Hundred Dollar Bill Being Cut With a Scissor....getty
Plenty of CEF investors worry about dividend cuts. And for sure, they’re something to keep in mind. But CEFs are not the same as stocks. When we invest in high-quality CEFs, there are a couple other things we need to remember when we catch wind of a cut:
High-quality CEFs will sometimes reduce payouts by a small amount so they can redeploy capital into oversold bargains. I’ll have more to say on this in a moment, but the upshot is that it holds the potential for us to make more in gains from this move than we lose in dividends.
As mentioned, these cuts are usually small, reducing the yield only a small amount (again, we’ll demonstrate this below).
Before we go further, we really should stop for a moment and talk about the importance of diversification. Across a portfolio of multiple CEFs, you can ensure your income won’t change much if you choose funds that are profitable, have big discounts to net asset value (NAV, or the investments in their portfolios) and solid fundamentals that will make them profitable over the long term.
Take, for example, two very different funds: the Nuveen Real Asset Income and Growth Fund (JRI), a holding of my CEF Insider service that mainly holds shares of real estate investment trusts (REITs), utilities and pipelines, as well as bonds issued by these firms; and the corporate bond–focused PIMCO High Income Fund (PHK). Both funds have cut dividends in the past.
What we are seeing here is a history of very small payout cuts over time, including a penny-per-share cut most recently introduced by JRI at the start of this year. PHK’s cuts are bigger but seemingly behind it as dividends have stayed stable since early 2020.
Now consider this. Although PHK’s dividend has been stable for three years, it has earned investors less money. To be sure, JRI’s recent penny-per-share cut does lower distributions a hair, bringing the current yield to 8.7% from 9.6%. But that’s still a very high income stream.
And if you aren’t happy with JRI’s dividend cut from early 2020, you can still sell, then redirect the profits into another CEF with a higher yield.
Moreover, JRI’s penny-per-share cut sets it up for further gains because it lets the fund redeploy its capital into REITs, which are particularly oversold now. An eye for value like that is why JRI is still a strong performer. Adding to its appeal is the fact that despite this, it trades at a huge 13.3% discount to NAV—while the poorer-performing PHK sports an 11% premium!
To delve a little deeper into CEF dividend cuts, let’s go back to JRI’s payout reduction in October 2017, when dividends were cut by half a penny per share. This cut was one reason why I recommended JRI to CEF Insider members. Speaking of Nuveen, I wrote in the October 2017 issue that: “The firm will cut dividends if it thinks that’s good for the fund as a whole—and in JRI’s case, it has been.” That was true in October 2017 and it’s still true in 2023.
It’s also true for a lot of closed-end funds. Of the 10 top-performing CEFs of all-time, all 10 have cut dividends at some point in their history, and seven have cut dividends over the last decade.
However, these funds have also outperformed their benchmark index funds over the same period while yielding about five times as much as the S&P 500, thanks to their 8.6% average yield. In short, these funds get you a high income stream that stays high, even after small cuts here and there, as well as market outperformance.
Check out how just one of those superstar CEFs, the Columbia Seligman Premium Technology Growth Fund (STK), has outrun the S&P 500 for a decade.
It just goes to show that with CEFs, when you focus on long-term total returns instead of a penny dividend cut here or there, and when you diversify into a collection of top-quality funds with high income streams and market-beating potential, you can create true wealth.
I have worked as an equity analyst for a decade, focusing on fundamental analysis of businesses and portfolio allocation strategies. My reports are widely read
Last week was a bit of a flashback to 2022 with bond yields weighing on stocks...getty
Despite the overall earnings picture improving, the S&P 500 fell by 1.1% for the week. There was little economic data, but rising yields weighed on stocks, especially growth stocks that had performed well year-to-date. According to FactSet, 69% of companies have exceeded earnings estimates, below the 10-year average of 73%. This week earnings season starts to ease, with only 60 S&P 500 companies scheduled to report.
Blended earnings, which combine actual with estimates of companies yet to report, are lower than forecasts at the end of the quarter but improved last week. The high earnings growth rate for the industrials is misleading since the airlines reported a loss in the fourth quarter of 2021 and posted a profit this quarter.
Consumer staples, real estate, health care, and materials remain the four sectors expected to post higher earnings than forecasted on December 30th. The energy sector earnings estimates held steady and retained the crown with the highest expected growth rate driven by increased energy prices, with expected earnings slated to increase by 58% year-over-year.
