Technicals indicate the S&P 500 will fail in its breakout attempt, writes Al Brooks....
Income at a Discount
10/14/2005 12:00 am EST
"We are introducing a new income strategy to our newsletter," says Gerald Appel, editor of Systems & Forecasts. Here, he explains closed-end funds, and his approach to buy these funds when they are trading at discounts to their net asset value.
"Because there is no redemption of closed-end fund shares, the only determinant of price is supply and demand. As a result, many closed-end fund shares trade at significantly less than the fair value of the underlying assets, or what is called their net asset value, or NAV. Funds available for less than the market value of their portfolios are said to be selling at a discount, while those trading for higher than their NAV are said to be trading at a premium.
"All else being equal, it would seem preferable to buy funds at a discount. Therefore, our strategy is to select funds with attractive yields which are selling at above-normal discounts and which have a record of keeping distributions in line with investment earnings. There appear to be a number of relative bargains for investors seeking ongoing income in the closed-end fund marketplace.
"Cohen and Steers Utility Fund (UTF NYSE) has been available at below market value for most of its history since inception in 2004. The discount is now at 15%, which is an all-time high for this fund. In 2005 year-to-date, the total investment return of UTF based on the underlying assets in the fund has been 16.6%. However, shareholders made only 12.5% (including distributions) during the same period. Because the share price has lagged the growth in the value of the underlying investments by 4% in 2005, the discount to NAV has widened by 4% this year.
"UTF appears attractive because of its 15% discount to fair value. A 6% discount is a more typical discount for closed-end funds. If the discount were to revert towards this more typical spread of 6%, investors in UTF could achieve capital gains above the underlying investment returns. Because this fund is just a year and a half old and has existed only during a strong bull market for the sector, the jury is still out as how it will perform during a full market cycle of advances and declines. We note that we have purchased UTF for our clients.
"We are also recommending a national municipal bond fund, Morgan Stanley Insured Muni Bond Trust (IMB NYSE). This fund yields 5.5% federal tax-exempt (equal to 7.6% taxable if you are in the 28% federal tax bracket), and is selling at an 8% discount to NAV. Default risk is relatively low because all the bonds are insured. (This is unusual for closed-end bond funds, many of which invest at least a portion of their portfolios in below-investment-grade bonds in order to generate extra yield.) Since inception, the total return of the fund has been 7.7% per year based on NAV. The fund was launched in February, 1991.
"We caution that this is a potentially risky fund. First, the average maturity of its bonds is 18 years. Second, the fund goes on margin to the extent of 50% of shareholder equity. As a result, the fund is very sensitive to interest rate changes and has suffered steep losses during past bond bear markets: 22% in 1993-1994, and 21% in 1998-1999, including income distributions. These significant risk levels might be potentially mitigated by buying at its current discount. For example, about half of the share price losses in 1994 and 1999 were due to the disappearance of a premium and the emergence of a discount."
While there is definite technical weakness ahead, Joe Duarte of In-the-Money Options, suggests buyin...
OPEC & Russia stay committed to production cuts as overall crude oil demand increases, reports P...
Markets this week will focus on three major central bank reports and next Brexit vote, says Fawad Ra...