How to benefit from consistent payments of more than 9% while the bond market is booming – Forbes

It’s no secret: corporate bonds are booming. But what might surprise some people is that we are not too late to participate. With a well-managed group of closed-end funds (CEFs), we can still exploit the strong returns of corporate bonds at a discount.

Even still dark Business Insider (famous for his exaggerated calls for an inflation-recession crash in 2022) recognizes the great environment that currently exists for bonds. Recently, BI I had to admit not only that “corporate bonds are the safest in years” but that this is also one of the best bond markets we have ever seen.

Demand for bonds has caused “inflows into U.S. corporate bond funds to reach record levels.” BI notes, while the Financial Times indicates that investors are “to a large extent moving away from less risky products” towards corporate bond funds.

It’s easy to understand why. View the returns of the following three CEFs focused on corporate bonds:

These are just three of many bond CEFs offering yields above 9%, and those yields are better covered by investments in these three funds than they have been in a long time. Here’s why.

Since the Fed began raising rates, bond yields – illustrated here by the average yields on bonds rated Aaa and Baa by Moody’s – have soared. Bond yields generally rise when default risk increases, but defaults this time remain moderate.

Currently, the default rate for private credit is 0.3% and that for investment-grade corporate bonds is around 0.5%. Poorly rated corporate bonds default at a higher rate, around 4.2%, including lower quality junk bonds, so a savvy bond fund manager should be able to avoid them and produce a high-yielding portfolio with relative ease.

And on the ground, we saw exactly this scenario play out. Consider PTY, listed above. During the 2010s, when interest rates were much lower than today, the fund’s net asset value (NAV, or the value of its underlying portfolio) soared. PTY’s portfolio (purple below) even outperformed the S&P 500 (as indicated by the benchmark index fund, orange below), thanks to management’s ability to pick winners and avoid losers.

Not only did PTY beat the stock, it also maintained its generous payouts, which now yield the rich 9.6% we saw in the chart earlier.

PTY has been so successful over the past decade that it has even paid special dividends (the spikes and drops you see in the chart above), despite low rates! Now that yields are much higher and defaults have not increased significantly, PTY will have an easier time maintaining its current payout than it would have in a decade.

Now I have to be honest: PTY was able to do this through a very aggressive trading strategy that other bond funds could not replicate. As a result, their performance was nowhere near as good. Both DHY and EVV fall into this category, which is why their long-term returns cannot match PTY’s performance.

But remember what happened to interest rates.

Unlike PTY, which trades aggressively, EVV and DHY have mandates that limit such aggression, so these funds tend to hold their bonds longer. The secret to their success is avoiding payment defaults. This helped DHY (purple below) and EVV (orange) outperform the broader corporate bond index.

Nonetheless, their long-term performance has been much lower than that of PTY, not only because of their longer holding periods, but also because they were constrained by low corporate bond yields before the pandemic. That’s no longer the case, which is why funds have more reliable dividends than they have in over a decade.

This brings us to the current price of these funds.

As we saw in the top table, while the price of PTY is very high (30.9% at the time of writing), DHY and EVV both enjoy discounts of 8.2%, which which makes them more interesting at the moment. PTY’s strong long-term returns were built in a different environment and are not very useful to us today for the future. With higher yielding bonds in the market and because these funds focus on holding higher yielding issues for a longer period of time than PTY, they are better positioned to secure today’s high yields.

Additionally, DHY and EVV benefit from discounts that make their payments more sustainable. DHY pays 9.2%, but thanks to the magic of CEF rebates, management only needs 8.5% based on net asset value to maintain that payout, while the 9.8% yield d ‘EVV becomes 9%, once again thanks to its discount.

These returns seem incredible, but they are sustainable in a market where bond yields have soared and interest rates, as Jerome Powell recently suggested, are about to fall.

Falling rates (and bond yields) will increase the value of DHY and EVV’s portfolios, while their returns will be locked in. This, in turn, could help both funds see the types of premiums PTY enjoys. If you buy now, you will likely get in before other investors, giving you the opportunity to sell these funds later, at higher prices.

Michael Foster is the senior research analyst for Contrarian perspectives. For more great income ideas, click here for our latest report «Indestructible income: 5 advantageous funds with stable dividends of 10.9%.»

Disclosure: none