Berkshire Hathaway BRK.B+0.9% continued to buy shares of Occidental Petroleum OXY+3.8% (OXY) in 2022 and now owns over 20% of the company. A previous piece discussed why Warren Buffett’s Berkshire Hathaway likes its holdings in Occidental Petroleum.
Blended revenues improved again last week and are well above the expected level at the end of the quarter. Energy, industrials, real estate, consumer staples, health care, utilities, and consumer discretionary have better estimates than at the end of the quarter. Sales in the energy sector illustrate the robust increase in energy commodity prices.
With 69% of the earnings season complete, the blended earnings performance remains below expectations at the end of the quarter. Combining actual results with consensus estimates for companies yet to report, the blended earnings growth rate for the quarter strengthened to -4.9% year-over-year, below the expectation of -3.2% at the end of the quarter.
Despite the improvement in fourth-quarter earnings expectations, expected earnings growth for the calendar year 2023 declined again this week and now stands at 2.5% year-over-year.
The communications services sector was the most significant contributor to the improvement in blended earnings for the S&P 500. Earnings beats by Walt Disney DIS-2.1% (DIS) and Activision Blizzard ATVI+0.3% (ATVI) positively impacted the communications services sector. As discussed previously, margin pressures have become more evident, with sales coming in as expected but earnings disappointing during this fourth-quarter earnings season.
Outside of earnings season, comments by Federal Reserve Chair Powell left the path of future hikes as data-dependent. Fed statement combined with recent data pointing to a stronger-than-expected economy, including the breathtakingly robust jobs report, have boosted bond yields relatively rapidly. Since last year, rising bond yields have generally weighed on stocks; last week was no exception.
After the better economic data and Fedspeak, markets are pricing in two more short-term interest rate hikes of 25 basis points (0.25%) in March and May hikes, with one possible cut by January 2024. This week holds some meaningful reports for financial markets and rate hike expectations, January consumer inflation (CPI), and retail sales.
Though the more economically sensitive cyclical stocks underperformed last week, they have trounced staples since the beginning of the year. This market action in 2023 points to fewer worries about the recession currently being priced into the market.
Headline earnings improved last week but remained below estimates at the end of the quarter. Still, stocks have focused more on macroeconomic factors like higher bond yields and the rising odds that the U.S. might avoid recession.
Companies will remain particularly sensitive to forward guidance from companies while the threat of recession in 2023 remains. This week’s consumer inflation (CPI) and retail sales reports will be crucial as markets try to divine the path of interest rates and the economy.
The young businessman tries to solve problems...getty
We’ve seen a big bounce (and 12%+ dividends!) in one particular type of closed-end fund (CEF) this year—and all of my buy indicators suggest this profitable play is still in its early stages.
Specifically, I’m talking about tech-focused CEFs—which we’re getting a nice second chance to buy thanks to last week’s earnings whiffs from the likes of Apple (AAPL) and Alphabet (GOOGL).
Buying a tech CEF is like buying an ETF that focuses on technology, but with two key differences:
Big dividends: the CEF we’re going to analyze today yields 12.1%—and it pays dividends monthly, too. You and I know that both of these things are unheard of in the world of “regular” stocks and funds.
Big discounts: This fund sports a 12.2% discount to net asset value (NAV)—CEF-speak for saying that we’ll pay just 88 cents for every dollar of its assets!
The fund is called the BlackRock Science & Technology Trust II (BSTZ). We’ll get to the “II” part in a moment. But first, it’s worth stopping to consider this fund has shot up over 20%, just one month into 2023.
Then there’s the dividend payout, which amounts to more than $100 per month for every $10,000 invested.
We’ve got more upside potential with BSTZ, too. Because unlike an ETF, this fund has two ways to deliver price gains: through the appreciation of its portfolio—which is still undervalued, due to last year’s selloff—and its 12% discount to NAV. As that discount narrows (and flips to a premium; likely, in my view), it’ll pull the price higher.
It’s always a good idea to question a yield this high, so let’s go ahead and pull apart the elements that support it.
BSTZ is a relatively new fund, having been launched in June 2019, so we don’t have a lot to go on with regard to its history, but it has raised dividends three times since inception (once in 2020 and twice in 2021, plus a nice special dividend that same year). That’s a great start. And there are other signs that we can trust BSTZ’s dividend.
While the fund lacks a long track record, its older sibling, the BlackRock Science and Technology Trust (BST), has been increasing payouts for nearly a decade while also offering the odd special dividend.
That is our first clue that BSTZ’s payout is sustainable: both funds are managed by the same group, and BST’s history of responsible payout increases should indicate that BSTZ’s future payouts will likely go up, not down. And our second clue is even more compelling.
