Where to Find High Yields at Discount Prices

BOSTON (TheStreet) -- The stock-market slump has led some investors to turn more defensive, and they are now clamoring for the safety of securities with high yields.

That means bond funds, Dow stocks and REITs. But they may be overlooking closed-end funds such as the BlackRock Credit Allocation Income Trust ( BTZ), which offer discounts of 10% or more and generous yields that may produce positive returns this year.

Picking a closed-end fund with an outsized yield trading at a discount to its net asset value (the perceived value of its underlying investments) can seem like finding a needle in a haystack. With diligence and research, they can be found, says Patrick Galley of RIverNorth Capital, a Chicago-based firm with nearly half of its $1 billion in assets invested in closed-end funds.

"A lot of closed-end funds are priced richly based on investors clamoring for that yield," Galley says. "That means a lot of high-yielding closed-end funds are trading at a premium to their net asset value. The deals can be found, but you definitely have to do more digging and more due diligence."

Unlike their open-end mutual-fund counterparts, closed-ends funds do not create new shares for investors to purchase. Instead, buyers need to acquire shares from existing holders. RiverNorth has become a go-to shop for investors looking at closed-end funds. RiverNorth's flagship fund, the RiverNorth Core Opportunities Fund ( RNCOX) is a Morningstar 5-star open-end mutual fund that is the only so-called "fund of closed-end funds," meaning it is one mutual fund that owns closed-end funds for its holdings.

Given the low-yielding environment in the market, thanks to accommodative actions by the Federal Reserve, closed-end funds have become an ideal investment vehicle for investors to enhance income, Galley says. But investors should err on the side of caution and review the discount or premium. That requires investors to conduct due diligence when chasing yields.

"Investors are going for yield, and they're not looking under the cover," Galley says. "Where is that yield coming from? Is it from risky assets or a return of capital? They're investing, unfortunately, for the yield and not for the prospects of total return."

There's a price to be paid for high yields, as the rule of risk-and-reward still applies. Galley singles out bank loan funds, which are floating-based securities that trade at a premium to their net asset values. Those funds look attractive to investors because of the floating rate, allowing owners to clip a 6% coupon that will increase as interest rates rise.

While that may seem like a tremendous investment, the premium to the net asset value prices in that hefty yield, Galley says. "Deeper discount closed-end funds provide more attractive value," he adds.

So with high-yield closed-end funds and bank loan funds priced above net asset values and investment-grade corporate bonds also trading at a premium, where can yield-hungry investors turn?

"Closed-end funds are a peculiar world because there aren't a lot of things you can exactly point to," Galley says. "I'd be an advocate of constructing a balanced portfolio. The edge or the alpha that we're going after is the discounts associated with the closed-end funds."

Some of the deep-discount funds Galley favors include those by BlackRock ( BLK), the world's largest investment manager with $3.7 trillion in assets under management. They are the BlackRock Credit Allocation Income Trust IV ( BTZ), BlackRock Credit Allocation Income Trust II ( PSY), BlackRock Credit Allocation Income Trust I ( PSW) and BlackRock Credit Allocation Income Trust III ( BPP).

These four credit-allocation funds are all trading at a 13% discount to their net asset values. The funds aren't pure plays in any one fixed-income asset class and instead are a combination of investment-grade corporate bonds, high-yield bonds, preferred stocks and government securities.

"You have to lift the hood and see if there is something fundamentally wrong with those," Galley says of the four BlackRock funds. "These don't fall into any one category and they lost as orphan funds. But there's nothing wrong with them. You're actually getting more diversification over multiple asset classes."

While the yields aren't earth-shattering at only about 6.5%, Galley is happy to have active management and a sharp discount that should narrow. "That's an additional return that will help the overall total return," he says.

For investors looking for an equity tilt, Galley suggests they turn to the Eaton Vance equity option funds, like the Eaton Vance Enhanced Equity Option A ( EEEAX), which trade at double-digit discounts with attractive yields. "They're writing options on an equity portfolio. It's an alternative way to generate income with exposure to the equity market," Galley says.

-- Written by Robert Holmes in Boston.

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