Bringing Closed-End Funds Out in the Open

Neil Powers didn’t get into his line of work for the public adulation: He manages a bond mutual fund, and a closed-end fund at that.

In the wake of the public’s decade-long feeding frenzy for open-end stock funds, closed-end bond products have been pushed to the periphery. But market dynamics change, as do investors’ appetites. Anyone looking for decent yields today should check out closed-end bond funds.

Powers’ fund, Putnam Premier Income Trust, boasts an SEC standardized annual dividend yield near 8.4% and has outperformed other bond portfolios--of both the open- and closed-end varieties--that target several areas of the fixed-income market.

As a closed-end fund, Putnam Premier Income has two prices. The net asset value, or NAV, is the per-share worth of the underlying bond holdings. Meanwhile, the actual price of the stock, which trades on the New York Stock Exchange, shows what investors are willing to pay for the portfolio, and the interest/dividends it generates, at any given moment.

Like many closed-end funds, Putnam Premier Income has typically sold at a discount, meaning the stock price usually is below the NAV. That discount is currently about 9%, meaning investors can buy a dollar of bond assets for about 91 cents.

Powers and co-managers Bill Kohli and Jin Ho target three different areas of the bond market in this fund: U.S. government IOUs; high-yield, or junk, issues; and international debt. Each of the three legs offers a different means of support, resulting in a diversified mix.

Powers, 35, has been at Putnam for 11 years and has been lead manager of the fund since 1995. He was interviewed by Russ Wiles, a Times mutual fund columnist.

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Times: Given the Federal Reserve Board’s interest rate hike of late March and the resulting turmoil in the financial markets, have you changed your bond market outlook?

Powers: No. Earlier in the year, investors were getting paid less to take on greater risks, which caused us to reel in some of our high-yield and emerging-markets exposure in favor of mortgage-backed securities. We reduced our risk profile.

We think the Fed might tighten another 25 to 50 basis points [0.25 to 0.50 percentage point] and that would be sufficient to put a damper on the economy without throwing it into a recession. With our mortgage weightings and generally shorter durations [maturities], we’re actually well-positioned right now.

Times: Your fund holds a combination of U.S. government, high-yield and foreign bonds. Why this mix?

Powers: The fund was launched in the 1980s, when Putnam was growing its strength in all three areas. We determined that a great portfolio would include one-third in each of those major sectors. Such a combination would help us maximize our risk-adjusted returns while maintaining a relatively high level of income. The high-yield, U.S. government and international areas tend to be [less] correlated with one another, providing diversification.

Times: Do you maintain an equal footing in the three areas or vary the weightings?

Powers: Over time, we do . . . overweight or underweight particular sectors, although each sector will never account for more than 50% of the fund’s assets or less than 25%.

Coming into this year, we had 43% in domestic high-yield and 7% in emerging-markets bonds, which we think of as foreign high-yield, for a total allocation of 50%.

We had the rest split 25% each in investment-grade international bonds and U.S. governments. Since then, we have brought our high-yield holdings down to 40% domestic and 3% in emerging markets. And we have reinvested the proceeds relatively equally in the international and U.S. government sectors, for about 28% each. Our U.S. government holdings, incidentally, are mostly in the mortgage-backed securities.

Times: Is each of the three managers responsible for a different slice of the asset pie?

Powers: Yes. I work on the domestic side, looking at mortgages and high-grade corporates primarily. Bill Kohli works on the international side, and Jin Ho is the portfolio manager on the high-yield side. Each of us is backed by larger teams of analysts in each of the major sectors.

Times: Who makes the allocation decision?

Powers: It’s a management team decision.

Times: As a closed-end fund, Putnam Premier Income has a relatively stable asset base, with no money going in or out. From a management standpoint, is the closed-end structure a help or a hindrance?

Powers: It’s a help.

There’s less cash flow coming into the portfolio that needs to be invested, nor do shareholder redemptions require that we sell holdings periodically. The great thing about the closed-end structure is that it allows you to run the portfolio with greater precision.

Times: Any thoughts, generally speaking, as to what might rekindle investor enthusiasm for closed-end products, which seem to be out of favor?

Powers: I think we’re starting to see the tide turn. If you look at discounts on certain other products, such as some of the muni bond funds, you will notice that discounts have narrowed lately and, in a few cases, have turned into premiums.

Investors realize that they need to diversify their new purchases away from just stock funds, especially at these valuation levels. As cash flows from stocks to the fixed-income side, that should provide greater demand for bond mutual funds. People looking for cheap yields will find that the closed-end arena is one of the best places to get it.

Times: Your fund, like many other closed-end portfolios, seems to sell at a chronic discount to NAV. What does that reflect?

Powers: It’s mostly a function of the malaise in the bond market, rather than a reflection on the closed-end vehicle. Over the last couple of years, we have seen $20 billion or more each month on average flowing into equity funds, while bond funds have been stagnant--no net inflows or outflows.

Times: What’s your discount these days?

Powers: About 8% to 9% recently, an improvement from 13.5% as recently as December. I think it means investors are starting to realize the value of a discounted closed-end bond fund.

