A Bargain Closed-End Income Fund

01/24/2013 6:30 am EST

Focus: FUNDS

Richard Young

Editor, Young's Intelligence Report

If you can find a solid income fund that's trading at a discount, it means you're buying top income stocks at below-market prices, notes Richard Young of Intelligence Report.

This month, I want you to purchase BlackRock Enhanced Equity Dividend Trust (BDJ). The closed-end fund's shares represent a portfolio of high-yield dividend-paying equities. To generate more income, the fund issues covered calls against its equities and uses the premiums to bolster its dividend payment.

Today BDJ yields 7.5%, and the strategy employed by fund management takes advantage of upside potential and protects against downside risk. The upside comes by investing in high-dividend payers.

An analysis by Young Research finds that since 1938, the 10% of stocks with the highest dividends have outperformed the 10% of stocks with the lowest dividends by over 570%. That's upside protection.

During bear markets, the call options sold by BDJ to generate income are worth more. As volatility increases in bear markets, the prices of call options increase, providing the fund with greater cash flow. A higher level of cash flow helps to protect against downside risk in a bear market.

What Else?

Perhaps one of the most compelling reasons to invest in a closed-end fund offering a 7.5% yield is to compare it to the alternatives. Risk-free T-bills are paying zero. Zip. Zilch. Nada. Factor in inflation, and you're losing money by lending to the federal government short-term.

Lend long, and you take on duration risk that will make your head snap when rates are allowed to normalize. The S&P 500 is paying you about 2% today. Not appealing, especially when corporate earnings are poised for a nosedive. You won't find yield in very many places today. The Federal Reserve has seen to that in order to force investors further afield into riskier asset classes. Don't take the bait.

Out of Favor

I always encourage you to mitigate risk when investing. Don't invest with the wave or with those seeking the "next big thing." That's a strategy that cripples IRAs and breaks nest eggs wide open. Today, BDJ is out of favor. Just take a look at its discount.

Buying BDJ gives you its underlying stock portfolio for 11.4% less than if you purchased the stocks one by one. As you can see on my chart, an 11.4% net asset value discount is one of the deepest discounts in the fund's history.

Good Names for Less

The discount is especially appealing when you recognize the good names you are buying for less than they're worth. Many of my equity Monster Master List names appear among the holdings of BDJ. Some of the other names in the top 10 that aren't part of my MML are ExxonMobil (XOM) and BHP Billiton (BHP).

ExxonMobil is the world's largest publicly traded oil and gas company. Its reserves are the largest in the industry, and it is the world's largest refiner and marketer of petroleum products. Exxon's chemical company could stand alone as one of the world's largest. Among its brands are some of the world's most recognizable, including Exxon, Esso, and Mobil. ExxonMobil's market capitalization is just behind that of Apple (AAPL) for second largest in the world at $400 billion. Today ExxonMobil pays a yield of 2.6%.

BHP Billiton is one of the world's largest commodities producers. The miner is active in producing aluminum, copper, energy coal, iron ore, manganese, metallurgical coal, nickel, silver, uranium, oil, and gas. BHP operates at over 100 sites around the world and employs over 100,000 people. Shares yield 2.8% today.

Buy BDJ to pick up great names at below cost. You will earn a 7.5% yield and profit when the gap between NAV and the price of the fund closes. If another recession hits, you'll be protected by higher option premiums that will support dividend payments.

Related Readings:

2 Closed-End Funds for Income

The Top ETFs for 2013

2 Picks from a Fund Guru

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