Posted by: Aaron Pressman on July 30, 2007
The other day, I offered up a couple of ways to hedge or speculate on the world of crashing sub-prime mortgages and loosey-goosey corporate borrowing binges. There are a zillion more, of course, as every Tom, Dick and Harry Hedge Fund Manager is no doubt trying to uncover ASAP. One of the best ways historically to invest in a contrarian manner is in the world of closed-end funds. These funds are sort of like mutual funds but they trade in real time on an exchange and have a fixed number of shares outstanding. That means when investors decide to pile in or out in a herd, the price per share can get out of whack with the value of a fund’s underlying assets. And that’s where opportunities can arise. When the discounts get extreme due to short-term investors fleeing, smart investors snap up the shares and the discounts narrow. It doesn’t always work, if say the reasons the short-termers got out proves to be valid, so you have to do your homework.
Mariana Bush, one of the savvier folk who follow closed-end funds, looked at a range of credit plays in a report last week for Wachovia Securities to sort out the opportunities from the traps. At the bottom of the credit world — the shakiest stuff — there are actually some closed-end funds that have invested in sub-prime mortgage securities and other financially-engineered exotica. During the most recent credit crash, from June 1 to July 11, so-called subordinated structured finance funds lost 11% on average, even as the reported value of their holdings dropped less than 3%, Bush found. So the funds, which used to trade at a premium to the value of their assets, now mostly trade at modest discounts of 5% or so. As a result, they sport insane yields in the 14% to 15% range. For example, Regions Morgan Keegan Strategic Income Fund (Symbol: RSF) yields 14.9% and RMK Multi-sector High Income Fund (RHY) yields 13.9%. But Bush says her firm is wary of further problems in the sector and no matter how enticing the funds may appear, she’s not pushing them.
Next up from the bottom on the credit food chain are funds that invest in high yield bonds, which have been hit by the widening gap between junk yields and Treasury bond yields. Back in June, the average junk bond yielded about 2.4 percentage points more than a Treasury bond of equivalent maturity. That spread blew out to more than 3.5 points in July. Investors in junk bond closed-end funds headed for the hills so discounts on some of these funds now exceed 10%, like the Western Asset High Income Fund (HIF) or the Dreyfus High Yield Strategies Fund (DHF). Again, with the odds favoring more carnage, however, Bush isn’t seeing a lot of value there.
Much closer to the top of the credit food chain, at least the credit of corporations, are funds that hold first-lien bank loans. These are among the most senior of borrowings and the least likely to get hurt by problems in the credit world. Funds like ING Prime Rate Trust (PPR) and LMP Corporate Loan Fund (TLI) trade at discounts of at least 5% and have tempting yields over 8%. Bush says PPR and TLI are two of her favorites in the area. The main risk with these type of funds would be if short-term rates dropped, for example if the Federal Reserve started cutting rates, because the bank loans they own typically charge a floating rate of interest tied to a benchmark like LIBOR. That’s not expected to happen as the Fed still seems caught up in a possible inflation spike.
Currency closed-end funds, also trading at slight discounts to their asset value, offer another opportunity in the current world of fixed income turbulence, Bush says. The Global Currency Strategy Income Fund (GCF) and the Nuveen Multi-Currency Short-term Government Income Fund (JGT) invest in a variety of interest-bearing securities from around the world. The Nuveen fund simply owns a bunch of non-dollar assets so it’s a play on the weaker dollar and yields over 9%. The other fund goes short some currencies and long others, some it’s more of an all-weather currency fund and yields almost 8%. Either way, they’re out of the way of our own nation’s credit ills.