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This 11% Yield CEF Has Big Upside Potential

If you like big yield and significant price appreciation potential, then this particular closed-end fund (CEF) is worth considering. It’s a sector-specific CEF that yields nearly 11% (paid monthly). And not only is the sector an attractive contrarian play for multiple reasons right now, the fund is trading at a double-digit discount to its NAV which suggests it may have even more upside rebound potential.


Tekla World Healthcare Fund (Yield: 10.9%):

The CEF we are talking about is the Tekla World Healthcare Fund (ticker: THW). The fund's objective is to seek current income and long-term capital appreciation through investment companies engaged in the healthcare industry, including equity securities and debt securities. The fund was launched in 2015, and asset under management have already grown to a healthy $440 million.

Sources of Income:

The current distribution yield on the fund is 10.9%. Perhaps the first thing you are wondering is how can a fund generate such a big yield? The answer is a combination of dividend payments, interest payments, prudent capital gains, and a moderate use of leverage. For reference, the following table shows the current asset class allocation within the fund.

The “Other” category is primarily leverage (the current leverage ratio is 21.4%). This is a conservative amount of leverage to help manage the fund. Worth noting, CEFs are generally limited by regulation to a maximum of 30% leverage anyway which helps limit risk. And for reference, the following table shows the breakdown of the fund’s recent distribution among investment income, net realized gains, and return of capital.

The ability for the management of the fund to maintain high dividend payments sourced from various categories is part of the reason that this fund (and CEFs in general) can be attractive to income-focused investors (i.e. they like/need the steady high income payments), and it’s also the reason management charges a significant fee (more on the fee later).

Healthcare Sector Contrarian Play:

Another reason we consider this particular investment to be attractive is because we believe healthcare sector investments are attractive right now. As we wrote recently, the healthcare sector…

“…is particularly attractive for a variety of reasons. For starters, it’s out of favor, and as contrarians, we like that (be greedy when others are fearful!). The health care sector has been clouded with uncertainty this [past] year because of the US election. Specifically, companies have had little clarity with regards to the future of health care laws, and the market hates uncertainty (therefore prices are down). However, we may be about to get a lot of clarity with the soon-to-be aligned White House and Congress. Specifically, we’ll get more clarity with regards to Obamacare (i.e. how much of it will be repealed) and with taxes (can president-elect Trump follow through on promises to make taxes more fair for health care companies versus their international peers?).”

As contrarians, we believe the healthcare sector is attractive right now, and this particular closed-end fund is one attractive way to play it. For reference, here is a one-year chart of the healthcare sector (as measured by the healthcare ETF, XLV) versus the overall market (as measure by the S&P 500 ETF (SPY)).

 

Discount to NAV:

Another reason we consider this particular CEF attractive right now is because its market price is trading at a large discount (-10.27%) relative to its net asset value (NAV) as shown in the following chart. 

Large discounts and premiums are generally a unique characteristic of closed-end funds (ETFs can have small discounts/premiums), and they can create attractive opportunities. The discount means if management liquidated all the fund’s holdings they’d be worth more than the current value of the fund’s shares. And while there is no guarantee that the share price will rebound closer to the NAV, they have been headed in the right direction over the last year (the discount shrunk in 2016). Additionally, management agrees the shares may be undervalued as they recently approved additional share repurchases which may help shrink the discount and increase shareholder value.

Risks:

Important to consider, closed-end funds (and this fund in particular) face unique risks. For example, closed-end funds generally have high expense ratios. At Blue Harbinger, we absolutely despise high expense ratios because they eat into long-term returns. However, we also believe the high expense ratios of CEFs are acceptable to SOME investors. In particular, if you are a mature investor that relies on income from your investments to meet living expenses then CEFs can be worth considering as an important part of your diversified investment portfolio. Said differently, the high fees may be okay if you understand you may be sacrificing some long-term capital appreciation in exchange for the relatively large and steady income payments you need to pay your bills.

On the other hand, if you are a young person still saving for retirement then CEFs are generally NOT prudent for you (i.e. you’re better off investing in very low expense ratio exchange traded funds because you don’t yet need the income). For reference, THW’s total adjusted expense ratio for 2016 was 1.47%.

Another risk is the less diversified leverage used by this fund. Specifically, this fund invests primarily in only the healthcare sector, and if the sector does not rebound then potential capital losses could be magnified by the 21.4% leverage ratio (i.e. the fund buys $1.21 worth of investments for every dollar it has).

Conclusion:

Overall, we believe this Tekla World Healthcare CEF is a fantastic opportunity for income-focused investors to consider adding to their diversified portfolio. Certainly, there are risks, however we believe the risks could pay off handsomely in the form of significant capital appreciation while you continue to receive big monthly distribution payments equal to 10.9% on an annualized basis.

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