What if downsizing gets a second wind (Kodak, Hasbro, Levi Strauss, Waste Management and Fruit of the Loom all announced plans to cut their U.S. work forces in the past seven weeks)?
What if the impending flood of cheap imports from Southeast Asia stirs the hot blood of U.S. protectionism, with electioneering politicians waving xenophobic fists?
Whenever my “what if” list gets this long, I feel bound to remind you that smart investors don’t own just stocks, they own bonds, too. If stocks disappoint, bonds could give your retirement plan a positive spin. Rates on 30-year Treasuries dropped below 6 percent last week, and when interest rates drop, bond prices rise.
I last waved this flag 15 months ago (NEWSWEEK, Sept. 16, 1996). Here’s the record since then: stocks up 42.4 percent, with dividends reinvested; high-quality corporate bonds up 21.6 percent, counting interest and capital gains. Stocks won the day. But as a protective position, you can’t say your bonds were shabby-and they carried less risk than the stocks you owned.
Going forward, who knows? The Baltimore mutual-fund company T. Rowe Price checked every fabulous five-year gain in stock prices since 1960. During those fat years, gains averaged 14.6 percent. But in the subsequent five years, stocks tended to quiet down-averaging a modest 8.7 percent. During those leaner periods, bonds yielded nearly as much as stocks. In calendar years when stocks declined, bonds almost always delivered positive returns. Diversified investors-those who owned both stocks and bonds-earned decent profits with lower risk.
Most of the bond money today is pouring into individual bonds or traditional mutual funds. But you’ll often find higher yields in the closed-end funds, which few investors know much about.
New buys: A closed-end fund normally raises money only once. It sells a fixed number of shares and invests the proceeds. Then it lists itself on a stock exchange, just like any other public company. To participate in its investment results, you buy shares through a stockbroker, paying the standard sales commission.
Unlike the mutual funds you’re used to, a closed-end fund has two measures of value: (1) net asset value-what all its investments are currently worth, and (2) market value-the price that investors are willing to pay to own its shares. The market price goes up and down, separately from what happens to the net asset value.
Typically, a closed-end sells at a discount from net asset value. If its bond investments are worth, say, $11 a share and the fund is selling for only $10, you’re buying it at a 9 percent discount.
When you buy at a discount, you increase your current yield. Say, for example, that the bonds in the closed-end pay 5 percent interest on their full $11 value-that is, 55 cents a share. If you can buy that interest payment for only $10, you’ll earn 5.5 percent-an extra 0.5 percent-without lifting a finger. Some funds pump up their yields even further by leveraging your investment-that is, raising extra money (by selling preferred stock or taking a bank loan) and using it to buy even more bonds. With 50 percent leverage, the fund in this example would yield around 6.6 percent.
But winning with closed-end investments takes work. You have to determine the fund’s average discount and buy only when the discount is even deeper than that. Such a price means the fund is out of favor, perhaps for good reason. But by buying cheap, you’re more likely to earn a capital gain. (Occasionally, closed-ends sell for more than their net asset value, which is normally not a good price.)
What can go wrong? The fund may own high-rate bonds that the issuer “calls in” (that is, redeems early), forcing your dividend down. The market or your fund’s investments might go sour, driving down the price of your shares. Some funds show high yields by paying out more than they’ve actually earned-a deception that’s hard for tyros to spot. Closed-ends can be smart investments, but they’re not slam-dunks.
George Foot of Newgate Management in Greenwich, Conn., touts closed-ends that buy municipal bonds. For example, he says, take AA-quality Managed Municipal Portfolio, selling last week at a 7 percent discount and yielding a tax-exempt 5.8 percent. That’s the same as getting a 9.7 percent taxable return in the top federal bracket-not obtainable in a quality bond today.
Need advice: For a leveraged fund, Foot suggests the AA-quality Nuveen Premium Income Municipal Fund (NPI), at a 6 percent discount and a 6.15 percent yield. For top-bracket investors, that equals a 10.25 percent taxable return. But this fund’s story shows why you need advice before chasing after closed-ends. Nearly a quarter of NPI’s bonds will be called in the latter part of 1998, at which point the dividend will drop. Foot says he’ll be out by then. So, a stock for trading, not for holding.
There are also taxable closed-end funds, for people investing with tax-deferred retirement money. They buy U.S. bonds, international bonds, even mortgages. Most of the funds that specialize in emerging-market bonds got slammed when Southeast Asia sank, but rallied almost immediately. Foot thinks they’re no longer yielding enough to compensate for the risk you take.
How do closed-ends compare with traditional bond mutual funds? The picture is mixed, says Donald Cassidy, a senior research analyst for Lipper Analytical Services. There’s a slight tendency for closed-ends to do better in good years and worse in bad years, partly because of the leverage they use. Investors in closed-ends often buy at deep discounts and sell when the discounts shrink, rather than hold for the long term.
Closed-ends aside, any bond investment will profit from falling inflation and slowing business activity. Maybe that’s not happening now. But wise investors diversify, just in case.
