Closed-end funds provide the role of ensuring significant diversification so that our income remains steady whatever weather the world throws at us this year, suggests Rida Morwa, income specialist and editor of High Dividend Opportunities.
The funds in our portfolio have a primary focus, buying in certain sectors or types of investments. This means you can gain instant diversity and exposure to dozens or even hundreds of tickers in a sector by buying a couple of funds.
What sets our CEF picks apart from ETFs is that they are "actively managed", meaning that a manager is actively deciding what to buy and sell.
A well-managed CEF will outperform the indexes in its sector. Therefore, at HDO, we take the manager of the particular CEF that we invest in very seriously, his track record, his portfolio, management team, and skills to maximize profits in good and bad times.
Second, some funds use leverage. Leverage amplifies positive and negative returns. So when you are very bullish on a sector, you want to look for leveraged funds.
The best thing about CEFs is that they tend to be very friendly to income investors. They pay out the majority of income and capital gains through dividends. Resulting in a relatively stable price over time and a hefty stream of dividends.
CEFs are the workhorses of our dividend garden. Providing a steady income stream while allowing us to quickly gain diverse exposure to a wide variety of investments.
Tekla Healthcare Opportunities Fund (THQ) — yielding yield 5.8%
If you are looking for growth at bargain prices, there is no better place to invest other than the healthcare sector. Despite having very strong tailwinds, this is one of the cheapest sectors that the markets offer today.
We can be very thankful that we live in a time where medical care is advancing, making illnesses and injuries that were once a death sentence, survivable. Heart surgery, knee and hip replacements, cancer treatments, and more have advanced at an incredible rate over the past 40 years. The costs have advanced right along with it.
THQ is diversified within the healthcare sector with 37% of the fund invested in pharma and biotech companies, 19% in medical equipment, and 19% of the fund invested in healthcare providers and services companies.
As a sector, healthcare has very strong fundamentals with an aging U.S. population increasing demand for medical services and equipment across the board.
The healthcare sector is only going to get hotter from here. THQ is a great way to take advantage of it and is currently trading at a 2.6% discount to NAV. THQ uses leverage to improve returns, they are currently leveraged at 20% of gross assets.
THQ is an actively managed fund with Tekla being one of the best managers in the field. This means that not only do you get an actively managed portfolio, but you also get access to "private investments" that are not listed or, in other terms, you would not be able to access as a retail investor.
As an added advantage, healthcare is one sector that is inflation resilient because it can pass the rising costs directly to the consumers. So it is a good sector to hold for the next few years as inflation (and inflation expectations) pick up.
Calamos Dynamic Convertible and Income Fund (CCD) — yielding 7.4%
CCD primarily invests in convertible bonds. These are bonds that collect regular interest payments but are convertible into common stock if the stock is above a certain price.
This conversion is usually at the option of the bondholder, meaning that once the common shares are above the conversion price, the bond price will increase along with it. Yet the bond will continue to collect interest payments and still has seniority in the capital structure.
Convertible securities offer investors the potential for equity-like appreciation while providing the downside risk protection of a fixed-income instrument. The defensive nature of this asset class makes investing in convertibles a compelling opportunity in today’s volatile and challenging environment.
CCD is our favorite CEF that invests in this "hybrid" security. This is one of our favorite ways to ride this bull market with a high yield. CCD is set to be a big winner over the next two years.
The primary reason we started buying HFRO is that it was trading at a very steep discount to NAV. At one point, the discount was 40%! Today, that discount is down to 14%. As HFRO's price has gone up, NAV continues to rise ahead of it.
We expect this discount to continue to close, and it will be accelerated when HFRO has experienced positive liquidity events. Their largest position is Creek Pine Holdings, an investment that constitutes 35% of their assets and is a preferred equity position in a joint venture with CatchMark Timber Trust (CTT).
On earnings calls, CTT has been openly discussing that they are in the process of recapitalizing this joint venture. When that happens, HFRO will have their position called and will collect a sizable profit.
Among HFRO's other holdings are non-traded REITs, which provide HFRO significant income and can provide a substantial capital gain if they IPO and start trading publicly.
They also have leveraged loans which are floating-rate corporate loans and they have debt tranches in CLOs. This combination of physical assets with real-estate and floating-rate investments provides a great level of inflation protection.
HFRO is a very reliable dividend payer, and in time their price should close the gap with NAV. Until then, we are happy to collect our 8.0% yield.
Conclusion
When tending your high-income portfolio this spring, it is essential to make sure that you have diversity. You need to make sure that your income is insulated from events that might negatively impact one sector or another.
Funds are a great tool to quickly add or reduce exposure to entire sectors. Clearly, "actively managed funds" are the best place to be, as their track record shows that they beat the vast majority of passive funds by a large margin. By investing in the right CEFs, your incoming cash flow will consist of both income and capital gains. This means that you will see your portfolio sustaining higher income for the long term. This is what we seek as income investors.
