Large stack of money saving coupons.
Closed-end funds (CEFs) are ready to climb after two months of decline. In preparation for this pop, some vanilla investors are buying this 11.1% dividend with its 14% downside.
Wait, What?!
Everyone hated bonds today. And yet, somehow, these bonds sell for $1.14 on the dollar.
I certainly wouldn’t. I would prefer fixed income than everyone else hated. (More on these reduced dividends in a moment.)
Who is this “I will pay a premium” beauty from the basic income ball? Convertible links. Convertibles pay regular interest. This way they act like links. You buy them and “lock in” regular coupon payments.
But convertibles are Also like stock options in that they can be “converted” from a bond into a stock by the holder. So you can think of them as bonds with upside potential similar to stocks.
You might think that few people are paying for the rise in stocks today. If so, well, you would be wrong. Fear dominates the financial markets today, but convertibles (for whatever reason) still attract a lot of people!
Let’s start with the Barclays Capital SPDR Convertible Bond ETF (CWB), the most popular mainstream (read: widely marketed) vehicle to buy convertibles. CCB’s yield is only 2.2%, but many investors and fund managers choose it because it’s easy.
But that 2.2% really insults true convertible connoisseurs. So these guys and girls pile into the closed fund (CEF) Calamos Convertible and High Income Fund (CHY). CHY has an overall yield of 11.1% and also has “convertible” in its name, so why not!
However, that dividend “alpha” relative to CWB is about all we have on the resume. CHY and CWB have performed similarly over the past 10 years, so they are the same, right?
Unfortunately no. Not today, at least. CHY earns a 14% premium to the value of its underlying holdings. Investors pay $1.14 for a dollar of convertible securities (while CCB buyers pay only $1).
It wasn’t always like this. Barely three years ago, we discussed CHY because it was trading at an 11% discount to its net asset value (NAV). It was selling for only 89 cents on the dollar!
It was a good deal. Over the next year, CHY soared 54%, including dividends. This reminds us contrarians once again why we always demand cuts.
With CHY trading at a premium, it is now poised to underperform. Avoid.
A better bet is the municipal credit (NVG) without Nuveen AMT. After U.S. Treasuries, muni bonds are the safest bonds in America. And lately, munis have been comparative darlings! No debt drama for those annoying payers.
When it comes to bonds, boring is good.
Munis are generally SO commonplace and reliable that they are rarely put on sale. And here’s the great thing about municipalities, at least for us investors: When they need money, they issue bonds. The authors of muni bonds are not sensitive to interest rates.
(Taxpayers, cover your ears!)
Which means muni funds are the place to be right now. Or at least soon. But you wouldn’t know that from their reviews. Unlike the convertible-powered CHY, boring old NVGs trade at 16% discount at its net asset value today.
Yeah! This well-managed muni fund is on sale at 84 cents on the dollar. Buy the stock for less than $10, receive $1.85 in NAV for free.
And oh by the way, the fund just came raised its monthly payment of 19%! The fund pays 6.1% and on a tax-exempt basis — they’re tax-exempt, remember — it’s even better. For my top tax bracket followers, that’s a tax equivalent return of almost 10.4%:
NVG tax equivalent yield
At the same time, this tax-advantaged dividend comes with not one but two safety margins:
- The 16% markdown. As this discount decreases, the fund will benefit from rising prices.
- Additionally, net asset value gains are likely as interest rates stabilize.
Yes, NVG is positioned to be a special trifecta for taxpayers. The American economy East slow down on the way to a possible recession. Which means that long-term rates will eventually fall.
This move will push cheap munis like these much higher. Not bad for supposedly boring obligations! Now is the perfect time to hop aboard the slow, steady, cheap muni train, before our rich friends park their high-flying, overpriced convertibles and head our way.
Brett Owens is chief investment strategist for Contrarian perspectives. For more great income ideas, get your free copy of his latest special report: Your early retirement portfolio: huge dividends, every month, forever.
Disclosure: none