Today we are in a situation that looks like a lot of like 2016. And back then, some savvy opponents tapped into it for quick returns of over 62%. The same setup is back again– and with it our chance for more upside potential plus yields above 10%.
There are two closed-end funds (CEFs) poised to deliver these high returns (and total returns); We will compare two popular options in a moment. Let’s start with the corporate bond market as there are many misconceptions floating around these days.
“Junk” bonds aren’t as risky as they seem
You may know high-yield bonds by their nickname: junk bonds.
The unfortunate label refers to low-rated or unrated debt securities issued by companies willing to pay investors a higher interest rate. They are considered risky because they default more often than higher-rated corporate bonds. And you do more fail, but their overall failure rates are still tiny.
Fitch Ratings, one of the most dovish credit bureaus out there, expects default rates to rise from 1.25% in 2022 to 1.5% in 2023 — both levels below historical norms far below the interest rates we’ve seen in 2020. Nevertheless, many bonds are traded fewer than during the pandemic. This has created a buying opportunity in bonds with sustainable cash flow and high yields.
And when you buy through CEFs, you automatically diversify across hundreds of bonds, reducing your risk of default to virtually zero.
2 Popular Bond Funds: One is a Better Buy
To get a clearer picture of the opportunity ahead, let’s analyze it PIMCO High Income Fund (PHK) and the PIMCO Dynamic Income Opportunities Fund (PDO). Both are run by the same manager and both have high returns: 11.5% for PHK and 10.6% for PDO.
Yet one is a great buy and the other less compelling, though both are poised to release in the next few months.
Despite similar management and investment strategies, PDO trades at a discount of 5.8% to net asset value (NAV, or the value of the bonds it holds), while PHK trades at a discount of 5.8% more than his portfolio is worth. That means that to fund its 11.5% dividend (based on its premium market price), PHK needs to generate a nearly 12% total return on its portfolio, which is impossible over the long run, but something for PHK Has could do for shorter periods of time in the past (more on that in a moment).
PDO, on the other hand, needs to earn 10% to fund its 10.6% yield as its market price is discounted to its NAV. It’s still a tough proposition, but not impossible. And here’s why.
A great return – and a great opportunity
Here we have an index of the effective yield that high yield bonds are currently paying. So if you buy a high-yield corporate bond now, you’re likely getting an income stream of about 8.6%, the highest we’ve seen since the pandemic began. It’s also a level we’ve only touched a few times in the last 20 years: 2002, 2008, 2011 and 2016.
Each time yields rose, the market was in its darkest days, with terrorism fears in 2002, a global economic crisis in 2008, a potential US debt default in 2011, and Fed rate hikes sparking recession fears in 2016. can’t repeat itself, but it rhymes.
And the rhyme between now and 2016 is hard to ignore. What happened to PDO and PHK back then? PDO did not exist, but the sister fund of the same name did PIMCO Dynamic Income Fund (PDI) did, and PDI and PHK rose an average of 62% over that period, providing a healthy return for investors who recognized the opportunity. It’s a setup so similar to today’s that it’s a good reason to be bullish on these so-called “junk” bonds.
Michael Foster is the Lead Research Analyst for Contrary outlook. For more great income ideas click here for our latest report “Indestructible Income: 5 Bargain Funds With Sure 8.4% Dividends.”