Times: What do you bring to the table that investors perhaps could not get on their own?

Powers: The ability to reallocate assets within the portfolio, efficiently and quickly.

For example, on the heels of deregulation in the telecommunications market late last year, we bought some corporate bonds in the cable and telecommunications sector. This was a situation where there was more demand than supply. By the time any of the bonds got around to individual investors, if they were even available, they were priced at richer levels.

Times: What types of bonds do you favor at the moment?

Powers: We like mortgage-backed securities a lot right now--Ginnie Maes and Fannie Maes. On a risk-adjusted basis, they’re about the cheapest types of securities out there. They yield about 100 to 125 basis points more than Treasuries of comparable maturities, while high-yield bonds yield about 300 to 350 basis points more than Treasuries. [Basis points measure yield in hundredths of a percent; i.e., 300 points equals 3%.]

So with mortgage-backed securities, you’re getting about one-third the yield spread of high-yield bonds, with much less than one-third the relative risk. So while high-yield bonds are richly priced, mortgages still offer a lot of value. Many are trading at slight discounts.

Times: We haven’t talked much about U.S. high-yield bonds. What’s an example of an issuer that you currently like?

Powers: Nextel Communications, which we have owned for a while. Bonds in the telecommunications sector as a whole should perform well now that the industry is behind its start-up phase and the big sunken costs already have been made by these firms. Now it’s a matter of just watching the good companies perform.

Times: The fund has achieved returns above 8% or so in five of the last six years. What will be needed to continue that good record?

Powers: The whole notion of managing as a team--with the right number of eyes looking at the entire global fixed-income market and across the U.S. bond spectrum--is critical. Having sufficient resources allows us to invest in areas where we see opportunities. Last year we invested a reasonably heavy amount in emerging markets when yield spreads there were significantly wider than they are now. We had the resources to go to Russia and South America to evaluate the situation in those places.

Times: Among your international holdings, are there any foreign nations that you particularly favor?

Powers: One key international piece is what we call “core Europe,” which revolves around Germany.

We don’t see enough economic strength to cause interest rates to rise dramatically there. We don’t think the Bundesbank will raise interest rates any time soon, because they really need the tax revenues generated by higher growth to help their budget situation, for purposes of the European Monetary Union. So I would suggest the risk of a rate rise in Germany is not significant.

Another area we like is the United Kingdom. The U.K. is mirroring some of what’s happening in the U.S.--a strong economy, rising short-term interest rates and a strong currency. It’s one of the highest-yielding countries in the world. Those are the two key areas for us, internationally speaking. We also like some of the emerging markets like Argentina and Mexico, now that yield spreads in those countries have widened a bit. Our international holdings predominantly are government bonds.

Times: Do you protect the fund from currency fluctuations by hedging international bets?

Powers: Yes, currently to a greater-than-normal degree. The idea is to reduce our international currency exposure to less than one-third of the portfolio.

Times: And this reflects your belief that the dollar will be stronger for a while longer?

Powers: Yes.

Times: Based on your earlier comment about searching for opportunities around the globe, I get the impression you don’t think your continuing good record hinges on a favorable bond market?

Powers: That’s right. Many people would say the bond market was unfavorable last year, yet we had a 9% return in that environment. Irrespective of what the bond market does, I think we can provide attractive total returns.

Times: What is your general interest rate outlook?

Powers: Strength in the economy will keep short-term rates from dropping too quickly. However, the economy is in a self-correction state, so if interest rates rise too far, it will choke off growth and rates will stop rising. The economy is in a state of equilibrium. It’s in a sweet spot. We expect that will continue for a while further. We won’t make any large interest rate bets one way or the other until we see that equilibrium break down.

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Putnam Premier Income Trust

Strategy: Closed-end fund that invests in a mix of high-yield bonds, foreign bonds and U.S. government debt.

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VITAL STATISTICS

Five-yr. avg. annual ret. (through Jan. 31): +9.8*%

Five-year avg. annual return for multi-sector closed-end bond funds: +8.2

Top high-yield bond holdings as of Jan. 31: Sears Credit 6.05%, maturing 2004; Midland Funding Corp. 13.25% (2006); Cencall Communications Corp. zero-coupon (2004)

Top U.S. government holdings: U.S. Treasury 6.5% (2006); GNMA (Government National Mortgage Assn.) 7% (2025-26); GNMA 7.5% (2025)

Top international holdings: German government 6.25% (2006); German 5.25% (2001); French Treasury 7% (2000)

Latest share price: $7.75

Latest net asset value per share: $8.55

Share price discount to net asset value: 9.4%

Stock ticker symbol: PPT (trades on New York Stock Exchange)

Assets: $1.1 billion

Phone: (800) 225-1581

Morningstar risk-adjusted performance rating, 1-5: ****

Source: Morningstar Inc.

*The total-return calculation is based on the fund’s stock market price rather than net asset value. As a closed-end fund, it can trade at a price that reflects a value either higher or lower than the liquidation value of its holdings.