how the underlying portfolio behaves. The discount will close in 2025, regardless of whether the high-yield market goes up or down, giving you an uncorrelated source of return.
Professional investors find such term closed-ends appealing. “If you buy term trusts at big discounts, good things happen,” says Bryn Torkelson, co-manager of the Matisse Discounted Closed-End Fund Strategy (MDCEX), a mutual fund that invests in closed-ends. “Aside from the discount, having a termination date is another factor that, for retirees, can make these really attractive.”
Matisse has a database that has tracked closed-ends’ discounts for more than 30 years. From this, Torkelson and co-manager Eric Boughton have built spreadsheets calculating how much in additional income each of the currently 37 term-trust closed-ends pays per year until liquidation, based on their discounts. Boughton says the historical average income benefit is 0.5 of a point per year; but based on today’s average discount, it’s 0.9. “If you have to pick a time in history to own term trusts in a diversified portfolio, today is a pretty darn good time,” he says.
Of course, closed-end funds have complicated structures that require scrutiny. Leverage can add to their underlying costs, volatility, and potential returns. (Western High Yield doesn’t employ leverage, so it’s simpler to understand.) Consider Western Asset Global Corporate Defined Opportunity (GDO), which matures in December 2024 and trades at a 9.7% discount. (I also own this.) It owns primarily BBB-rated or better bonds, so its credit quality is better than Western High Yield. But it’s also levered. The fund paid 2.5% in interest on its borrowings in fiscal 2018. That boosted its expense ratio from about 1% to 2%.
Yet it’s important to remember that the manager is investing the leverage to produce additional yield. “The portfolio is currently about 28% levered,” says Western Global’s co-manager Christopher Kilpatrick. “That leverage is pretty actively managed. Before the recent selloff, it ranged from 20% to 24%. As valuations improve, we increase the leverage to take more exposure, assuming investments are more attractive,” he says. Because of the leverage, the fund’s underlying portfolio now yields 6.9%—7.7% at its discounted share price—a yield currently unheard of in investment-grade bonds.
The term closed-end with the deepest discount currently is Eagle Growth & Income Opportunities (EGIF), at 19.5%. That presents a 25% upside when the fund liquidates in May 2027. I own it, and it’s the Matisse fund’s eighth-largest holding. Yet it isn’t for retirees seeking high income, as half its portfolio is in stocks, and it’s volatile. It also has a high underlying expense ratio—over 2%—after factoring in leverage, although the underlying management fee recently was cut from 1.05% to 0.85%, Boughton says. Experienced investors might consider it an equity, rather than bond, substitute.
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