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Fund with a high distribution yield

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October 10, 2012 – Comments (0) | RELATED TICKERS: PEO

On a search for yield last month, I stumbled across a Barron’s article (may need subscription) profiling a closed-end fund that recently announced “its commitment to an annual 6% minimum distribution rate.”

Let’s see, cash accounts, CD’s and t-bills yield approximately nothing, 10-year T-notes yield something under 2%, the S&P500 yields 2.2%.  6% is – let me open a spreadsheet – click, click, keyboard, click, keyboard, enter – wow! - 6% is a LOT more than all of those.

The fund is Petroleum & Resources (PEO) and it’s currently trading at a 12% discount to net asset value.

6% yield, trading at 88 cents on the dollar, sounds pretty good.  But, seems like there’s always a ‘but’ with high-yield stuff, there are some risks and a few questions.

The distribution track record looks good.  The fund had a distribution rate of 7.1% for 2011, 5.5% for 2012 and the five-year average is 7.9%.  There’s another ‘but’ here.  At least part of that gusher of yield looks like it’s coming from a drawdown of assets.  At the end of June ’12, net asset value per share was 27.69.  NAV at the end of June ’11 was 33.70.

The top ten holdings make up over half the asset value and are some of the premier names in the energy sector.  ExxonMobil, Chevron, Schlumberger, Occidental, Anadarko and so on.  An interesting point – the highest yield in the top ten is number six Dow Chemical at 4.4%.  None of the top ten holdings yield anywhere near enough to cover a 6% payout based on dividend payouts.

That means the fund needs to count on goosing revenue with things like covered call strategies, trading, leverage or paying down assets to meet the new commitment.  The payout history shows management seems to be doing a decent job of juicing returns and that some of the juice may be coming at the expense of NAV.  The latest annual report shows a choppy net asset value at year end over the last five years.  For Dec 31 of ’07 – ’11 NAV was up, down, up, down and dropped from $36.61 to $30.73 over the stretch.  The latest quarterly shows the fund does write option contracts, but doesn’t appear to use leverage to any significant extent.

The fund sports a 5-star CAPS rating with only 63 picks, 60 of them are outperforms.  The fund has fooled most Fools playing it, only 22 of the active picks have positive scores including two of the three red thumbs.

If someone forced me to make a pick, I’d give PEO a green thumb.  Since no one’s forcing me, I’m staying on the sidelines.  I like the discount to NAV, quality companies in the holdings and high yield.  I don’t like the prospects that part of that yield may be paid from assets.  After all, if I were putting money with professional management, I'd want him or her to manage and grow the investment, not just turn around and hand the capital back.

I can see how the new commitment to a 6% yield would be very appealing to someone who needs investment income in this ZIRP environment.  I just hope folks carefully review and are comfortable with everything behind that commitment before jumping in.

Anyone have more to add on this fund?  

Fool on! 

Russ

Disclosure: Long CVX (not fun today).  No position in any other security mentioned.

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