Since BST’s portfolio has nearly tripled in less than a decade—even after the big tech selloff of 2022—the fund has built up enough profits to sustain payouts for many years to come.
This isn’t surprising given its portfolio. Despite tech’s struggles last year, Apple (AAPL), Microsoft (MSFT), Mastercard (MA), and Visa (V) have been tremendous long-term outperformers. They’re also BST’s top positions, and these, in addition to the fund’s investments across the tech world, caused the line in the chart above to go up and to the right for years.
While it doesn’t necessarily follow that BSTZ can do the same, this is one more encouraging sign.
A Quick Guide to Sustainable CEF Dividends
There’s another strategy you can use to see if a CEF’s payouts are likely to stay where they are or go up, or if there’s a risk of a dividend cut.
The key is to look back at the fund’s long-term total NAV return (or the return of its underlying portfolio, including dividends) and compare it to the fund’s payout. This calculation is a good first step in determining whether a CEF can maintain its current payout level.
Since inception, and after the worst decline in tech stocks since the Great Recession, BSTZ’s 8.7% average annual total NAV return suggests a sustainable 8.7% yield on NAV.
Don’t sound the alarm bells yet! Because BSTZ’s 12.1% yield is based on its (discounted) market price. And the fund’s 12% discount means that, based on per-share NAV, BSTZ’s yield on NAV (or what management needs to make in the market to hand us its 12.1% yield on market price) is just 10.6%, which is easier to get than 12.1%.
Now let’s assume that 2022’s bear market was an aberration—a very realistic assumption, as tech continues to drive every aspect of our lives and will continue to do so for decades to come. That makes BSTZ’s 12.1% yield extremely stable: before 2022, its annualized return was 38.9%, or more than triple its current yield.
One of the hottest trends in finance is prepaid muni bonds structured to help local utilities buy decades worth of renewable electricity. They’re good for the environment, but even better for the banks that will profit from cheap financing, trading profits and federal tax breaks.
Socially responsible investing, marketed under the moniker “ESG” (short for environmental, social and governance), is a huge and growing business. In 2015 global ESG-related assets were $2.2 trillion, according to PwC, growing to $9.4 trillion in 2020 and nearly doubling in 2021 to $18.4 trillion. Sustainable bonds are a big slice of this pie.
Globally, over the last two years, an average of more than 400 bonds have been issued per quarter, totaling over $1.7 trillion, according to the London Stock Exchange’s Refinitiv group. European issuance is more than double that of the U.S., but a wave of new green bonds is coming here.
One particularly vibrant corner of this market: ESG-certified municipal bonds, such as those designed to help local communities prepay for decades’ worth of green electricity. According to Monica Reid, the founder of Kestrel, which charges “a fraction of a basis point” of a new bond deal’s face value to verify new issues as “social,” “green” or “sustainable,” there have been $85 billion worth of these municipal bonds issued in the U.S. in the last two years.
Reid’s Hood River, Oregon–based team of 27 analysts and engineers certified nearly a third of them. “Not everything is green or sustainable or socially beneficial because it’s financed with municipal bonds,” Reid says. “The muni market is also where coal ash dumps are financed, ports and airports. It’s where turnpikes and toll roads are financed.
We are very discerning. Internally we have a do-no-harm criteria. If repayment is from oil royalties or gambling revenues, that’s a problem.” Like so many environmental trends, this one started in California. Over the past 14 months enormous Wall Street banks such as Goldman Sachs and Morgan Stanley have persuaded ultra-green electric power agencies in Northern California to hand them roughly $2.7 billion, with $2 billion more in the works.
The power agencies raise that upfront cash by selling tax-free municipal bonds of the type Kestrel certifies. In return, the banks so far have promised to deliver into the California power grid 2.2 million megawatt hours per year of “green” electricity, sourced from solar, wind and hydropower.
There are many winners. The banks get cheap loans to spend on whatever they want. Californians, like the residents of 15 other states and the District of Columbia, get to pick their provider and can choose to put their money toward greener power. And investors can hold the bonds comforted by the knowledge that they have invested in something not only green but backed by a big bank’s guarantee.
The loser? Uncle Sam. If Morgan Stanley issued its own similarly structured corporate debt to raise funds, it would likely pay 6% or so interest, subject to federal tax. But when Morgan raises cash via a municipal prepaid green electricity deal at a 4% interest rate, it incurs no federal tax. On $3 billion in green power munis so far, that would equate to some $50 million a year in forgone tax revenue.
