Strategizing to Secure 11% Dividends and Financial Safeguard by 2025
As I pen this, the S&P 500 boasts a staggering 28% total return for 2024. This incredible performance could potentially soar even higher with the traditional year-end surge, known as the Santa Claus rally.
This phenomenal achievement has undeniably benefited the equity funds within CEF Insider, amplifying their stock holdings' value and offering a substantial cash bonus due to their high yields.
However, it's essential to pause and consider the context behind such a significant milestone. While corporate earnings are indeed ascending, their pace is far from keeping up with the hasty progress of stock prices, resulting in an elevated S&P 500 price-to-earnings (P/E) ratio of 28 in comparison to its historical average of 16.1. This situation leaves companies in a precarious position, with the challenge of sustaining brisk earnings growth in 2025 under immense pressure.
In this atmosphere of resilient growth and escalating risks, volatility is likely to remain a persistent factor, necessitating proactive measures to mitigate its impact. A promising solution is to invest in Closed-End Funds (CEFs) specialized in corporate bonds. Our CEF Insider portfolio currently contains four such investments, each averaging a yield of 11%. This is over nine times the rate offered by a typical S&P 500 stock.
CEFs represent a thrilling opportunity to capitalize on the vigorous economy and exuberant stock market trend while managing exposure to potential volatility. This strategy, essentially an exercise in diversification, is as traditional as it is prudent.
For long-term income generation, we are not enticed by Exchange-Traded Funds (ETFs) for our bond exposures. Instead, we are drawn to CEFs that concentrate on corporate bonds.
Two Potent Perks of Closed-End Funds (CEFs)
This strategic choice bestows us with two powerful advantages: first, purchasing CEFs that trade at a discount to net asset value (NAV). This metric is unique to CEFs and represents an opportunity to invest in funds below their intrinsic value.
Second, we are rewarded with an enhanced income stream, as CEFs yield an average of 8% across the board, with corporate bond CEFs far surpassing this average.
As an instance, examine the Western Asset High Income Opportunity Fund (HIO). Currently boasting a remarkably high yield of 10.8%, HIO would produce an annual income of $100,000 for an investor investing $930,000.
Even more tempting, HIO grants its investors monthly dividends, equating to $8,333 per month.
Still more captivating, this dividend is on a steady ascendency.
Irrespective of the pandemic and its impact on ultra-low interest rates, HIO diminished its payouts. However, in recent times, HIO has raised its distributions due to the Federal Reserve's swift increase in interest rates, ensuring that corporate bonds must now pay out more interest to their lenders.
As a result, HIO's management has more income to distribute to its shareholders—that's us!
Yet wait—the plot thickens.
Is the Fed Cutting Rates Again?
If the Federal Reserve chooses to reduce interest rates, will HIO cut its dividends as well?
It's a valid question, so allow me to explain.
By examining HIO's bond portfolio, we can identify two significant factors: the weighted average life of the bonds it holds and the effective duration. The former implies that these bonds will, on average, mature in 6.7 years, at which time HIO will need to acquire new bonds. Should rates be lower then, HIO might be compelled to decrease its payouts.
Conversely, considering effective duration, which takes into account callability and optionality, HIO's portfolio of bonds will actually mature in just under four years.
Therefore, if interest rates fall by 2027, it is likely that HIO's payouts will subsequently decrease. However, if rates rise, then the payouts will rise, too.
Now, let me elucidate something crucial: no one can accurately predict where interest rates will be in 2027. Rates may either decrease or increase. In the interim, an investment in HIO will reward you with a solid 10.8% income stream. That's eight times the income offered by a typical S&P 500 stock.
And if rates do indeed decrease? Here's the catch:
Minimal Dividend Cut with HIO
During the pandemic's extreme phase, rates plummeted by over 85% in a matter of days. In the subsequent two years, HIO diminished its payouts by a mere 6.25%. Should the Fed once again precipitously reduce interest rates, the ensuing payout cut to HIO's 10.8% yield would be a meager decline to 10.1%.
The critical aspect is that any potential reduction in dividends is already factored into HIO's share price, which is why it currently exhibits a 5% discount to NAV, with this gap narrowing as investors realize the exaggerated risk assessment of an impending rate hike.
In essence, wary investors focused on speculations regarding the Fed's future actions are most likely to shun HIO. Nonetheless, discerning investors taking a closer look stand to reap the rewards of a promising double-digit yield that boasts a stable foundation, persisting for several more years to come.
Michael Foster serves as the Chief Research Analyst for the platform known as Contrarian Outlook. For further profitable income suggestions, explore our most recent report titled "Unshakeable Income: 5 Affordable Funds delivering consistent 8.6% dividends."
Disclosure: none
In the current investment landscape, retirement income seekers might find closed-end funds (CEFs) specialized in high yield bonds appealing. For instance, the Western Asset High Income Opportunity Fund (HIO) offers a high yield of 10.8%, producing an annual income of $100,000 for an investor investing $930,000. This fund also provides monthly dividends of $8,333.
Moreover, even in the face of interest rate fluctuations, HIO's dividends have shown resilience. Though the pandemic led to a significant drop in interest rates, HIO only reduced its payouts by 6.25%. This demonstrated stability is a valuable feature for investors seeking secure retirement income sources, especially considering the unpredictability of future interest rate movements.
Consequently, retirement investors consider high yield bond funds, such as HIO, crucial components of their income portfolio, offering attractive yields with a degree of safety during periods of interest rate volatility.
