Income Using CEFs Experiences and Questions

[AlabaMalaysia]

I have been looking into some different scenarios of what types of bonds and how much income I would want from them once we hit our FIRE number in hopefully 2-3 years. I would like some feedback for anyone that has owned CEFs or opinions on this strategy =

Looking at some bond CEFs something like PDI for example if I took $200k of the $1.4M-$1.5M nest egg we will have at FIRE date it would generate ~$20k per year at today's distribution rates. Add $50k of something like BND and some muni bonds just for diversification that would yield enough plus the remaining $1.2M of stock index funds dividends to more than pay for our annual estimated SWR/expenses at around 2.75%-3%.

So with $250k in bonds for income only purposes, and the remaining $1.2M of stock index holdings for growth to keep up with inflation costs would this be a valid strategy for our age (39 two years from now)? I realize CEFs using leverage could have some wild swings, but if the purpose of the $250K is only for income even if say that $250k got eroded by 1/2 in 10 years my overall portfolio 10 years later would be much higher anyways due to the 85% stock holdings. Am I missing anything with a scenario like this and does anyone have experiences using CEFs for income generation. Thank you for any replies/opinions.

 

[COcheesehead]

Look at total return. In 2020 when the market was down 35%, some bond like CEF’s were down 60%. Some came back, some not all the way, yet. 10-11% dividends come with risk and houses like PIMCO have been known to cut payouts too, so there’s that.
I am not saying don’t do it, just go in with your eyes wide open.

 

[Ian S]

I have owned CEF's on and off for years. As you note in the PDI example, they can employ all kinds of strategies to enhance yield. The other wrinkle with any CEF is the net asset value rarely if ever equals the market price. When the market price is less than the NAV, the CEF trades at discount and when it's higher, it trades at a premium. PDI typically trades at a premium and if you look at the history, the swings in that parameter can be significant. See https://www.cefconnect.com/fund/PDI Also you might want to check out its investment strategy which suggests to me a lot of emerging market/currency exposure. Also, costs of CEF's tend to be quite high but I suppose as long as they're performing well, that's not much of an issue. In any event, I think CEF's can be a good investment as long as you are aware of how they work and differ from open end funds. For example, I prefer to buy when the discount is high and I generally avoid those CEF's selling at higher than usual premiums.

 

[AlabaMalaysia]

Thank you both for the replies and thoughts to think about. I have studied CEFs quite awhile but just never messed with them in the accumulation phase so never have had actual skin in the game experience. The big swings you mention COcheesehead is noteworthy because if I am no longer earning income from work I am not sure how I would react even though I'd like to think I would never do anything just collect the distributions and leave the shares alone. Also you mention total return, since I have not yet had any bonds in my portfolio before is total return really all that important for the income side of a portfolio if the purpose is just to provide income generation?

Ian since you have been in them before could you see a scenario where you buy at a good price depending on the particular CEF and just hold onto it long term just for the income? I have always seen the discussion around CEFs of people doing what you describe = buy when discount, pocket the income until the NAV rises to a high premium and sell to later re-buy or buy something else. My thinking was to just buy in next 2 years at some point and just hold for the income portion of my portfolio with just a 10% weighting to cover income needs but not trading in and out.

 

[big8pointer]

I have a number of various CEF's in my portfolio. It comprises a small part, 6%-7%, of my total investment. I hold various CEF's from from Nuveen, Calamos, Eaton Vance, etc. The things I look for in a CEF are discount to NAV, steady or rising distributions, and where the distributions are not from ROC. I also look at the % of leverage the CEF has. I tend to hold for long term in order to help juice up income for retirement. But again, they are a part of my overall investment mix.

 

[Flyfish1]

I am an income investor - well I am now. With about one year to go, I shifted from long term index buy and hold/momentum investing to income. Actually did the majority of the shift just before the big drop in 2020. I hold a broadly diversified collection of income assets REIT's, CEF's, baby bonds, preferred, etc.. I am not concerned with total return as I see no reason to ever sell a single share except for strategic repositioning. In fact, the plan is to reinvest 20% of gross income into new shares even year, living on the other 80%, thus being a net buyer of shares every year in retirement. Thus , this year to date my holdings are down for the year, yet my income is up. I am drawing 80% of gross income from my after tax accounts to help fund a home renovation and have done so for the last year, and my income is up.

The one thing that concerned me was increasing income yearly to cope with inflation. Knowing that CEF's , etc. are not going to have a continued upward climb in NAV over the years one must plan accordingly and putting 20% of gross back into the pool will accomplish that.

