As of 2024, the S&P 500 has delivered an impressive 28% total return, raising expectations that this figure could climb even higher with the anticipated ‘Santa Claus rally’ that often occurs at year-end. Such gains present a favorable outlook for equity funds in the CEF Insider portfolio. These funds not only contribute to substantial stock gain, but they also provide significant cash yields. However, while corporate earnings are increasing, they do so at a slower rate than stock prices, resulting in a price-to-earnings (P/E) ratio of 28 for the S&P 500—almost double the historical average of 16.1. This discrepancy raises concerns about the sustainability of earnings growth, increasing pressure on companies to maintain robust performance going into 2025. Thus, while stock momentum appears strong, volatility risks are concurrently on the rise.
In light of the potential volatility, closed-end funds (CEFs) holding corporate bonds present an appealing strategy for mitigating risk while leveraging the benefits of a robust economy. Currently, the CEF Insider portfolio includes four such funds that yield around 11%, which significantly outpaces the dividend yield of typical S&P stocks. This strategy aligns with a broader principle of portfolio diversification, allowing investors to gain exposure to the equities market while having a buffer against the inherent risks of stock investing during uncertain economic times.
Investing in CEFs offers two primary advantages. First is the opportunity to buy at a discount to the net asset value (NAV); these funds are often traded below their portfolio value, which can enhance long-term returns. Second, CEFs typically yield higher income, averaging around 8% across the sector, with corporate bond funds yielding even more. A prime example is the Western Asset High Income Opportunity Fund (HIO), which currently offers a yield of 10.8%. Such a yield can provide substantial income—potentially generating about $100,000 yearly for a $930,000 investment, paid out monthly.
HIO is noteworthy for its monthly dividend payments and a recent increase in distribution levels. Following a period of reduced payouts due to historically low interest rates, HIO has raised its distributions due to higher interest payouts from the corporate bonds it holds, prompted by the Federal Reserve’s aggressive rate hikes. Although there might be concerns about future rate cuts by the Fed affecting HIO’s dividends, the fund’s bond portfolio has several considerations worth noting, especially regarding the weighted average life of the bonds and effective duration metrics.
The nature of HIO’s bonds suggests they have an average life of 6.7 years, but a more nuanced understanding of effective duration reveals that bonds will mature sooner—within about four years. This means HIO’s payouts could indeed be affected by the prevailing interest rates at the time of bond maturation. However, regardless of the potential fluctuations, HIO provides a consistent income stream that is notably higher than the typical S&P 500 stock. Moreover, the potential for a significant drop in rates, similar to the extreme shifts seen during the pandemic, would likely result in only minor cuts to HIO’s payouts.
Historical data shows that even during drastic rate reductions, HIO only lowered its payouts by 6.25%—a minimal impact relative to its overall yield. Presently, HIO trades at a discount of around 5% to its NAV due to market concerns over interest rate changes, although this discount is gradually narrowing as investor sentiment shifts. This scenario is particularly attractive to informed investors who recognize the underlying strength of HIO’s yield in the face of market fears, positioning them well to capitalize on the fund’s long-term income potential. With such insights and market dynamics, CEFs, especially those focused on corporate bonds, could offer a strategic hedge for investors looking to maintain strong income streams amid volatile equity markets.
