From Teeka Tiwari, editor, The Palm Beach Letter: On February 7, 2008, the unthinkable happened.
The auction rate security (ARS) market froze over. No one showed up for the bidding.
And billions of dollars of investor money essentially evaporated overnight.
Let me explain…
The big banks created ARS in the early ’80s. By 2008, it was a $330 billion market. It’s estimated that 50% of the market was made up of individual investors.
The pitch was a seductive one…
You could make a fat 5.75% yield on a triple-A rated bond that was 100% liquid.
Auction rate securities were a type of bond that had never failed. They were marketed as a short-term, high-yield alternative to money market funds—which had a yield rate of around 3% at the time. The interest rate on auction rate securities would reset every 35 days at auction.
Thousands of investors “reaching for yield” invested between 2007 and 2008.
To be fair, auction rate securities were a great product as long as other banks showed up every 35 days to bid on the securities…
But on February 7, 2008, no one showed up.
With no new buyers, sellers couldn’t sell.
All of a sudden, these wonderful high-yielding and liquid investments were essentially illiquid. For all practical purposes, they were worthless. No market existed to sell them in. In order to get their money back, investors had to wait for the securities to mature.
Even eight years later, $50 billion is still tied up in auction rate securities that won’t mature for another 10-20 years.
This is money that was supposed to be used for down payments on homes, tax bills, medical bills, and vacation funds.
It was essentially gone overnight.
I’m telling you this story today to warn you about a similar “reach-for-yield” disaster setting up in the closed-end fund (CEF) market right now.
A CEF is like a mutual fund. It invests in a collection of assets and shareholders of the fund share in the gains and losses.
But a closed-end fund is different than a mutual fund in one important way…
A typical mutual fund issues new shares every time a new investor comes into the fund. But a closed-end fund issues shares just once.
If you want to buy shares… you have to wait for someone else to sell theirs.
That means you can buy and sell CEFs in real time on stock exchanges. With a normal mutual fund, you have to wait until the end of the day, and then you pay what is known as the net asset value (NAV) of the fund. The NAV is the value of the securities and cash held by the fund divided by the amount of shares outstanding. A traditional mutual fund always trades at its NAV.
But that’s not always true for closed-end funds. These funds can trade at big discounts or big premiums to NAV.
That’s what’s happening to CEFs today. Investors are so desperate for yield that they’re overpaying for these funds.
Take the Pimco High Income Fund (PHK). On September 14, 2015, the fund traded at a small discount (0.47%) to NAV. Fast forward to today… and investors are now paying a 50% premium (see chart below). Put another way, they are paying $1.50 for every $1 in assets—simply because PHK yields 12.51%.
But PHK’s premium means that if the fund was liquidated tomorrow… or if PHK simply returned back to its NAV price (which most CEFs do), new investors would take an immediate 30% loss.
Let that sink in. That’s what reaching for yield looks like.
The problem isn’t with PHK. Pimco is a great company. I like a lot of its products. The problem is that investors are blindly overpaying. Pimco’s management can do everything right and new investors will still lose 30% of their money when PHK corrects to its NAV price.
And PHK is just one of the closed-end funds trading for an outrageous premium to its NAV right now.
Anyone investing in these funds is taking a big risk. If these funds simply return to NAV prices, they’ll lose money.
Key takeaway: If you’re looking for yield, here’s what you should do instead… Look for yields in closed-end funds that are trading at a discount to NAV.
This way, if the fund goes back to its NAV—or ends up trading for a premium—you make money. And you can often collect strong income in the meantime.
We’ve been investing in these types of funds in The Palm Beach Letter. In August, I got my subscribers into a closed-end fund with an 11% yield that was trading at a 6.5% discount to NAV. We snapped up another CEF at a similar discount with a 10% yield in July.
So the deals are out there… You just have to do your homework. And never, ever pay more than net asset value. If you do, you’ll soon learn the inevitable result of “reaching for yield.”
Reaching for yield is a symptom. America’s retirement crisis is the disease…
With traditional retirement income (Social Security, pensions, and 401(k) plans) all on the verge of collapse, retirees are reaching for yield in droves. This will not end well…
That’s why I held an emergency top-level meeting with Mark Ford, Tom Dyson, and other PBRG experts to address the retirement crisis in America. The result was something we call your Retirement Plan B.
It’s a unique blend of stock market and off-Wall Street ideas that could turn every $50,000 into $1 million or more during retirement.
As a bonus, you’ll also get three “instant income opportunities” that could help you make hundreds—even thousands—of dollars within 24-48 hours of receiving them. You can take a seat at the table for free, right here.