Far too many investors think inflation is bad news for closed-end funds (CEFs), for one simple reason: they fear that it will increase CEF borrowing costs. (Because CEFs, of course, use leverage to varying degrees.)
It sounds like a reason to be concerned. Inflation, after all, raises interest rates, and higher rates obviously mean CEFs would have to pay more to repay their loans.
Bad news, right?
Not so fast! Because almost everyone forgets the other side of the story – that inflation (at least these days) comes with a strong economy – and this generates returns on investment that will more than offset any slight increase in CEF borrowing costs.
Today we are going to take a look at what the current inflation situation means for our CEF insider wallet. Next, we’ll look at a CEF with a 5.1% dividend that is perfectly set up to take advantage of this new high inflation, high growth world.
Forget the Hype: Let’s Put This Inflation ‘Push’ in Context
One thing that holds many investors back these days is the magnitude of the latest spike in inflation: a 5% jump in May, the biggest consumer price hike since 2009. But we have to look beyond it. of that single number to get the real story. , something the market (for once!) seems to understand. Equities are on the rise, even with rising inflation and rate fears!
This is our first clue that these inflation fears are exaggerated. The other thing to keep in mind is that inflation isn’t as bad as it looks, if you look at May’s 5% figure in context.
Given that the number for May 2021 is compared to prices for May 2020, when the economic blow from the pandemic was reaching its full strength, it’s easy to see a big spike. In the longer term, however, inflation is subdued. Over three years, we have only seen 6.8% inflation, or 2.2% annualized, which is much closer to the 2% rate that the Federal Reserve set as its target.
This is half of our favorable configuration for CEFs. Now let’s look at the other side of our CEF ledger: the strong economy I mentioned earlier.
We find that average hourly earnings, in nominal terms, are increasing at a higher rate in recent months, as wages rise to match the higher cost of goods and services. Of course, this is no surprise; there has been an endless parade of stories of employers desperate for help, offered sign-up bonuses for certain jobs and an overall stronger position for workers.
It’s still unclear to what extent we can attribute recent price hikes to these higher wages, but early data suggests that higher wages are a big contributor. This Is Push up business costs, of course, but it’s also a type of inflation that pushes up consumer spending too, and by a lot!
This indicates a vibrant economy where people go to stores and buy things, and with vaccination rates still on the rise in the United States, you can expect more consumers to do so. Which, of course, is great for stocks.
About this CEF “watch list”…
In an era of wage growth and more aggressive consumer spending, first-tier investors mostly opt for a consumer discretionary ETF like the SPDR Consumer Discretionary Fund (XLY)
One problem with these funds is that they both have You’re here
While Tesla was obviously a great buy in 2020 (or, for that matter, since its IPO), the stock is hit now, shortly after it was added to those ETFs.
This kind of situation, of course, is why we prefer CEFs! Their managers can pull out of stocks like Tesla when they fall and are also free to build more balanced portfolios, not tied, as they are, to a major index.
And then there are the dividends. Consider a fund like the BlackRock Enhanced Capital and Income Fund (CII), whose return of 5.1% eclipses that of ETF options. And it’s much better balanced, with Microsoft
The best part is that CII’s management team sold Tesla before its last dive – a smart move that helped it avoid a drag on its net asset value (NAV, or the value of its underlying equity portfolio. ).
Michael Foster is the Senior Research Analyst for Contrary perspectives. For more great income ideas, click here for our latest report “Indestructible Income: 5 windfall funds with secure 7.4% dividends.“