The Other “D” Word in Closed-End Funds
When investors think closed-end funds, the word discount often comes to mind. The fact that fund shares can trade below net asset value (NAV) is one of the most significant and unique aspects of the closed-end structure; however, a growing number of investors are attracted to these funds for another reason – distributions.
The ability of closed-end funds to generate and pay attractive distributions over the last several years has resulted in strong valuations among all types of closed-end bond funds; in fact, many are trading at premiums to their per-share NAV.
Behind Attractive Distributions
The closed-end structure provides several advantages that can help bond fund managers generate more attractive income levels than comparable open-end funds or through direct investment in the underlying securities.
- Closed-end funds’ fixed capitalization means managers are not encumbered by redemptions and cash inflows.
- This also allows them to invest a larger portion of the portfolio in less liquid underlying holdings, if they favor such holdings.
- Perhaps closed-end funds’ biggest structural advantage is the ability to use leverage and the level of leverage that can be employed.
Leverage is not only used to magnify NAV performance (making good performance better and bad performance worse), but more commonly, to boost income to common shareholders. Funds accomplish this by harnessing the normal upward-sloping yield curve: using a leveraging instrument whose cost is tied to short-term rates, then investing the proceeds at higher long-term rates.
Fixed capitalization makes it easier for funds to maintain regulatory-required asset coverage levels and, therefore, higher levels of leverage. For instance, closed-end municipal bond funds are about one-third leveraged, while taxable U.S. and foreign bond funds average just under one-quarter of leverage.
The declining interest rate environment and upward sloping yield curves that have prevailed since the end of the financial crisis have helped leveraged bond funds turn in strong NAV performances and generate attractive payouts.
Declining Earnings = Lower Payouts
Lately, the flattening yield curve and a shift of portfolio holdings into lower-yielding positions have put pressure on the distributions that funds can offer. A flatter yield curve means that incremental income is somewhat lower. Furthermore, as older, higher-yielding portfolio holdings mature, are called, or are refinanced, the proceeds are invested in what the market currently can offer – lower-yielding holdings. Not surprisingly, closed-end bond funds’ distributions have been cut. Some in repeated baby steps, others in large leaps. This chart shows the percentage of dividend cuts and dividend increases by bond fund category for the first quarter of 2013.
Source: Thomas J. Herzfeld Advisors, Inc.
The greatest numbers of cuts have been among municipal bond funds, many of which tend to slowly whittle away at their monthly distributions to closely match them to the current and predicted level of ongoing earnings. These small changes are less dramatic, and with the average municipal fund in the sector still paying out a tax-exempt 5.3%, investors still love them. In fact, the group traded at an average discount of just -0.8% at the end of March 2013, although they had been trading even more richly, peaking at a +3.7% premium in early October 2012.
Taxable bond funds, especially high yield, have also had more distribution cuts than increases. Some fund groups opt to make larger cuts and adjust payouts less frequently. Funds that pay quarterly rather than monthly distributions tend to have larger individual payouts (three months’ worth instead of one), so a distribution cut is more noticeable. Average valuations for the taxable bond fund groups have contracted more than four percentage points from their peak at an expensive average premium of +4.2% at the end of the third quarter 2012, to their current -0.1% average discount levels.
Keep Both “D” Words in Focus
The greater the distribution cut, the more likely investors will react (or better yet, overreact), widening discounts. When investors are rushing for the exits, we seek to find attractive entry points for short-term trades. Typically, larger payout cuts often mean the new distribution level will be sustained for a longer period of time. That can provide a better opportunity to get in at a discounted price, and reduces the odds of another distribution cut in the near future.
Just as quickly as discounts widen, they can narrow again, but the share price won't necessarily recover to previous levels. With what appears to be a long-term discount widening trend in the fixed income sector, our preference is to sell if the discount narrows significantly or inverts to a premium – then wait for the next trading opportunity.