Financial Professionals

Market Insights

A A A

Weather Report for Closed-End Funds

08/12/2013

It has been a turbulent summer for closed-end funds, and the investment climate is still quite unsettled. The following is our take on the current weather and forecast for changing conditions, along with where we think investors can take advantage of climate change.

Premium/DiscountCurrent ConditionsForecast
Bond Funds
8-12-Herzfeld 1.1
From -6.89% to
-9.08%
Investors have given all types of bond funds a chilly reception since the end of May when long-term interest rates began to rise. Average discount levels for taxable bond funds have widened, from -1.06% at year-end 2012 to -6.89% of late, while foreign bond funds widened from an average -3.26% to -9.08% currently.
Several high-flying, premium-priced bond funds are now among the most out of favor! In some cases, discounts have widened more than five percentage points. We consider this a good short-term trading opportunity but caution investors to be aware of how rising interest rate trends may impact individual funds over the long term.
Municipal Funds
8-12-Herzfeld 1.2
Average
-7.36%
Many municipal bond funds traded at share prices above net asset values (NAVs) during much of last year and early this year as investors paid premium prices to enjoy attractive tax-exempt distributions. The rise in long-term rates, exacerbated by leveraged capital structures, sent investors into a whirlpool-selling frenzy. Oh, and did we mention Detroit?
Not only do many experts consider municipal bonds to be undervalued as a result of recent selling pressure, but in the rush to get out, closed-end fund investors have pushed share prices of many funds to double-digit discount levels. At these valuations, the funds pay particularly attractive tax-exempt distributions, some higher than 8%! Watch out for funds that may be vulnerable to dividend cuts, and we suggest treating these as short-term trading opportunities rather than long-term holds.
Recent IPOs
8-12-Herzfeld 1.3
Average
-4.28%
After more than a year of strong receptions for new issues of closed-end funds, the initial public offering (IPO) market ran for cover with many underwriters opting to take the summer off. The IPO calendar was cut from several funds being launched per month to just one new fund in July. A reversal in investor sentiment toward bond categories fueled the change in the weather.
We know of no new funds scheduled to be brought to market in August, but the September calendar is already filling up. Funds with sunnier outlooks are being favored, such as MLP (master limited partnership) and senior loan funds. Several funds that came to market in 2012 and early 2013 are now sporting attractive discounts as initial investors sold into the bond market downturn. The bargain pricing makes it a good time to establish positions in funds managed by some of the most well-respected and best-known advisers.
Equity Funds
8-12-Herzfeld 1.4
From -4.02% to
-7.16%
For several years now, equity funds had been largely overlooked with investors favoring fixed income categories that offered much desired income. Average discount levels are currently -4.02% for U.S. equity funds, -6.66% for specialized funds, and -7.16% for the foreign equity group.
Discounts within equity categories remain relatively wide, especially for foreign funds, which means there are opportunities to acquire long-term holdings in a broad variety of specialized strategies. In addition, funds that have experienced persistently wide discounts are beginning to come under activist pressure to narrow their discounts, providing potential opportunities for gains.
Senior Loan Funds
8-12-Herzfeld 1.5
Average
-0.96%
The senior loan fund category, also referred to as loan participation funds, has fallen to uncharacteristic average discount levels lately.
Senior loan funds are expected to be particularly favored by investors in a rising interest rate environment because interest paid by underlying loans within the portfolios generally adjusts higher with prevailing rates. In addition, these funds tend to use leverage whose costs float in line with short-term rates. To maintain the benefit of an upward-sloping yield curve, both income and leverage costs are typically based on the same index.
MLP Funds
8-12-Herzfeld 1.6
Average
+0.80%

Funds that invest in master limited partnerships have received a sunny reception from investors, primarily as a result of strong performances and the increasingly attractive levels of distributions they pay.

A master limited partnership (MLP) offers the tax advantages of a partnership and the liquidity of a publicly traded stock, and generally operates in the natural resource industries.

MLP funds are among the most misunderstood group of all closed-end funds; nevertheless, their popularity is expected to persist as the underlying securities have a continued bright forecast. Furthermore, many of these issues pay taxes at the fund level, and although NAVs are adjusted for tax reserves, that cash is still available to generate income. We tend to look for opportunities to buy MLP funds at discount levels, but they are few and far between. When picking a fund in which to invest, be sure to check if it is a pure MLP play, or one that limits MLP holdings to avoid paying taxes at the fund level, as such funds include other types of securities in their portfolio.

Long-Range Forecast We expect atmospheric pressure to persist between now and at least year-end, with more active than usual seasonal tax-related pressures throughout the fourth quarter.

As our regular blog readers know, our specialty is trading closed-end funds; therefore, we welcome these varied weather patterns as they provide us with investment opportunities.

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.