Today we are in a situation that seems a lot like 2016. And back then, some savvy naysayers exploited it for quick returns of 62% and more. The same configuration is back Again– and so does our upside odds, plus returns north of 10%.
There are two closed-end funds (CEFs) ready to deliver these high returns (and total returns); we’ll compare two popular options in a moment. First, let’s take a look at the state of the corporate bond market, as there are a lot of misconceptions floating around right now.
‘Junk’ bonds aren’t as risky as they seem
You may know high yield bonds by their nickname: junk bonds.
The unfortunate label refers to low-rated or unrated debt issued by companies that are willing to pay a higher interest rate to investors. They are considered risky because they default more often than higher-rated corporate bonds. And they do default more, but their overall default rates are still miniscule.
Bond default rate
Fitch Ratings, one of the most pessimistic credit rating agencies, expects default rates to fall from 1.25% in 2022 to 1.5% in 2023, two rates below historical norms and far below the rates we’ve seen in 2020. Yet many bonds are trading for less than they did during the pandemic. This created an opportunity to buy bonds with sustainable cash flows and high yields.
And when you buy through CEFs, you automatically diversify across hundreds of bonds, reducing your risk of default to virtually zero.
2 Popular Bond Funds: One is a Best Buy
To get a clearer picture of the opportunity before us, let’s dissect the PIMCO High Income Fund (NYSE:) and the PIMCO Dynamic Income Opportunities Fund (NYSE:).Both are managed by the same manager and both have high yields: 11.5% for PHK and 10.6% for PDO.
Still, one is a great buy and the other is less compelling, though both are set to appear over the next few months.
Bigger discount gives PHK an advantage
Despite similar management and investment strategies, PDO trades at a 5.8% discount to net asset value (NAV, or the value of the bonds it holds), while PHK trades for After what is his wallet worth? This means that in order to fund its 11.5% dividend (based on its premium market price), PHK needs to achieve a total return of almost 12% on its portfolio, which is impossible in the long term, but some thing that PHK has been able to do in the past over shorter periods of time (more on that shortly).
PDO, meanwhile, needs to earn 10% to fund its 10.6% return, as its market price is discounted to its net asset value. This is still a difficult feat, but not impossible. And here’s why.
A big yield and a big opportunity
Here we have an index of the effective yield that high yield bonds are currently paying. So if you buy a high-yield corporate bond now, you’re likely to get an income stream of around 8.6%, the highest we’ve seen since the pandemic began. It’s also a level we’ve only reached a few times over the past 20 years: in 2002, 2008, 2011 and 2016.
Each time yields soared, the market was in its darkest days, with fears of terrorism in 2002, a global economic crisis in 2008, a potential US debt default in 2011 and price hikes. Fed rates creating recession fears in 2016. History, as they say, may not repeat itself, but it rhymes.
And the rhyme between now and 2016 is hard to ignore. So what happened to PDO and PHK back then? PDO did not exist, but its twin fund, the same name PIMCO Aggressive Income Fund (NYSE:) did, and here’s how he and PHK fared over the three years after rates peaked in 2016 at levels similar to where we are now in 2022.
Latest Round of Rate Hikes Driven Strong Returns for These 2 Corporate Bond CEFs
As this chart shows, PDI and PHK have risen 62% on average over this period, providing a healthy return for investors who have seen this opportunity. It’s such a similar pattern to today that it’s a great reason to be bullish on these so-called “junk” bonds.
Disclosure: Brett Owens and Michael Foster are contrarian investors looking for undervalued stocks/funds in US markets. Click here to learn how to take advantage of their strategies in the latest report, “7 Outstanding Dividend Growth Stocks for a Secure Retirement.”