Here’s How I Pick The Best CEFs For 7%+ Dividends (5 Simple Steps)

This is one of many instances where blindly buying a CEF would have cost real money. And what makes things even more frustrating is that CIF was actually a better pick at the start of 2017—until it became a too-crowded trade by the start of 2018.

And CEF investors who aren’t diligent and bought CIF when it was good and held it when it became a disaster are facing massive losses, leading us to a really important question: how do you avoid this trap?

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My 5-Point System

When choosing CEFs, I look at five crucial points that drive each buy call I make. And they can help guide you, too. They are:

1. Management: How good is the team at the top, and has the fund changed horses lately (frequent management changes are an obvious red flag)?
2. Discount: What’s the fund’s discount to its net asset value (NAV, or the value of its underlying assets), and what has that markdown been historically? We want a current discount well below the long-term average to drive our upside.
3. Portfolio: What does the fund hold now, are there any big changes to the portfolio, what’s the rationale behind those changes, and how are those assets going to perform in the future?
4. Dividend: How sustainable is the payout, what are the chances of a dividend cut, and how low can the payouts go? (Key here is to look at yield on price, yield on NAV, changes in NAV and total net investment income, or NII)
5. Current Climate: How does the fund’s investment strategy fit within your broader portfolio and view of changes in the broader economy?

In other words, I combine a variety of bottom-up questions about the fund’s portfolio, strategy and management with top-down questions about the asset class and economy as a whole.

The System in Action

To show how this works, let’s look at an example: the PIMCO Dynamic Credit Income Fund (NYSE:PCI).

Back in early 2016, my colleague and Contrarian Outlook Chief Investment Strategist, Brett Owens, and I worked together to figure out what the future held for PCI. You can read his original buy recommendation right here .

The first step was to look at the fund’s management.

In early 2016, the fund was changing its strategy away from high-yield corporate bonds to mortgage-backed securities. The complexity of these investments scared some, but we saw this as a positive for PCI. We also saw it as a sign that the fund was in the process of a transformation that would be good for its returns—and shrink its discount to NAV.

We were right.

In July 2016, PIMCO announced that it would change the fund’s name (it used to be called the PIMCO Dynamic Credit Income Fund) to reflect its new mandate. Fund manager Daniel J. Ivascyn, who has become a legend in finance, was largely behind the change as he took a more active role at the fund.

He had good reason to. At the time, PCI was the most discounted of PIMCO funds.

And while mortgage-backed securities sound scary to a lot of people because of their role in the Great Recession, PIMCO saw things differently (and so did we). Mortgage defaults were going down and the housing market was a lot stronger, which made the heavily discounted mortgage-backed securities a steal.

So PCI’s change in strategy, driven by top-notch management, and its portfolio quality indicated that its deep discount was a buy signal. It also showed that the fund’s 11.9% dividend yield was sustainable.

What’s happened since? A 33.7% total return, even after the recent market madness:

A Quick Ride Up