Non-Traditional High Yield Favorites

06/09/2014 9:00 am EST

Focus: FUNDS

Samuel Lee

Editor, Morningstar ETFInvestor

If you invest in actively managed junk bond funds, they had better be really good or cheap (preferably both), because a 1% expense ratio eats up all the expected excess return from junk bonds, cautions Samuel Lee in Morningstar ETFInvestor.

And if you're favoring the highest-yielding, bottom-of-the-barrel bonds, you had better be invested with an elite manager, because that sector of the market is going to get devastated when the credit cycle turns.

That said, bonds rated CCC and under are not necessarily undesirable. Fortunately, there are some decent fixed-income opportunities in closed-end funds (CEF). Below are two of my favorite funds in the non-traditional credit group.

My first pick is PIMCO Dynamic Credit Income (PCI), which trades at a 5%-6% discount and yields 8% on market price. It's not cheap, though, with a 2% expense ratio that's only partially offset by the yield pickup from its discount.

I like this fund because, like many PIMCO CEFs, it has exhibited outperformance on a NAV basis against similar-mandate PIMCO mutual funds, even after adjusting for leverage.

While the sources of PIMCO CEFs' outperformance are opaque, I think the drivers are 1) an illiquidity premium from concentrating in hard-to-trade bonds and 2) security selection. PIMCO CEFs are almost like hedge funds in that they take idiosyncratic bets, apply lots of leverage, and charge relatively high fees.

PIMCO Dynamic Credit Income is an unconstrained fund, so it's hard to predict how the portfolio will be positioned in the future. Historically, it's had a mix of junk bonds, bank loans, non-agency mortgage-backed securities, agency MBS, “stressed” debt, and developed-markets debt.

However, since Alfred Murata took over as lead portfolio manager and Dan Ivascyn was added to the roster early this year, the fund's allocation to non-agency MBS and non-US developed markets debt has ticked up, and its duration has dropped to 4.5 years. A positive sign is that Bill Gross has been loading up on the fund recently.

Another fund of note is TCW Strategic Income (TSI), managed by Tad Rivelle's team at Metropolitan West.

At first glance, TCW Strategic Income doesn't look like much. Since all but eliminating leverage and cutting its distribution, the fund yields about 5% on market price. It's also small, with $262 million in assets, and less liquid than my other picks.

The fund's main strength is its exceptional value compared with other well-managed unconstrained funds. While its 7% discount isn't deep, its 1% expense ratio, plus the yield pickup from its discount, means an investor effectively pays around 0.6%.

TCW Strategic Income today owns less-liquid, more complicated bonds like non-agency MBS and asset-backed securities. However, it can own pretty much anything and will even time its exposure to the S&P 500 (SPX) through futures.

It's clear from Rivelle's letters that he's aware of the credit cycle and has a contrarian streak, two qualities necessary for thriving over the long run in credit markets.

Rivelle and his wife own over 600,000 shares between them worth more than $3 million today. They most recently bought shares in January for about $5.30 each. I want to reiterate that TCW Strategic Income is small and illiquid, so be careful and patient when buying.

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More from MoneyShow.com:

Five Fund Strategies for Income

High Yield Bonds: More of the Same?

High Yield Bonds: The Next Crisis?

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