The S&P 500’s impressive 28% return in 2024, potentially boosted further by a Santa Claus rally, has fueled significant gains for equity funds. These funds benefit investors not only through price appreciation but also through substantial dividend payouts. However, this surge raises concerns about market sustainability. The S&P 500’s price-to-earnings (P/E) ratio, currently at 28, far exceeds its historical average of 16.1. This signals a potential overvaluation and puts pressure on companies to maintain high earnings growth in the coming year. While the market’s momentum suggests continued growth, the risk of short-term volatility is also increasing. This necessitates exploring strategies to mitigate these risks while maintaining a healthy income stream.
One approach to counter market volatility and secure a strong income stream involves diversifying into closed-end funds (CEFs) specializing in corporate bonds. These funds offer several advantages. Firstly, they often trade at a discount to their net asset value (NAV), allowing investors to purchase assets at a price lower than their intrinsic worth. Secondly, CEFs are known for their high yields, averaging around 8% across the asset class, with corporate bond CEFs often exceeding this average. These funds provide exposure to the broader economic growth driving stock market gains while offering a degree of insulation from equity market fluctuations. This diversification strategy balances growth potential with risk management.
The Western Asset High Income Opportunity Fund (HIO) serves as a prime example of a corporate bond CEF offering a compelling investment opportunity. Currently yielding 10.8%, a $930,000 investment in HIO would generate $100,000 in annual income, distributed monthly at $8,333 per installment. This substantial income stream is further enhanced by the fund’s recent distribution increases, driven by rising interest rates. The Federal Reserve’s aggressive rate hikes over the past couple of years have compelled corporations to offer higher yields on their bonds. Since HIO holds a portfolio of these bonds, the fund’s managers have more income to distribute to shareholders. This income growth potential makes HIO an attractive option for income-seeking investors.
A natural question arising from the current market environment is the potential impact of future Federal Reserve rate cuts on HIO’s distributions. While the market anticipates potential rate cuts, HIO’s portfolio characteristics provide some insights. The weighted average life of the bonds held by HIO is 6.7 years, meaning these bonds will mature, on average, in 6.7 years. However, the “effective duration,” which considers factors like callability and other redemption options, suggests a shorter timeframe of slightly under four years. This implies that if interest rates decline by the end of 2027, HIO’s payouts might decrease. Conversely, if rates rise, payouts are likely to increase.
Predicting interest rate movements in 2027 is inherently uncertain. While rates could move in either direction, HIO currently offers a substantial 10.8% income stream, significantly exceeding the average yield of S&P 500 stocks. Moreover, historical data from the pandemic period provides a reassuring perspective. During the pandemic, when interest rates plummeted dramatically, HIO’s distributions decreased by a relatively modest 6.25%. This suggests that even in a scenario of significant rate cuts, HIO’s yield would likely remain attractive, potentially decreasing from 10.8% to around 10.1% based on current share prices.
The market appears to have already factored in the potential for dividend cuts, as evidenced by HIO’s current 5% discount to NAV. This discount has been shrinking recently as investors recalibrate their expectations regarding the likelihood of future Fed rate hikes. While some investors might shy away from HIO due to concerns about interest rate movements, those who delve deeper recognize the fund’s potential. HIO offers a double-digit yield supported by solid fundamentals, making it a compelling option for long-term income-focused investors willing to look beyond short-term market fluctuations. The fund presents a balance of high income potential and manageable risk, especially for those who understand the nuances of the bond market and the dynamics of interest rates.