Anyways, never found a lot of support on this site for income investors, as most seem dogmatically stuck on passive index, buy and hold investing. Nothing wrong with it, it clearly works, but so does income investing and can allow a higher income in retirement. Always amazes me when people claim that a dividend over 2% is risky. Well run real estate assets easily spin off 6% or more, heck one of my safest assets, cash value life insurance has a 5% dividend.

Lots of good resources out there on Seeking Alpha and can check out the Contrarian Outlook as well.

Just my opinion

 

[mrfeh]

Thank you for any replies/opinions.

Take this with a grain of salt, as I don't know anything about CEFs, but my gut reaction is that if you're relying on such a strategy and retiring at <40, you don't have enough money saved.

 

[Freedom56]

CEFs are much better than passive funds. Many fixed income CEFs have outperformed the S&P 500 over the past 20 years. I have owned many in the past. I normally buy them during periods of market plunges when they trade at a significant discount to asset value. I hold them for a year or two until they recover and then sell them when they start trading above asset value. During periods of rising interest rates, the leveraged CEFs are subject to precipitous selling. However, this creates a buying opportunity and good entry points. The general rule of thumb is to buy a good quality CEF below asset value 3 months before the last interest rate hike.

 

[AlabaMalaysia]

Take this with a grain of salt, as I don't know anything about CEFs, but my gut reaction is that if you're relying on such a strategy and retiring at <40, you don't have enough money saved.

I believe hopefully we will have enough saved only needing to withdraw SWR 2.75%-3% to meet all our needs/desires and Firecalc even when I project 60 years and $10K annual more than our actual $ withdraw amount still gives 100% result to be conservative.

 

[AlabaMalaysia]

CEFs are much better than passive funds. Many fixed income CEFs have outperformed the S&P 500 over the past 20 years. I have owned many in the past. I normally buy them during periods of market plunges when they trade at a significant discount to asset value. I hold them for a year or two until they recover and then sell them when they start trading above asset value. During periods of rising interest rates, the leveraged CEFs are subject to precipitous selling. However, this creates a buying opportunity and good entry points. The general rule of thumb is to buy a good quality CEF below asset value 3 months before the last interest rate hike.

Thank you for the insight and suggestion on your experience with CEFs and how you manage them. We are still 2-3 years away from FIRE so watching the current rate increases I will pay attention to their price action as you suggest.

 

[AlabaMalaysia]

I am an income investor - well I am now. With about one year to go, I shifted from long term index buy and hold/momentum investing to income. Actually did the majority of the shift just before the big drop in 2020. I hold a broadly diversified collection of income assets REIT's, CEF's, baby bonds, preferred, etc.. I am not concerned with total return as I see no reason to ever sell a single share except for strategic repositioning. In fact, the plan is to reinvest 20% of gross income into new shares even year, living on the other 80%, thus being a net buyer of shares every year in retirement. Thus , this year to date my holdings are down for the year, yet my income is up. I am drawing 80% of gross income from my after tax accounts to help fund a home renovation and have done so for the last year, and my income is up.

The one thing that concerned me was increasing income yearly to cope with inflation. Knowing that CEF's , etc. are not going to have a continued upward climb in NAV over the years one must plan accordingly and putting 20% of gross back into the pool will accomplish that.

Anyways, never found a lot of support on this site for income investors, as most seem dogmatically stuck on passive index, buy and hold investing. Nothing wrong with it, it clearly works, but so does income investing and can allow a higher income in retirement. Always amazes me when people claim that a dividend over 2% is risky. Well run real estate assets easily spin off 6% or more, heck one of my safest assets, cash value life insurance has a 5% dividend.

Lots of good resources out there on Seeking Alpha and can check out the Contrarian Outlook as well.

Just my opinion

Thank you for sharing your strategy and how you handle income generation. I believe my father has a similar approach of only spending like 60% of his bond interest with the rest growing and reinvesting buying more shares which has seemed to work for him the past 10 years. I was thinking to still keep 85% of our $ in the stock index funds for inflation growth protection due to our young age with hopefully only 10-15% going towards these income instruments would be enough to generate more than enough income for our needs should shield us from inflation I guess?

 

[Montecfo]

I have owned CEFs over time, most recently owning a bank loan CEF last year, purchased at a large discount, sold at a much smaller discount. I made about 13 pct total return on a 6 percent return on NAV.

In my opinion, that is the way to do it.

I also held a Muni bond ETF for a couple of decades. Bought at a discount, sold at a premium. No leverage. Nice yield.

Also own a leveraged CEF which holds REITs/Real estate. Had done really well since I bought it but now at a premium and I'd love to sell but it's a huge capital gain. First world problem.

You have to watch for the use of leverage. It can magnify return but also increases risk.

