(11/16/12) 5 Big-Yield Funds to Watch

You can go out and hunt for yields, or you can find a good manager who knows how to "make" yields using options. After setting some rigorous criteria, this handful made the cut, notes Jim Fink of Personal Finance.

Today’s low-yield world puts income investors in a tough spot.

Fixed-income alternatives are uninÂspiring: five-year US Treasuries yield 0.74%, ten-year US Treasuries yield 1.73%, and investment-grade corporate bonds yield only 3.18%. Newly issued corporate bonds—which have reached $3.3 trilÂlion in value so far in 2012—are being sold at an even lower average yield of 2.68%.

To earn a decent annual return, a fixed-income investor currently needs to assume much greater credit risk in the form of non-investment-grade bonds (i.e., less than triple-B rated, also known as “junk”), which curÂrently average 6.68%.

The problem with junk bonds is that there is an increased risk of default, especially in a weak economic environment as we are experiencing now. Since the beginning of 2011, the default rate on junk bonds has more than doubled, from 0.8% to 1.8%, and JP Morgan forecasts the default rate to rise further into 2014.

High-yield, dividend-paying stocks are another alternative, but investors have already bid up high-yield stocks to arguably nosebleed levels. According to fund manager AllianceBernstein, stocks with yields 20% or more above the market’s now acÂcount for 44% of the S&P 500 on a cap-weighted basis. That’s their highest share in the last three decades, and well above the historical average of 36%.

High Yields at a Discount
One high-yield asset class flying under investors’ radar and which remains attractively priced is covered-call closed-end funds (CEFs).

Studies have demonstrated that a covered-call equity portfolio outperÂforms a buy-and-hold stock portfolio over the long-term. The outperÂformance of covered calls is most pronounced in down markets, which makes the strategy especially attractive to risk-averse investors. The strategy may also offer a tax shelter, since the option income is classified as capital gains, and thus can be used to offset capital losses.

There are 600 CEFs in existence, and about 300 of them are currently trading at a premium to their net asset value (NAV)—“the largest number of funds at a premium we’ve seen.”

I don’t recommend buying CEFs at a premium to NAV, because it means buying securities for more than they are worth. It would be like paying $1.05 for a dollar bill. Almost all of the CEFs trading at premiums hold fixed-income securiÂties. However, CEFs that invest in stocks remain reasonably priced, and on average are trading at a 6% discount to NAV.

Using the www.cefconnect.com screener, I found 31 stock CEFs that focus exclusively on a covered-call option strategy. Their average disÂcount to NAV is -8.1%, which is greater than the stock-CEF average (a good thing).

Only one covered-call CEF trades at a premium to NAV (+9.86%) and I consequently would avoid it—the GAMCO Natural Resources Gold & Income Trust (GNT). This CEF pays a super-high 10.66% annual yield, but if the CEF were to trade at NAV, the capital loss from the CEF price decline would almost wipe out this yield.

The average yield of all covered-call stock CEFs is 9.85%, which is more than three percentage points greater than the average yield of the entire stock CEF universe. Sounds impressive, but keep in mind that covered-call CEFs are able to pay out more in cash because selling call opÂtions caps the upside appreciation of the underlying stock.

For example, if a CEF holds a stock trading at $48 and a call option with a $50 strike price is sold against it for $1.50, the maximum profit the CEF can earn from that stock position is $51.50—a 7.3% rate of return [($51.50/$48) -1]. In contrast, a CEF without covered calls benÂefits from stock appreciation without restriction.

Still, many conservative investors may gladly forfeit speculative upside stock potential that may never materiÂalize in return for receiving additional income up front. In determining which of the 31 covered-call CEFs is most attractive, the yield should not be the determining factor.

Yield chasing never works because high yields can signify high risk of a dividend cut and/or a cash payÂout based on destructive return of capital rather than based on investÂment profits (e.g., income or capital gains). “Total return” is the name of the game, which is defined as the combination of cash yield and capital appreciation. Receiving a 10% cash yield but losing 10% in NAV equals a zero total return and is a worthless return of capital.

Also important is a fund manager good at picking stocks and who outÂperforms a passive index benchmark. Consequently, I screened the covered-call CEF universe for those that met the following criteria:

Positive one-year return on NAV
Annual cash yield lower than one-year return on NAV
Market price at a discount to NAV
Annual expense ratio below 1.2%
Positive 3-year “Alpha” (a measure of risk-adjusted outperformance) against its benchmark index greater than 2% annualized

Out of the 31 candidates, only five covered-call CEFs made the cut, and all five came from just two fund families located in my favorite cities, Chicago-based Nuveen and Boston-based Eaton Vance. The five covered-call CEF star performers are listed below in descending order of yield: