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2014 Outlook for Closed-End Funds

01/06/2014

With many of 2013’s headwinds behind them, the outlook for closed-end funds in early 2014 is increasingly positive. Here is a review of some of the various challenges presented last year, and our view on the year ahead.

 

2013 Challenge

2014 Outlook

IPO Activity After a strong start in 2013, the number and size of closed-end fund IPOs faltered mid-year. A decades-long emphasis on bringing to market funds that offer attractive income was hurt when long-term interest rates began to rise and share prices of newly issued funds fell to discounts shortly after their launches. We expect very few closed-end funds IPOs in early 2014 as issuers and underwriters struggle to come up with offerings that will be popular and fulfill investors’ needs. An eventual rebound will be tied to diversity in the types of new funds offered and retail acceptance of the products. We predict new offerings will focus less on income and more on growth objectives and alternative strategies.
Distribution Rates The declining trend in interest rates over the past few years put closed-end fund distributions under pressure during most of 2013.   Not only were fund holdings generating lower earnings, but some of the most attractive holdings were being called away and/or refinanced. The result? Dividend cuts across many income categories. The rise in long-term interest rates has some benefits for investors. We expect closed-end fund distribution rates to be more sustainable in 2014. In fact,some funds may even increase their payouts. Although long-term rates are higher, short-term rates remain low. This results in a steeper yield curve which can enhance a fund’s ability to boost income to common shareholders using leverage.
Discounts to NAV A sell-off in all types of bond funds began in mid-May 2013, impacting the net asset values (NAV) of leveraged closed-end income funds the most, while widening discounts for almost all funds. Poorest performing sectors were hit with another wave of selling pressure at year-end as investors took losses to offset gains realized from other investments.   As equity funds paid out unusually large capital gain distributions for 2013, investors further intensified their selling of bond funds to offset these unexpected taxable gains. The widest average discounts of the year occurred in the third week of December. The urgency to sell losing positions to realize tax losses has passed and discounts have already begun to narrow. Furthermore, investors are enjoying a relative degree of certainty surrounding the Fed’s policy towards interest rates after a year of nervous guessing. Experts speculate that there is still a tremendous amount of cash sitting on the sidelines earning little or no dividends or interest. Investors’ unfulfilled desire for income and the urge to get back into equity markets, which made record gains in 2013, should lure investors back to both bond and equity closed-end funds in 2014. We expect the added demand should continue to narrow discounts along the way.
Discount Narrowing Actions & Dissident Activity Considering the strong prevailing valuations in early 2013, with many sectors trading at narrow discounts or even premiums, there was little need for fund managements to take action to narrow discounts. As a result, it was a slow year for tender offers and only three funds took the most aggressive action—liquidation. The most prevalent initiatives were new and stepped up open market repurchase programs.   As discounts widened in the second half of the year, however, some large shareholder groups began contacting managements and requesting more aggressive discount-narrowing action. We expect more dissident activity and discount-narrowing initiatives in 2014.   Fund managements have become increasingly proactive in managing persistent discounts over the past several years, but have favored only moderate actions. We predict funds will take more aggressive approaches, including an increased number of tender offers and perhaps even some open-endings and liquidations over the coming year.   In addition, we believe dissident activity will focus more on bond funds and less on equity funds as the popularity of the two asset classes has inverted.
Investment Positioning The long-term passive equity fund investor came up the winner in 2013, in spite of the fact that closed-end equity funds were out-of-favor throughout much of the year. However, 2013 was the exception rather than the rule.

On the other hand, after riding a wave of good performance from the end of the financial crisis until early 2013, the buy-and-hold strategy failed for bond fund investors.

Equity funds are starting 2014 at relatively wide discounts and, as a result, we believe they will receive increased investor attention as a good way to participate in the equity rally at bargain prices.

After a year of uncertainly with regard to interest rates, we also expect somewhat more confidence in the stability of bond markets.   But it will be a combination of discount pricing and attractive, stable distributions that will help entice investors back to closed-end bond funds.

Dual Approach in Evolving Environment

Historically, a trading strategy that seeks to buy closed-end funds with wide discounts and to sell when discounts narrow, increases returns and helps reduce risk by maximizing exposure to undervalued funds and minimizing exposure to those that are overvalued. Extreme discount widening at year-end 2013 suggests that there may be an equally dramatic “January” effect, as discounts typically narrow in the absence of tax-selling pressures.

While such a scenario might appear to make the case for active trading, the extreme nature of closed-end fund undervaluations and potential for more sustainable earnings support a longer-term focus for certain categories and individual funds. Therefore, we view this as an ideal time to select well-managed funds trading at attractive entry prices to establish them as core holdings for the coming year.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.