In my most recent post Beware the Dividend Yield Trap, I discussed how to avoid getting sucked into buying into a closed end fund (CEF) or a mortgage REIT simply by looking at the dividend yield.

In this post, I am going to contradict myself with an important caveat: this post is for people that are already comfortable with how a closed end fund is structured, know the levels of volatility that they can handle and are comfortable with leverage. If you are one of those people, then a high dividend fund or mortgage REIT may be right for you.

If you are familiar with the concepts just mentioned, then you are likely a pretty knowledgeable and seasoned investor. I am going to dive into some of the mortgage REITs and CEFs mentioned and not mentioned in previous posts and explain in more detail the risks and benefits of investing in these stocks.

Choosing Your Benchmark

Your benchmark is the baseline of what you compare your fund to. I see a lot of misuse of benchmarks in financial press and literature. Your benchmark should have similar risk and asset class to what you are investing in. Therefore you shouldn’t compare your CEF which holds high yield fixed income assets to the S&P 500. Although there may be strong correlation between the performance of the two, the S&P 500 is large cap equity risk and should be compared to other funds that focus on the large cap equity space in the US.

The point of my last post is that over the long term of 5 years or more, if you are looking for 7-9% type annual returns, then putting your funds in an equity index fund or a balanced index of stocks and bonds is your easiest and best bet. I used the example that the returns of the index would likely beat mortgage REITs like NLY and CEFs like ACP and do it with a lot less risk.

However, that comparison wasn’t exactly fair. The S&P 500 isn’t the benchmark for funds like these. Rather the benchmark for NLY may be FTSE Nareit U.S. Real Estate Index and that of ACP may be the Barclays Capital U.S. Corporate High Yield Bond Index. To further complicate this, since ACP uses leverage, we may want to divide the volatility and return of the Barclay’s index by the percentage of equity in ACP to arrive at appropriate benchmarking return and volatility.

For example, if the Barclays index returned 8% in 2017 and ACP returned 12% but with 50% leverage, we would have expected ACP to return 16% that year (8% / 0.5). 12% was underperformance and we may be tempted to try another fund with returns closer to or better than the leveraged index return.

In the example of NLY, their investor relations website touts how they have beaten the S&P 500 by over 2X since it’s IPO in 1997. However if you look at the total return of the FTSE Nareit U.S. Real Estate Index over the period from 1997 ending at 2016, the return has actually been 4X the return of the S&P 500, so NLY underperformed the index of which they are a part of!

Source: Seeking Alpha

So knowing what you should be comparing your returns to is important. Leveraged stocks and funds can add value over the long term though, as long as they are able to use their leverage responsibly.

Fixed Income May Be the Exception

There is a particular closed end fund that has shown to outperform its unleveraged portfolio over time and managers have seemed to use their leverage responsibly. These are municipal bond closed end funds. The closed end funds can deliver return a few different ways:

• Price return
• Income
• Tightening of an NAV discount
• Discount to NAV capture

Over time these funds have shown to beat out the return of open ended municipal bond funds, noting that certain time periods tended to underperform.

Source: Rareview Capital

These periods of underperformance were in rising interest rate environments. Why is this? Because they are leveraged funds that constantly need to issue new debt to maintain their leverage. In a rising rate environment, the new debt being issued gets more expensive as rates go up and depresses earnings.

In a falling interest rate environment however the opposite is true. Leverage is getting cheaper and earnings start to grow as this is cycled in.

Essentially they are doing what a bank does, borrowing short (like deposits for a bank) and putting those funds to work with long term assets. The funds tend to keep a reasonable amount of leverage too at 36%. Not a figure so high that you start to see wild swings in the CEF price being the norm.

Buying at a discount makes a difference as well. I have seen a number of “hot” closed end funds tank after investors jumped in and punched up the share price high above the NAV. Before Bill Gross left PIMCO many of the CEFs there traded at high premiums to NAV. This still persists with some funds to this day. It could just be the name recognition of PIMCO and the association made with that firm and Bill Gross’s outperformance for some many years but returns like that of their High Income Fund don’t really seem to warrant the 25% premium to NAV that the fund sees right now.

The Time is Now

In essence this can be extrapolated to any fund or mortgage REIT that uses leverage to maintain its payout. If you are looking at a shorter term horizon like 3 years, now may be the optimal time to jump into leveraged funds and REITs. It’s pretty much consensus at this point that rates will likely fall further into next year. Now may be the time to load up on those stocks that can take advantage of this environment.

As always though, they have to be the right investments for you. Muni bonds make sense for those that are in the top income brackets, because they are untaxed. The lower yields, compensate for the fact that the bonds are not subject to any local, state or federal taxes.

Source: Rareview Capital

In addition, for mortgage REITs you may want to consider if your portfolio is sufficiently diversified to be taking on the risk of a single stock, even if it is a well managed one like NLY. Keep in mind that the index has outperformed this name over time. If I were putting my own money to work in this particular sector, I would buy the index first then add to a position in a name like NLY until rates look likely to tick up again. I then would just reinvest in the index after that point.

Conclusion

In any type of environment, there are always going to be opportunities. If you are a sophisticated investor, comfortable with volatility and leverage, then now may be the time to take some measured risks by getting into a few well run muni CEFs, mortgage REITs or even taxable fixed income CEFs. Sometimes the trap isn’t a trap, if you know what you are doing.

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