Maybe it’s worth it. After all, it’s a model that could quickly spread across the nation and help underwrite the development of enormous amounts of greener energy. But it also could add up to billions of dollars in hidden annual subsidies to rich Wall Street banks. That might not play well in Peoria.
California is one of 10 states that have enabled the creation of local electricity-purchasing cooperatives called Community Choice Aggregators. They have names like Marin Clean Energy and Silicon Valley Clean Energy, and were formed to enable Californians to buy power marketed as 100% “green.” In recent years these co-ops have entered multidecade contracts directly with the owners of solar fields and wind farms to buy their electricity output.
But these electric co-ops are utterly unequipped to manage a host of complex contracts with financial counterparties. So last year the Marin co-op joined with sister entities in places like Silicon Valley, Berkeley and Carmel to set up what’s known as a conduit issuer, the California Community Choice Financing Authority (CCCFA), essentially a shell agency with the power to issue tax-free municipal bonds.
In the last 14 months, CCCFA has issued $2.7 billion in three different Clean Energy Project Revenue Bond deals, with tax-exempt coupon rates of 4%, courtesy of Morgan Stanley and Goldman Sachs. The money goes toward prepaying for 30 years of renewable electricity. Prepaying comes with a discount. CCCFA members, for example, expect to save $7 million per year on their electricity purchases. Continue reading…..
Vanguard, others predict bonds will rival single-digit returns on stocks; best bets are overseas.The era of big returns on stocks is over. It’s time for investors to recalibrate their expectations. That’s what many Wall Street firms and advisors are telling their clients.
Look for lower returns from U.S. stocks during the next decade compared with what has historically been the case, and expect U.S. bond returns that are on a par with equities. The best returns are projected for overseas stocks and bonds. Returns from most asset classes are projected to be positive.
“The next 10 years will be different than the last 10 years,” says Jim Masturzo, partner and chief investment officer of multi-asset strategies at Newport Beach, California-based Research Affiliates. “It will be more normal.”
Expect Single-Digit U.S. Stock Returns
With inflation at the highest levels in 40 years, against a backdrop of rising interest rates and a decline in valuations, long-term returns for U.S. equities are projected to be in the low- to mid single-digit territory. That’s compared with a historical yearly average of 12%-13% before inflation, and well below the nearly 16% average annual returns of the past decade.
This is clearly a whole new world to which investors are unaccustomed after decades of low inflation and the near-zero interest rates of the past 10 years. “Returns will be more muted compared with history and especially the past two years, especially for equities,” says Roger Aliaga-Diaz, head of portfolio construction and chief Americas economist at The Vanguard Group.
Bond Returns to Rival Stocks
On the brighter side, bonds are seen giving equities a run for their money, as fixed-income returns are projected to rival those of stocks.
“Bond market returns could equal equity returns with less risk,” says Joseph Carson, economic consultant and former chief economist at AllianceBernstein. Returns on stocks in the next decade will appear “minuscule” at 4%-5%, he says, mainly because “equity returns for three of the last four decades were far above average.”
Stocks benefited from declining inflation and lower bond yields in the 1980s. Stable inflation and expectations of “a new era of long cycles of growth and earnings” pushed stock returns higher in the 1990s. And “in the decade ending 2020 it was zero rates and inflated market multiples” that led to outsize gains in stocks, says Carson.
The Lost Decade
The outlier decade proved to be 2000 through 2009, a period that included the terrorist attacks of Sept. 11, 2001, as well as two punishing recessions and accompanying bear markets that dragged down returns and set the stage for easy money conditions. In what became known as the Lost Decade, stocks delivered a negative annualized total return of 0.95%, the only decade outside the Great Depression in which total returns for the period were negative.
At the start of the decade, a bubble in technology, telecommunications, and media stocks burst, resulting in a recession and the bear market of 2000-02, when stocks fell nearly 50%.
Not long afterward came the global financial crisis of 2007-09, precipitated by a housing meltdown brought about by banks and mortgage companies extending credit and making nontraditional interest-only and adjustable-rate loans to high-risk borrowers that were then packaged into mortgage-backed securities and collateralized debt obligations and sold as stable and safe investments.
With home prices skyrocketing, the Federal Reserve started raising rates to cool the market, which prompted a wave of mortgage defaults and a subsequent liquidity crisis. The result: the deepest and longest-lasting recession since World War II. Stocks fell about 55%. The unemployment rate more than doubled.