From what I can see of PDI, it is not something I would be comfortable relying on for income as there is just too much risk. In particular in a volatile rapidly changing market, I see this more as a more speculative investment (look at the long and short exposure). But that's just me.

As an aside, I think the view of caring about the distribution only since you plan to hold forever is one that often fails in reality. Most investments are eventually sold and how the principle has held up pretty much always matters. And that is a component of total return.

When the investment's performance begins to lag, the value declines and lots of people wish to sell. And liquidity can be an issue with CEFs.

Overall, I love CEFs but you have to be very selective and match the investment to your objectives, and really know what you are buying.

Or so it seems from here.

 

[Ian S]

Ian since you have been in them before could you see a scenario where you buy at a good price depending on the particular CEF and just hold onto it long term just for the income? I have always seen the discussion around CEFs of people doing what you describe = buy when discount, pocket the income until the NAV rises to a high premium and sell to later re-buy or buy something else. My thinking was to just buy in next 2 years at some point and just hold for the income portion of my portfolio with just a 10% weighting to cover income needs but not trading in and out.

With CEFs, I pay close attention to discount/premium, the nature of the distributions e.g how much if any is return of capital and to a lesser extent, the fund fees and costs. Some CEFs can have pretty consistent discounts or premiums. Others may vary significantly over time. I think for any given fund, try to get in when it's "cheap" relative to its asset value and reevaluate the holding if it gets expensive. Another thing to consider (it's happened in the past to one of my funds) is the potential to convert to an open-end fund. I think that usually happens when there's a persistently high discount and even a whiff of that happening will cause volatility in that particular fund. That said, CEFs are not a big part of my portfolio and all that I have are in ROTH or regular IRA accounts.

 

[RobLJ]

I bought PDI in March 2020 (took a paper loss on PCI that I bought about a year earlier); it is a good income fund although PIMCO's funds are often at a premium to Net Value so it's not wise to buy if the premium is more than a max of 10%.
We're withdrawing to the top of the 12% bracket, so I've been slowly buying other CEFs with the withdrawals that we don't spend. We have about 100k in various CEF in different areas of the market., with about 20k in a extreme short-term bond fund for emergencies (it's down about 1.5% so far this year, which is fine). The REIT CEF and infrastructure CEF have done very well the last year, and I own a couple other muni CEFS that are largely non-taxable dividends (they've been crushed this year but I'm about even on them.) The CEFs are throwing off about 6500 a year in dividends/income. If I don't spend it, I just reinvest at the end of the year.

 

[Phroig]

Of the PIMCO CEFs, only PDO is trading at a discount. PIMCO also puts out a UNII report each month, which indicates coverage ratios for their funds. PDO and PTY have the best coverage. CEFConnect is a great site for research.

 

[AlabaMalaysia]

I have owned CEFs over time, most recently owning a bank loan CEF last year, purchased at a large discount, sold at a much smaller discount. I made about 13 pct total return on a 6 percent return on NAV.

In my opinion, that is the way to do it.

I also held a Muni bond ETF for a couple of decades. Bought at a discount, sold at a premium. No leverage. Nice yield.

Also own a leveraged CEF which holds REITs/Real estate. Had done really well since I bought it but now at a premium and I'd love to sell but it's a huge capital gain. First world problem.

You have to watch for the use of leverage. It can magnify return but also increases risk.

From what I can see of PDI, it is not something I would be comfortable relying on for income as there is just too much risk. In particular in a volatile rapidly changing market, I see this more as a more speculative investment (look at the long and short exposure). But that's just me.

As an aside, I think the view of caring about the distribution only since you plan to hold forever is one that often fails in reality. Most investments are eventually sold and how the principle has held up pretty much always matters. And that is a component of total return.

When the investment's performance begins to lag, the value declines and lots of people wish to sell. And liquidity can be an issue with CEFs.

Overall, I love CEFs but you have to be very selective and match the investment to your objectives, and really know what you are buying.

Or so it seems from here.

Thank you for the detailed response. Very helpful in how I need to view these instruments.

 

[clifp]

when I was in my dividend/income investing phase, I owned a fair number of CEF.
I think they are gradually becoming extinct since, the structure of ETFs solves many of the problems that CEF were meant to solve. (A rush of outflows requiring the fund manager to sell his long-term but unpopular holdings.). So I think you'll continue to see the Nuveens and PIMCOs of the world convert their funds to ETFs.

It is also worth reading about what happened to CEF during the great recession. I know both the Big Short and Too Big To Fail (Books not movies) went into some detail about what happened. TLR it was ugly

I would never buy a CEF a premium.

Despite, all the warnings the fact that you can buy $100 worth of income-producing assets for $90 is a great deal. It often can make up for the higher expenses.


CEFconect.com is a good resource