Bringing CEFs Out of Their Discount Stupor
Sharp market corrections typically get a great deal of media attention as investors line up for further details. Last year’s most prominent headlines included the Federal Reserve’s tapering of its open-market bond buying, rising long-term interest rates, and losses in interest-rate sensitive issues. Largely ignored were equity markets as they quietly surged to report strong gains for 2013.
This year, as equity indices struggle, bonds have turned in the surprise gains. Nevertheless, investors remain nervous and cautious, with that sentiment reflected in persistently wide discounts throughout the closed-end fund industry. We believe a combination of trends is poised to shake fund valuations out of their caution-induced discount stupor.
Discount Levels Wide and Stable
Average discounts of closed-end funds have vacillated within a particularly narrow range for most of this year, between -6% and -7%. What is most interesting, however, is how widespread discount valuations have become. Unlike in the past when some sectors were weak while others were strong, all major categories are currently trading at average discounts, falling within a narrow band, as captured in the chart below.
About 88% of all funds are currently trading at discounts, with a full 25% at double-digit levels! To us, overdone investor pessimism presents inefficiencies and creates opportunity.
Let’s look closely at some market undercurrents and how they may provide the potential for future profit.
Higher Tax Rates Prompt Demand for Tax-Advantaged Investments
Wealthy investors were no doubt surprised by significantly higher tax bills when completing their annual tax returns last month. As a result, many are now interested in tax-advantaged securities. While several types of closed-end funds are structured to fit that profile, closed-end municipal bond funds are perhaps best known for this use.
Not only is the municipal interest these funds pay out tax-exempt, but distribution rates for closed-end municipal bond funds remain particularly attractive, averaging 5.9%. In absolute terms, these yields are superior to U.S. Treasury rates as well as many other taxable investments, while their taxable equivalent yields approach 10% for investors in the highest income brackets.
Other types of funds that include payouts taxed at favorable rates or distributions that may be all or in part tax-deferred, include those that:
- distribute qualified dividend income,
- pay a portion of their distributions from long-term capital gains, and
- distribute much misunderstood tax-deferred return of capital. This group includes funds that focus on investment in Master Limited Partnerships (“MLPs”).
It’s Not a Bond, It’s a Closed-End Fund
In many ways, investors look at closed-end funds as they would a long-term, fixed-rate bond. This is partly the result of a decades-long bias of bringing to market leveraged funds that have a high income objective. Although leverage exacerbated net asset value declines for many closed-end bond funds last year, even funds with positive net asset value performance suffered share price declines as investors indiscriminately rushed to sell. As a result, scores of well-managed funds are languishing at attractive discounts.
Furthermore, an important detail that appears to have been overlooked is that closed-end funds are actively managed portfolios, not static investments like an individual fixed-rate bond. In fact, one of the basic advantages of the closed-end structure is that when times are rough, portfolio managers can buy rather than be forced to sell into weakness. At present, not only do fund managements expect a changing interest rate environment, but they are managing portfolio holdings as well as leverage characteristics to capitalize on those changes. This type of prudent use of the benefits of the closed-end structure has already begun to enhance performance for many funds in 2014.
Higher Long-Term Rates Can Sustain Earnings Streams
Last year’s rise in long-term interest rates had an unrecognized benefit—potentially more sustainable earnings streams.
To better understand this, let’s focus on the past several years when interest rates fell. During that period, portfolio managers were plagued by early calls and refinancings that stripped portfolios of their highest yielding securities and left managers having to redeploy assets into lower yielding positions. Somewhat higher rates have allowed funds to hold on to more of their most attractive positions and even to reinvest available cash in securities paying somewhat higher yields. This is expected to help closed-end funds maintain strong payouts going forward.
Increased Confidence is Key
The essence of the closed-end fund structure is its “closed” capitalization, or fixed number of outstanding shares. With a static supply of shares available, discounts and premiums are the measure of a fund’s popularity, as dictated by shareholder sentiment.
Going back to our municipal bond fund example, as investor demand has begun to grow, average discounts have narrowed from almost -10% in mid-December 2013 to their current -5.29% level. Nevertheless, one-third of the large 201-fund muni group still trade at discounts wider than -8%. Discounts for taxable bond funds have similarly narrowed, from -8.47% to -5.25%, while as many as 45% of those funds still trade at discounts wider than -8%.
Investor caution based on interest-rate sensitivity and a fear of the impact of leverage continues to be priced into fund valuations, although concern is slowly waning. Leverage has enhanced closed-end fund performances in 2014 as interest rates have declined somewhat; for instance, the much-watched 10-year U.S. Treasury rate currently stands as 2.60%, down from 3.00% at the start of the year. In addition, many investors are beginning to trust forecasts that interest rates will remain low for at least the next few years.
A Quiet Rebound Ahead?
We expect income-focused closed-end fund discounts will continue to narrow, as investors return to this area of the market, lured by their recent performance; attractive, and in many cases, tax-advantaged distributions; as well as easing concerns about a sharp rise in interest rates.
Remember, bad news travels quickly while good news often takes longer to seep in. As favorable underlying trends slowly pull closed-end funds out of their current stupor, we believe now may be a good time to take strategic positions in select deeply-discounted income funds.