Bonds are more boring than your Grandpa’s stories about the 1950s. Yes Grandpa, we know you didn’t have TV back then. No, we don’t care.
But guys like me have to tell you do own them in your portfolio. We do this because we don’t want to get sued, and to encourage risk-adverse investors to smooth out their returns by including an asset class which just about always does well as stocks implode, and vice versa. OOH LATIN I’M FANCY.
I’ve even gone as far as arguing that investors should sell their bonds when the market tanks, freeing up cash to buy undervalued stocks and temporary tattoos, for some reason. Eight year olds don’t even think those are cool anymore. No. I don’t care if yours says Spiderman. Put it away, dammit.
There’s just one problem. In a world where interest rates are lower than Bernie Sanders’s chances for the White House (BOOM STILL GOT IT), nobody wants to earn 2% interest. So they migrate to other bond-like securities like REITs or preferred shares. These give higher yields, but usually come with increased interest rate risk.
Check out how much more volatile preferred shares and REITs were compared to bonds over the last five years.
That boring blue line is the thing you want to own during turbulent markets. Those other lines are pretty much the definition of turbulent.
(Goes to dictionary.com, adds “squiggly red and sorta orange lines” to definition of turbulent, gets kicked off the internet forever)
But what if there was a way you could have your cake and eat it too? Is there really a way to get interest rates of 5-10% without taking on big price risk? And did you immediately stop reading and start daydreaming about cake once you saw that word?
Perhaps there is. Let’s take a closer look at leveraged bond funds, a unique product that uses debt to goose returns.
What’s a leveraged bond fund?
Let’s start at the beginning. What the hell’s a leveraged bond fund?
It’s simple. A normal bond fund buys bonds. These bonds pay interest to the fund, which passes it onto you, the investor. You then show your accountant a little cleavage in the hopes that he’ll get you out of paying taxes on this interest.
A leveraged bond fund is basically a bond fund on steroids. The bond fund uses debt to buy even more bonds. The interest on the bonds is more than the interest on the debt, which increases the yield on the whole portfolio.
Remember when I told you guys to how to borrow to buy REITs, letting the dividends pay the interest and keeping the remainder? It’s pretty much like that, but with bonds.
Let’s look at a couple of real life products as examples, starting with the Dreyfuss High Yield Strategies Fund (great band name, amirite?), which trades under the ticker symbol DHF on the NYSE.
This is a fund I’ve owned for years, btw.
It works like this. The fund invests in high yield bonds, investing in companies like Crysler, Rite Aid, Ally Financial, and names like that. These are household names, but they’re definitely not blue chip stocks. On their own, these bonds probably yield in the 5-8% range, depending on the crapitude of the issuer.
In total, the fund owns about 200 different bonds, diversified among pretty much every sector. Approximately 5% of the portfolio is in energy, which isn’t an alarming percentage.
The fund then borrows an additional 33% of its net asset value and puts that cash into more bonds. So it has approximately $260 million of its own capital and $90 million of borrowed money. The interest rate on the debt is quite low, under 2%. Oh, and it has a management fee of more than 1%.
The leverage really adds to the return. Shares pay out $0.0290 each per month, which works out to a yield of approximately 11.2%. That’s succulent, especially in a low interest rate world.
The issue with this leveraged bond fund is the volatility. It already invests in the riskiest bonds, and then it adds leverage to the mix. That combination means you’re looking at equity-type of returns for something that’s supposed to add stability to your portfolio.
So much for that idea, at least from a bond perspective.
But what if we used assets a little more stable?
Leveraging municipal bonds
Dreyfus has a very similar leveraged bond fund that invests in municipal bonds instead of junk, which trades under the ticker symbol DMF on the NYSE. How did it perform?
Pretty well, actually. Over the last five years it gained 11.3% while the junk bond fund lost 34%. Including dividends, we’re looking at a return of approximately 7-8% a year for the muni bond fund.
The current yield isn’t nearly as exciting as the other Dreyfus product, coming in at about 5.5%. That’s half as much as the leveraged junk bond fund, but it’s still a hell of a lot better than you can get investing in government bonds or GICs.
It’s hard to draw conclusions from just two data points, but screw it. I’m going to do it anyway. It’s pretty clear that if you’re going to use a strategy like this, you want to own quality bonds. There’s a reason why the munis did better than the high yield stuff. It’s because munis did better in general.
And for Canadian investors, it’s tough to find Canadian versions of these closed end funds. There are only approximately 150 total Canadian closed end funds, with the majority not using any sort of leveraged bonds strategy. I could only find a couple while researching this post, and they’re so tiny we could probably all get together and buy them outright.
One other note of caution when buying closed end funds. Most trade at a discount of between 5% and 15% of their net asset value. So don’t buy an IPO if it comes out unless you like lighting your money on fire. Wait a few weeks for the discount to be established and then buy.
And if you come across any kind of closed end fund that trades at a premium, run away. Back when I wrote for Seeking Alpha, I wrote about a closed end fund that traded at a ~50% premium to its net asset value. In the meantime, it has dipped below a 10% premium, before settling in at a an average premium of 30% so far this year. Investors who bought at the big premium have lost money.
Anyhoo, let’s wrap things up. Leveraged bond funds can be used as a bond substitute, assuming you’re willing to stomach a lot more volatility. But you should probably just stick with bonds. The only real advantage to one of these funds is the increased yield.