When I began my investment career several years ago, closed-end funds (CEFs) were an even more esoteric asset class than they are today. But I think we can thank issuers like PIMCO, DoubleLine and Blackrock for bringing these fantastic investment vehicles into the broader investment spotlight. For individual investors, the audience to which CEFs are largely marketed, analyzing these unique vehicles isn’t like a simple comparison between ETF indexes or subtle expense ratio differences. Instead, there are a myriad of factoids and information to digest before an investor can make an informed decision about a closed-end fund.
There is also the question of modern portfolio management techniques, which can sometimes be taxing for us to analyze as a firm, let alone an individual investor trying to decipher a fund’s underlying strategy. I want to highlight PIMCO because they have a very well-articulated mix of products, and nearly all of their taxable bond funds employ the use of advanced derivative strategies.
A quick trip to PIMCO’s website reveals simple things like a fund’s stated objective, manager, yield, leverage ratio, and expenses. These characteristics are all easy enough to decipher until you reach the portfolio’s composition. Although illustrated to the letter of the law, and simplified as much as humanly possible, there is a lot of information that most investors are not likely to unravel.
One example of this complexity can be found by examining the current portfolio composition of one of our holdings in the Flexible Growth and Income Report, the PIMCO Income Opportunity Fund (N:PKO). At first glance, it appears like a well-established mix of holdings in sectors such as emerging markets, non-agency mortgage backed securities, and global high yield bonds.
However, that really only illustrates a small portion of what is happening within the fund. Upon further investigation, investors will discover credit default, interest rate, and currency swaps. While swaps can be a tough subject to dive into, I want to attempt to clarify and simplify examples of basic interest rate swaps so that investors can more easily understand what they are investing in, and how modern portfolio management techniques can be implemented to control key risks.
A swap is an agreement with a counter party, usually a large money center bank such as Bank of America or JP Morgan, which agrees to take the other side of the risk that a portfolio manager would like to assume or presumably hedge from a portfolio. For example, if the manager of PKO wants to remove some of the duration from the portfolio to protect investors against rising long-term interest rates, they would likely select a position that would short or go inverse long-term Treasury bonds; this is referred to as a pay-fixed swap.
It’s called a swap because you’re swapping interest from one index and in return will receive interest in another index. The easy part is that usually one index is always a short-term floating rate index such as 3-month LIBOR. So if you own a pay-fixed swap, you will pay the interest rate of long duration Treasury bonds, which at today’s rates is around 3%, and you will receive interest from the floating rate counterpart, or 3-month LIBOR, which is right now is about 0.32%. The magic of swaps is that you have to pledge very little portfolio capital to receive a large notional value, or the value of the position you’re seeking to hedge.
Conversely, if a portfolio manager wants to gain exposure to an index, or go long, you would enter into a receive-fix swap. For example, if you want to add exposure to high yield bonds you would enter into a swap where you receive the interest from an index of securities that might pay roughly 5%, and then you would pay 3-month LIBOR, or only 0.32% in return. Similarly, you would only have to pledge a relatively small amount of portfolio capital to maintain a very large income stream from the notional value of the swap.
So an investor might ask: Why would a portfolio manager opt to use such complicated instruments when they can just buy and sell bonds instead?
There are a few specific reasons: One of them is that a swap can be added or removed in minutes, without all of the individual transactions it would take to add diversified exposure to a certain sector of the fixed-income market. Furthermore, swaps don’t require individual security credit research, which in the case of PIMCO, can occupy hundreds of man hours to complete, review, and execute.
In addition, swaps add an inherent amount of leverage to a portfolio, without having to issue structural leverage to the fund, otherwise known as adding leverage from borrowing capital, reverse repurchase agreements, or bank lines. For example, a CEF might only have to pledge $20-$40 million in capital to receive $200 million in notional value for a swap.
The downside is that swaps carry inherent counter party risk, so if the bank that entered into swap agreement goes out of business, you would potentially lose the pledged capital of the swap. Furthermore, these are basic examples of swaps; they can get extremely complicated and depending on the terms of the swap can sometimes react violently to even small changes in the market.
The bottom line is that swaps can be a great way to hedge inherent portfolio risks or add income to an existing portfolio of well researched, and hand-picked cash-settled bonds. I wanted to highlight PIMCO’s suite of CEFs because they have done a masterful job of managing their derivative and swap overlays in addition to the solid credit research found within their funds. They have added both alpha over their benchmarks and controlled volatility, which has enhanced investor returns.
While this is complicated subject, I plan to dive deeper into increasing the awareness and understanding of fixed-income derivatives in future articles and would also invite any questions that CEF investors might have to better equip their own personal research capabilities. Selecting CEFs isn’t easy, but with the right set of research tools investors can learn to better understand the risks and rewards of investing in the growing market of CEFs.
Disclosure: FMD Capital Management, its executives, and/or its clients may hold positions in the ETFs, mutual funds or any investment asset mentioned in this article. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.