Closed-end bond funds trading at discounts
Closed-end funds, or CEFs, are mutual funds that trade on the exchange like stocks. "Following the 3rd-quarter sell-off, a number of closed-end bond funds with solid assets are selling at unusually deep discounts," says Martin Fridson, chief investment officer at wealth management firm Lehmann Livian Fridson Advisors. He favors funds with a mix of investment-grade and high-yield corporate bonds.
While Fridson didn't recommend specific funds, one example is the BlackRock Credit Allocation fund. It invests in investment-grade bonds and junk bonds and trades at about a 12% discount to its net asset value. That gives it a juicy yield of 7.8%. This fund and many others like it use leverage (borrowed money), which can boost returns when interest rates are low but depress returns when rates are high.
In choosing a CEF, Fridson offers these recommendations:
- Look for consistency of return: top quartile performance in 1-, 3- and 5-year performance versus peers and benchmarks.
- Confirm that the management team that produced the superior performance is still in place.
- Verify that the superior performance wasn't the function of a single, aggressive sector bet.
- Look for deeper discounts than the historical average.
- As a bonus, look for price momentum.
Energy and financial stocks: Value and Fed play
Energy stocks have been beaten down by the plunge of oil prices over the past 18 months, making them an attractive bargain, says Nicholas Colas, chief market strategist for Convergex brokerage firm. Meanwhile, the Federal Reserve will almost certainly raise interest rates next year, making financial stocks attractive, he maintains.
As for energy stocks, "commodity prices seem to have stabilized," Colas says. His clients "think the selling is overdone." The S&P 500 Energy index has returned a woeful -20.7% over 1 year through early November, compared with a positive, albeit meager, return of 1.9% for the entire S&P 500.
"U.S. oil production is declining, and demand is still strong in the U.S.," Colas says. In addition, the world economy continues to grow and should recover from its recent slowdown, implying stronger future demand for oil, he says. "Tie that all together and you have a good value story."
A boost in rates in 2016 would allow banks to earn more income on their loans and bond holdings. Meanwhile, banks are generally able to lag behind the Fed's pace in raising rates for their depositors, so banks' net interest margin should increase, Colas says.
Master limited partnerships: Sifting through the rubble
Tim Ghriskey, chief investment officer at Solaris Asset Management in New York City, recommended MLPs last year. And he's just as bullish this year after about a 31% plunge in the Alerian MLP Index of 50 companies over the past 12 months, thanks to weak oil prices. MLPs, which trade like stocks, consist mostly of firms that own oil and gas storage or transportation facilities, particularly pipelines.
The units of partnership "have been decimated, and now they are a real bargain and offer a high yield," Ghriskey says. The Alerian index sports a yield of around 7.9%.
"Trends are still in favor of natural gas," Ghriskey says. "There is a lot of conversion from fuel oil to gas for heating, ventilation and air-conditioning systems." In any case, oil prices can easily pop back up, he says.
In addition, MLPs that own pipelines often have long-term contracts, with fees that escalate over time.
There's also a tax advantage. MLPs' payouts to investors are mostly return of capital rather than dividends, so they aren't taxed but are subtracted from your cost basis. But beware that you have to file a complicated K-1 tax form every year.
High-yield bonds: Buy the dip
Junk bond prices have tumbled amid the oil-price plummet, stock market volatility and concern about rising interest rates. The Barclays U.S. Corporate High-Yield index has produced a return of -2.8% in the past year. And the index's yield has risen to about 7.6%, compared with about 1.7% for the Barclays U.S. Treasury index yield.
"Yield spreads have widened to the point where lenders are reluctant to extend credit to lower-rated borrowers," says Jack Ablin, chief investment officer for BMO Private Bank. "But it's not a distressed asset class. The default rate is quite low." The default rate for high-yield bonds totaled 2.5% through September.
Yields at these levels are quite attractive compared with other income-producing assets, he adds. "We would use the near-term turbulence as a more attractive entry point."
Tom Fredrickson, an independent financial adviser in New York City, also sees the high-yield space as appealing. "It might be a reasonable strategy to allocate a sliver of one's portfolio to a low-expense, no-load high-yield fund, such as Vanguard High-Yield Corporate," he says. The fund has an expense ratio of 0.23% and yields 5.6%.
But bear in mind that these are bonds of companies with below-investment-grade credit ratings. "They are far riskier than plain vanilla bonds and should not substitute for those bonds," Fredrickson says.
High-yield bonds: The bearish case
Not all investment experts are enthusiastic about junk bonds. "If the Fed raises interest rates and Treasuries do badly, high-yield bonds shouldn't do well either," says Mick Heyman, an independent financial adviser in San Diego.
"You might get a positive return if the economy does well," Heyman says. A strong economy can boost the earnings of companies issuing junk bonds, making them less likely to default. "But you're still much better off going into stocks," he says. "There's less risk and more potential for capital gains."
And if the economy does poorly, "these things (junk bonds) could get crushed because investors have to get out of low-quality assets," Heyman says. "So high-yield bonds could underperform, whichever way rates go."
In a balanced portfolio, "growth stocks are the best choice to make money," Heyman says. "You can have risky stocks and safer dividend stocks." And for true safety, you can opt for cash and low-risk bonds, he says. "People want to get that extra yield (from junk bonds,) but they perform more like underperforming stocks."
Biotechnology stocks: Still overvalued
The S&P Biotechnology Select Industry Index has plummeted 21% since July 17 but still has more than tripled over the past 5 years. "Biotech stocks are expensive and highly speculative," says Solaris' Ghriskey. That's because many of the medical treatments pursued by biotech companies don't pan out.
"The price of pharmaceuticals remains in the cross hairs of politicians," Ghriskey adds. Several of them have complained about the high prices that biotech and other drug companies are charging for their products. "For the long term, biotech stocks are a great place to be, but in an election year they seem to be a bipartisan punching bag, so there could be headline risk," says BMO's Ablin.
Biotech stocks could be among the first to fall if the overall market tumbles, Ghriskey says. "Given a stock market somewhat constrained by slowing global growth, (coming) increases in interest rates and other issues, I would be cautious of high-valuation names in what remains a very high valuation group," he says. Ghriskey and Ablin say shares of smaller biotech companies are the most dangerous. If you are interested in investing in biotech shares for the long term, wait until after the presidential election, Ablin says.
Long-term Treasury bonds: Vulnerable to Fed rate hikes
© CARLOS BARRIA/Reuters/Corbis
With the Fed poised to boost interest rates, Treasury bonds with maturities of 10 years or more are "a bad place to allocate capital," says Convergex's Colas. "Bond yields have to move higher if the economy continues to improve and the Fed raises rates." When yields go up, bond prices fall.
Colas sees economic growth of 2% to 2.5% next year. "That's not great, but it's sound enough to make the long end of the yield curve go higher," Colas says.
He acknowledges that long-term Treasury yields failed to rise in the face of Fed easing in the mid-2000s. But with the 10-year Treasury around 2.3%, less than 1 percentage point above its 2012 record low of 1.395%, "it's hard to believe that if we get another year of economic growth and we get Fed rates, the long end doesn't need to sell off," Colas says.
The Fed has kept short-term interest rates near record lows for more than 6 years. Colas expects the central bank to lift rates 2 to 3 times in the next 12 months, by 25 basis points each time.