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An Unusual Season for Closed-End Funds

12/10/2012

For many investors, the fourth quarter is a time to assess their portfolios, consider reallocations based on market outlook and their upcoming tax bills, and, if feasible, seek to minimize their tax burden. In past years, it was common for investors to take losses to offset gains realized earlier in the year.

As a result of selling pressure from such reshuffling, year-end discount widening is a typical seasonal phenomenon among closed-end funds. The year’s biggest losers are often the best candidates for tax-motivated selling.

However, 2012 is shaping up to be somewhat different. Most funds have turned in strong year-to-date gains due to investor demand for attractive distribution yields—something closed-end funds have been able to deliver. As a result, tax-loss selling is not expected to be pronounced; instead we expect investors to realize gains.

Not Waiting for Fiscal Cliff Resolution
Uncertainty related to the “fiscal cliff” is dominating year-end trading decisions. The expectation that lawmakers may not act quickly enough to prevent automatic tax increases and spending cuts written into the Budget Control Act of 2011 are causing investors to sell profitable holdings.

For months the financial media have touted harvesting gains. Although doing so would mean triggering a taxable event for 2012, positions sold at a profit can be reestablished, locking in a new, higher cost basis and potentially reducing the future tax burden.*

In addition to the effects on the market of investors implementing this tax strategy, individual sectors viewed as most vulnerable to the potential outcome of fiscal cliff negotiations declined markedly in mid-November. For instance, utility funds typically pay a large percentage of their distributions from qualified dividend income (QDI); and tax rates on QDI are expected to rise from 15% to 18% if the Bush-era tax cuts are allowed to expire. Also, funds with concentrated holdings in Master Limited Partnerships (MLPs), which have been very popular among investors because of their ability to pass through tax-advantaged distributions and pay attractive distribution yields, were hit hard on concerns about whether their favorable tax treatment would survive. After years of premium valuations, several funds in these high-flying groups fell to discounts.

Responding to the initial round of net asset value (NAV) declines, closed-end fund investors reacted, selling aggressively after the first sign of dropping values and quickly eroding premiums. The mini-panic snowballed, spreading to all fund categories, even those where NAVs remained strong. For instance, municipal fund NAVs actually rose slightly during the worst of the two-day decline, but their share prices were down by several percentage points as tenuous premiums evaporated.

The chart clearly shows the extent of the downdraft in the average discount for the industry, which provided an excellent buying opportunity for short-term trading as well as attractive entry points for longer-term positions.

While most funds quickly recovered the bulk of their losses, discounts remain wider than they were before and investors are still uneasy. We attribute the buying support to professional investors who stepped in as discount levels widened, but these shareholders are not expected to stick around for the long term.

If no clear compromise for resolving the fiscal cliff (or picture of what a compromise might look like) emerges, we predict there will likely be continued selling pressure through December as investors closely monitor events in Washington. We expect additional attractive buying opportunities among closed-end funds before year end.

*Any comments in this article are not to be considered as tax advice

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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.