WEALTH MANAGEMENT EVOLVED
Posted on: May 29th, 2019
Contributor
With interest rates on traditional retirement investments hovering near zero, retirees sought income from other investments. Too often, the final result has been losses instead of higher income.
This experience is one reason why you should insist on a margin of safety in your investments. A high income yield is nice, but you need to look behind the yield to ensure it is sustainable and the value of your principal is secure.
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Many retirees like to invest for income. It’s been hard to generate much retirement investment income since the Federal Reserve began its extraordinary monetary policy following the financial crisis. With interest rates on traditional retirement investments hovering near zero, retirees sought income from other investments. Too often, the final result has been losses instead of higher income.

Closed-end mutual funds (CEFs) are one of those investments. CEFs can increase your portfolio returns, but investing in them has an extra layer of risk.

There’s a key distinction between CEFs and the better-known open-end mutual funds.

An open-end fund doesn’t have a fixed number of shares issued. Instead, at the end of each day the fund company tallies the total value of the fund’s portfolio as well as the new investments and redemptions for the day. Based on the value of the portfolio, it issues new shares for the new investments. Each share has the same net asset value and can be redeemed for the net asset value. The total net asset values of the shares equals the net asset value of the fund.

A CEF has a fixed number of shares. The CEF goes public much like a company does, and its shares trade on a stock exchange. The net asset value of the fund changes as the investments in the portfolio change. But the price of the shares changes with demand and supply for them.

A consequence is that shares of a CEF rarely trade at the net asset value. Instead, the shares trade at more than the net asset value (a premium) or less than the net asset value (a discount).

As a general rule, you don’t want to buy a CEF unless its shares are trading at a discount to net asset value. You’re buying a share of the portfolio for less than it’s worth. It’s even better to buy a CEF when the shares are trading at a discount that exceeds its average discount for the last year or longer.

Buying a CEF that’s trading at a premium can be risky. At some point it’s likely that the shares will decline in value until they are trade at net asset value or lower.

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A case in point is the recent behavior of some PIMCO closed-end funds.

PIMCO Global StocksPLUS Income (PGP) sold at enormous premiums. In 2016 the premium peaked at 105.23% of net asset value. Investors were paying more than twice the value of the assets in the fund to own shares in the fund. Its average premium over the last 10 years is just below 60%. In 2018 it had an average premium of 31.16%, and in 2018 its average premium was over 51%.

PGP invests a portion of its cash in stock index futures and the rest in bonds. It also uses leverage. The result was it delivered stock-like total returns and paid a distribution yield of almost 10%.

That was a deal that was hard to turn down for many investors. But it also wasn’t sustainable.

In April PIMCO reduced the fund’s distribution by 23%. PGP quickly declined more than 11%, wiping out more than a year’s worth of yield in one day. The fund was down more than 13% over one month.

Other PIMCO CEFs had a similar experience at the same time.

PIMCO High Income (PHK) had its distribution reduced 24%, and it declined 11% in one day. Its premium before the distribution reduction was over 47%.

The distribution of PIMCO Strategic Income (RCS) was cut 15%, and the fund declined almost 7% in one day.

Some other PIMCO CEFs, including tax-exempt bond funds, suffered distribution cuts and sharp price declines.

The share prices of the funds haven’t recovered since the distribution cuts, but they generally have stabilized at the post-distribution levels.

This experience is one reason why you should insist on a margin of safety in your investments. A high income yield is nice, but you need to look behind the yield to ensure it is sustainable and the value of your principal is secure.

These CEFs have had high premiums for years. That made many investors believe the premiums and yields were sustainable. But they weren’t. High premiums meant there was no margin of safety in these funds. In fact, the premiums made the share prices more vulnerable to any bad news than most investments. There was no way to know when an event might come along that would cause their stock prices to take a hit. But the premiums in the share prices made it likely that would happen at some point and that the share price decline would be sharp and swift.

 

URL: https://www.forbes.com/sites/bobcarlson/2019/05/29/how-reaching-for-higher-investment-income-can-bite-retirees/#7b9fdfe727e6

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