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Appel's Bond Bet: At a Discount
06/02/2006 12:00 am EST
"One strategy to identify attractive closed-end funds is to look for funds selling at large discounts relative to their peers and relative to their own historical discount levels," notes Gerald Appel. Here, he looks at a bond fund trading at a 14% discount to net assets.
"As a rule of thumb, a discount of at least 10% that is also at or above the long-term average discount for the fund warrants serious consideration. Salomon Brothers High Income Fund II (HIX NYSE) now trades at a 14% discount, meaning that you are paying 86 cents for each $1 of underlying bond assets in the fund. A discount this large boosts the yield you receive from the underlying bond assets. Specifically, if the fund were not selling at any discount, its yield would be 7.2%, which is to say that you would receive $7.20 per year for each $100 of underlyings.
"The fund invests in high yield debt, mainly in the US but also in emerging markets. These types of bonds are inherently risky, which is why they have historically paid high dividends. HIX further increases its income earnings and risk by employing leverage. The potential volatility was manifest between 2/28-7/31/2002, a period when the fund’s NAV lost more than 17% (including dividends).
"It is to the fund’s credit that in the past year the portfolio managers have reduced their use of leverage significantly. (Closed-end fund managers are paid based on the total assets under management including amounts borrowed. As a result, they have an incentive to maintain margin balances, so I consider it a sign of attention to shareholders any time a fund manager reduces the amount of leverage.)
"Your yield as a shareholder is therefore $7.20 divided by $86.00, which is 8.4% per year. A yield of 8.4% is very attractive, but only if the level of risk is reasonable and only if the fund is really earning that dividend. Note that a closed-end fund can set its dividend as high as it wants to, and a number of closed-end funds deliberately set their dividends above expected earnings as a marketing move. This practice can be a pitfall for unwary investors.
"The current dividend is supported by investment income. HIX has paid out slightly more in dividends than its bond holdings earned in interest during each of the past five years. During this period capital gains more than made up the deficit. Since HIX holds mainly high yield bonds, its capital gains represent improvements in the perceived creditworthiness of the bond issuers whose debt HIX owns. Starting November 2005, HIX cut its dividend; its current yield of 7.2% of NAV appears sustainable given the most recent level of reported net investment income.
"On 12/31/2003 HIX was selling at a 15% premium. From 12/31/2003-4/30/2006 the fund has lost 4% including distributions. During the same period the NAV has gained 29%. Since November 31, 2005 (the date of the lowest share price), both NAV and share price have been climbing. HIX has also been stable during the past two weeks of market turbulence. This is a good sign. Overall, HIX has the potential to continue paying its generous dividend. The size of the current discount potentially cuts the risk. HIX is recommended as a long term holding at any discount of 12% or greater to NAV."
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