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Closed-End Funds Take Advantage of Bond Shakeout to Reposition

10/10/2013

The fundamental advantages of closed-end funds’ “closed” capital structure include professional management and the ability to use leverage. In our May 14, 2013 blog, we discussed how funds were using these benefits to prepare to cope with a changing interest rate environment. Now let’s examine how they have maneuvered within the current shakeout in bond and income markets to position themselves to benefit from steepening yield curves.

Yield Curves Have Steepened over the Past Year

Sources: Barron’s Statistics/Bloomberg, Loop Capital; yield curve graphics courtesy of Barron’s
Reprinted from the October 2013 issue of The Investor’s Guide to Closed-End Funds monthly research

Trading Up

It is clear that investors’ fear that the Federal Reserve would begin to taper its monthly bond purchases earlier than expected resulted in widespread selling pressure over the summer. Investors aggressively redeemed their holdings in fixed-income mutual funds, forcing portfolio managers to sell in order to meet redemptions. The forced selling put additional pressure on bond prices, further fueling the rise in interest rates.

Closed-end funds, on the other hand, are not plagued by redemptions at inopportune times. In the face of the downdraft, they had four options:

  • Hold on to current portfolios holdings
  • Sell to reduce exposure
  • Buy additional holdings at distressed prices
  • Buy and sell, to reposition portfolios

While various fund managements favored different choices, many used the opportunity to reposition, increasing credit quality and/or positioning for enhanced future income.

Incidentally, simply being able to hold onto current portfolios had an advantage. The rise in long-term rates provided the passive benefit that now fewer existing holdings with attractive yields are likely to be refinanced and called away — something that had been reducing fund earnings over the past several years. Furthermore, as the pace of refunding slows, less supply in the form of new issuance comes to market, improving the supply/demand dynamic of the market.

Harnessing Future Tax Benefits

As funds sold older, existing holdings to reposition portfolios, many realized losses — and even these losses provide a potential benefit. The funds can apply net realized losses against gains, and if losses exceed gains in the current year, they can be carried over to use in the future. In fact, tax changes implemented with the Regulated Investment Company Modernization Act allow such loss carryforwards to be applied against future net realized gains until they are all used up. Under past rules, unused losses expired after eight years.

Going forward, this means that when these closed-end funds realize gains, they may not need to distribute them to shareholders. Instead, the proceeds can stay in the fund, generating future earnings and supporting ongoing distribution yields.

Agility in Managing Leverage

Since 2008, most funds have eliminated auction rate preferred share leverage in favor of new forms of:

  • Structural Leverage: issuing other types of preferred shares, issuing fixed or variable rate notes, or arranging for bank loans, conduit financing, commercial paper, etc.
  • Derivative and Economic Leverage: tender option bond programs, reverse repurchase agreements, swaps, short-selling, option trading, lending portfolio holdings, etc.

Over the past few years, as short-term interest rates have remained low, closed-end funds expanded the number of forms of leverage used while seeking to lower associated costs. Over the past year in particular, funds actively renegotiated the terms of debt leverage. At the same time, inherent costs associated with new forms of preferred share leverage declined as these securities have gained acceptance in the marketplace. By diversifying the types of leverage used, adding flexibility to alter amounts and switch between forms of leverage, closed-end funds have enhanced the potential benefits leverage can offer — something that came in handy recently. 

herzfeld_10-9-13_1.2
Source: Thomas J. Herzfeld Advisors, Inc.

Leverage Adds Risk and Potential Return

Using leverage magnifies changes in net asset value, both good and bad, which means that when markets turn against the funds, their underlying values will fall further than those of unleveraged funds. As a result, various already highly leveraged funds were forced to delever over the summer as they approached minimum asset coverage requirements. For some of these, the advantage of enhanced leverage flexibility helped; they were able to adjust leverage levels promptly and without significant disruption.

More interestingly, funds that were less heavily leveraged were able to quickly increase leverage and, with the added cash, snap up bargain-priced underlying holdings.

Closed-End Funds Sport Bargain Prices

Selling by closed-end fund investors has widened discounts on almost all funds since late May. Additional market uncertainty related to the government shutdown, budget negotiations, and debt ceiling, as well as upcoming traditional year-end tax selling, promise to make it a good period of time to begin to hunt for deeply discounted bargains.

Many funds are currently trading at what we consider to be attractive valuations. The average discount of all closed-end funds is -7.67% — a sharp contrast to the average premiums they were trading at a year ago! Income funds, in particular, are trading at what we believe to be especially eye-catching discounts.

Summary of Average Discount Levels by Fund Category

Category

Average Current Discount

Convertible Funds

-8.4%

Taxable Bond Funds

-7.5%

Foreign Bond Funds

-9.5%

Municipal Bond Funds

-7.6%

Source: Thomas J. Herzfeld Advisors, Inc., as of October 7, 2013

In our opinion, enhanced future earnings dynamics created by portfolio shifts implemented in the recent shakeout – plus higher distribution yields based on discounted prices – add up to this being an opportune time for investors to consider adding closed-end fund products to their portfolios.

Information contained within this blog should not be considered tax advice.

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.