Are Investors Really This Dumb?

In searching for the best investments, value investing legend Benjamin Graham had a simple philosophy: buy dollars for $0.50. That sounds simple, but apparently, some investors haven't gotten the message -- and they're happily paying as much as $1.75 for the same dollar.

The best place to find these sorts of discrepancies is in the world of closed-end funds. In some cases, investors pay way too much -- but in other cases, you can pick up some interesting bargains.

The priciest bonds out there
Bill Gross has said that he thinks Treasury bonds are overpriced. Yet his own PIMCO closed-end funds are currently the biggest offenders for charging premium prices for their shares. As a recent Barron's post discussed, the Pimco High Income Fund (NYSE: PHK  ) and the Pimco Global StocksPlus & Income Fund (NYSE: PGP  ) both had premiums to their net asset value of more than 70%.

Why would this happen? The answer has to do with the hugely attractive dividends these closed-ends pay. Based on their most recent monthly payments, the funds have distribution yields of 11.6% and 10.8% respectively. But after digging a little deeper, what becomes clear is that those distributions don't necessarily reflect the income the funds' investments generate -- and slowly but surely, investors are having their own capital handed back to them.

Consider these facts:

  • Both funds use significant leverage, with the High Income Fund having $1.41 billion in total assets but only $840 million in net assets after taking its borrowings into account, according to Morningstar. With current low rates on borrowing, that allows the funds to double up on higher-yield bonds -- but it also leaves investors dangerously exposed if the value of those bonds falls.
  • Both funds have had part of their monthly distributions characterized as a "return of capital" for tax purposes. That's a positive from a tax liability standpoint, but it's a negative if you want to live off your income and preserve your principal.
  • Perhaps most important, neither fund has particularly rare investments. With a combination of derivatives and various types of bonds, the portfolio resembles something you'd expect to see in many high-yield portfolios.

To be clear, I'm not knocking those investments themselves. AIG (NYSE: AIG  ) bonds appear in both portfolios, and while that's undoubtedly a risky proposition, the current value of AIG's shares show investors' belief that those bonds will eventually pay in full. Similarly, Ford (NYSE: F  ) may currently have junk bond status, but many expect the company to climb back to investment-grade status in the near future.

The long-term perspective
What bothers me, though, is what has happened to the per-share value of the funds' assets over time. Just in 2011, Pimco High Income saw its net asset value fall from $9.10 to just $7.27. Back in early 2007, its net asset value was more than $15. Even after considering the dividends it paid out, the fund lost money on a net-asset-value basis -- yet the stock climbed. For the other fund, NAV went from more than $27 in early 2007 to less than $11 at the end of 2011.

More troubling is the fact that as recently as 2008, these funds traded at a discount to their net asset values. It's true that the low-interest-rate environment has helped all leveraged investments, from these dividend-paying closed-end funds to high-yielding mortgage REIT Annaly Capital (NYSE: NLY  ) and its peers. But just as Annaly is vulnerable to a rise in short-term interest rates, so too will these closed-end funds face big challenges once the leverage punch bowl gets taken away.

Don't pay up
When closed-ends like these trade at discounts -- as they did in 2008 -- they give investors big bargains. But trying to jump in now just because of their inflated yields is riskier than it's worth. Even if you're hungry for income, look elsewhere to get payouts you can count on going forward.

Let me suggest just such a place to look. The Motley Fool's latest special report looks at several stocks that have the features you need to have a rich retirement. It doesn't cost a dime -- but grab it today while it's still available.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.

Fool contributor Dan Caplinger sticks with discounted closed-ends. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital and Ford. Motley Fool newsletter services have recommended buying shares of Annaly Capital and Ford, as well as creating a synthetic long position in Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never charges a premium.


Read/Post Comments (7) | Recommend This Article (24)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 25, 2012, at 11:03 AM, lewellen180 wrote:

    The article says, at one point, "Yet his own PIMCO closed-end funds are currently the biggest offenders for charging premium prices for their shares."

    The funds themselves do NOT, repeat NOT, set the price for their shares, nor do they receive (except at the initial offering) a financial gain for you buying them.

    After the initial offering, if you buy a share of a closed-end fund, you're buying the share from another investor, not the fund itself.

    While one could quibble with the investment choices the fund managers make, their use of leverage, the return of capital, the expense ratio, and so forth, it's the market - i.e. investors - setting the premium (or discount), not the fund managers.

    The funds themselves aren't the offenders in charging premiums. Investors are the offenders here - and, yes, it seems that many of us are that dumb.

  • Report this Comment On January 25, 2012, at 11:17 AM, terracomm wrote:

    i'm one of the believers in the bond bubble.

    and this is just one more reinforcement.

    stay away!

  • Report this Comment On January 25, 2012, at 11:29 AM, TMFGalagan wrote:

    @lewellen180 - You're absolutely right, and I didn't mean to imply that the funds were somehow involved in somehow pumping the shares. This is purely a phenomenon of investors in the secondary market.

    best,

    dan (TMF Galagan)

  • Report this Comment On January 26, 2012, at 7:20 AM, definer wrote:

    It's also all a matter of timing. I purchased PHK in August for the monthly dividend. I have seen capital appreciation of more than 4% since then and have also received more than 4% in dividend payout since then.

    As mentioned by lewellen180, the price of the stock is determined by the market - the supply and the demand. Overvalued or not, the market has been kind to me so far.

  • Report this Comment On January 27, 2012, at 6:06 PM, sikiliza wrote:

    Looks like the author was saying simply that one shouldn't buy a fund whose price is greater than its NAV. He however went off on a tangent lunging at Gross and Pimco for "charging 70% premiums". Like someone mentioned above, once the issue is done PIMCO has no hand in setting the prices for the Funds that are traded on the open market.

    This could certainly have been written better.

  • Report this Comment On January 29, 2012, at 6:44 AM, linkmont2 wrote:

    TMFgalagan states:

    "The long-term perspective

    What bothers me, though, is what has happened to the per-share value of the funds' assets over time. Just in 2011, Pimco High Income saw its net asset value fall from $9.10 to just $7.27. Back in early 2007, its net asset value was more than $15. Even after considering the dividends it paid out, the fund lost money on a net-asset-value basis -- yet the stock climbed. For the other fund, NAV went from more than $27 in early 2007 to less than $11 at the end of 2011."

    and yet according to morningstar the 5 year NAV growth for both funds was greater than 5%.

    there's a serious difference of arithmetic here.

  • Report this Comment On January 31, 2012, at 3:51 PM, gcomp wrote:

    "...so too will these closed-end funds face big challenges once the leverage punch bowl gets taken away."

    Just listen to the Fed, that's not going to happen until the end of 2014, highly levered mREITs & levered CEFs will be printing money until then, which is why the leveraged CEFs trades trade at a premium. There's money laying on the table, you can take it or, if you believe in the Efficient Market Hypothesis, doubt that it's there.

    If you're in the trade until late 2014 and these CEFs sell off in expectation of rising rates, it's your own fault, you stuck around the trade too long, but that's the case with any trade.

    And if you're worrying about what will happen to something you own almost 3 years from now, you need to focus more on the near-term, this isn't a buy and hold market right now.

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