The interventions to rescue the financial system and the economy during the crisis introduced ultraloose monetary policies that were reintroduced more recently during the pandemic crisis of 2020, creating a boom in asset prices and driving inflation to the highest levels since the 1980s. Aiming to rein in spiraling prices, the Fed has boosted the federal-funds rate six times this year at an aggressive pace and plans to continue until it sees clear signs that inflation is abating and heading back to its target rate of 2% from more than 8%.
That’s driven up yields on bonds, driving their prices lower, and sent stocks sliding. No one expects inflation and interest rates to stay at current levels over the next 10 years, but they will be at higher levels than has been the case in the past decade. And that will affect valuations.
The Case for Bonds
“Definitely, the case for bonds in the portfolio is coming back,” says Aliaga-Diaz of Vanguard. “Higher yields make the case for bonds stronger.” Over the next 10 years, Vanguard is forecasting annualized nominal returns, that is before adjusting for inflation, on U.S. equities of 4.7%-6.7% and U.S. bonds at 4.1%-5.1%.
Research Affiliates projects annualized nominal returns on U.S. equities of 2.3% over the next decade. Its forecast for U.S. bonds is 5.1% on an annualized nominal basis. Morningstar Investment Management projects U.S. stocks will deliver 5.5% in annualized nominal returns and 4.8% for U.S. bonds.
Of course, stock and bond returns will vary from year to year, but these long-term annualized forecasts provide a gauge that helps firms construct diversified asset-allocation portfolios that can be tailored to optimize returns for different risk tolerances.
Investment firms also calculate these projections in real terms, which means they factor inflation into their models in addition to other variables such as valuations, earnings growth estimates, and dividend yields to obtain a more accurate assessment of potential total returns. Still, it has become standard practice for firms to issue forecasts in nominal terms because that is what is reflected in client accounts.
As Vanguard’s Aliaga-Diaz explains: “If you start with a $1,000 investment in 2022 and your portfolio returns 10% in nominal terms in 2023, your account will be $1,100. In real terms, your account would be worth $1,080 measured in 2022 dollars.”
Many investors may be gun-shy about embracing bonds, burned by steep double-digit losses this year in their portfolios at a time when stocks fell into a bear market.
The popular investment strategy of structuring portfolios with a mix of 60% stocks and 40% bonds to achieve attractive risk-adjusted returns with lower volatility, the so-called 60/40 portfolio, failed to provide the diversification and balance that made it a tried-and-true investment approach for so long, delivering 10.6% average annual returns for the past 40 years.
The Morningstar US Moderate Target Allocation Index, which serves as a benchmark for the 60/40 strategy, is down 17.53% this year, while the Morningstar US Market Index is down more than 21%. But what worked so well for so long will work again, say strategists.
“There is a fear and concern that what we saw this year with stocks and bonds coming down together represents a new regime,” says Aliaga-Diaz. “But we will get back to the normal relationship.”
That view has been echoed by others, including Morgan Stanley’s chief cross-asset strategist Andrew Sheets, who has forecast a 10-year annualized return of 6.2% for the strategy. “While we do expect the 60/40 portfolio to deliver lower risk-adjusted returns compared with those over the last four decades, that doesn’t mean it is broken,” he wrote in a report issued this summer.
Starting Points Matter
A key driver of these forecasts comes down to prices: Lower prices point to higher implied returns. “Starting prices matter,” says Philip Straehl, global head of research and investment management at Morningstar Investment Management. “U.S. valuations have improved dramatically in the last 12 months. There’s been significant repricing in the U.S. equity markets.”
That’s even more true internationally, where stocks have had the added burden of coping with the strong U.S. dollar and weakened local currencies on top of inflation and rising rates. Strategists say developed and emerging markets represent the best opportunities for the highest returns.
Morningstar Investment Management forecasts stocks in developed international countries will return 9.4% annualized over the next decade. For emerging markets, the expectations are even rosier at 11.8%. Vanguard’s outlook for stocks in developed international countries is for annualized total returns of 7.2%-9.2%, and 7%-9% in emerging-markets equities. Research Affiliates is forecasting 13.1% returns annualized for emerging markets over the next 10 years and 12.6% annualized for developed international markets.
“Our recommendation would be to look outside the U.S.,” says John Thorndike, co-head of asset allocation at Boston-based investment manager GMO, which bases its outlook on a seven-year investing time frame. “If you are going to take equity risk, take the bulk of it in non-U.S. value stocks. We think you should take the risk. These stocks are attractive.”
Hundred Dollar Bill Being Cut With a Scissor....getty
