Closed-end bond funds continue to gain a lot of attention as investors search for yield in a very low interest rate environment. At Closed-End Fund Advisors, we do our best to educate investors on how to avoid some of the big closed-end fund mistakes and this article is an effort to continue that endeavor.
We also are replying to Steven Pikelny's article last week on the Morningstar "CEF Weekly" comparing Undistributed Net Investment Income (UNII) to body fat - essentially saying that: UNII balances for CEF bond funds are a tax liability, UNII is irrelevant for municipal funds and that the UNII trend "is a functionally useless metric, and muddles the overall point." I have to whole heartily disagree with this statement. We suggest you read his article in order for ours to make sense.
Current Discount Levels and Tends
Discount and premiums exist at varying levels for individual funds in major CEF groupings, like Taxable Bond funds and Municipal Bond Funds. However, tracking the trend movements on a grouping helps to identify investor and market trends that are being applied across the closed-end fund sector vs. NAV movements, which act on more traditional market forces and reasons.
We give a one-year look back (left) at discounts for the two main bond CEF groupings which we believe demonstrates investor perceptions and interest in the various CEF options for their bond portfolio exposures. The trends that Municipal and Taxable CEFs follow are often significantly different.
UNII Trend and Earnings Trend
CEFA has developed UNII Trend and Earning Trend as data points in our weekly CEF Universe Data Service, a tool that we find crucial in managing our client bond fund positions. With the current challenge of owning bond funds at near-all-time-low interest rate levels, we feel it is important to do two things for bond fund exposure: 1. Doing what we can to own funds that are unlikely to cut their dividend levels (maintaining pay-outs to clients) and 2. Swapping funds over time on relative value (trying to grow principal above NAV movements). We believe this is the only way to keep your head above water over the next 5-10 years with bond exposure due to the almost inevitable interest rate increasing environment. Does anyone think rates will be the same or lower in 2018?
- We hope to clarify where we believe UNII can be misused
- Explain why UNII and Earnings Trend should both be considered in concert with Earnings Coverage ratios in reviewing a bond CEF's dividend risk
- That UNII levels show clear trends over time that can help make investment decisions for bond funds.
- Return of Capital (ROC) is barely prevalent in bond CEFs.
The CEFU service is the source of all closed-end fund data discussed in this article unless otherwise noted.
We believe Morningstar has done a great job at expanding closed-end fund coverage for the benefit of investors and investment professionals alike over the past few years, and are glad to see three internal analysts write regularly on the fund structure. This week, I think Steven wrote a nice article on how to calculate future tax liability in a CEF. I am also looking forward to sitting on the closed-end fund panel at their 25th Anniversary Investment Conference in June 14th in Chicago.
While I am not completely refuting Steven's article, I think he missed a few important factors in closed-end fund evaluation and where UNII analysis can get off track. Before we dig deeper into how and why we analyze bond CEFs in a certain way, let's build off his UNII claim and see where we disagree on it being an important data point. Here is how I agree UNII analysis can have misconceptions or be considered noise:
- UNII is a life-to-date balance for a fund. Funds report GAAP UNII balances, when tax-adjusted UNII levels would be more accurate to determine a "cushion" or "deficit" for the fund. We have confirmed this with portfolio managers of almost every sector in the bond grouping.
- Taxable bond funds need to pay out 98% of its net investment income to avoid excise tax (this keeps UNII growth very small in most cases.).
- Muni bond funds are allowed to pay out less and retain more net investment income (NII) which helps them grow UNII balanced over time.
- The older a fund gets, the higher UNII can go above (typically for muni CEF) and below (typically for taxable bond CEFs) due to the life-to-date nature of the item.
- UNII can be old or stale where, in my opinion, after a few months is almost useless in making portfolio decisions. We prefer UNII data from the previous 1-4 months in order to keep it recent, but also to allow for quarterly updating UNII funds to allow more funds in our potential investment universe.
- UNII is available for equity CEFs but we have yet to see any trends or ways in which this data point is a useful metric for equity CEF analysis.
Review: How Does a Bond CEF Work?
A portfolio manager at a closed-end fund takes fixed or permanent capital raised through an IPO and buys bonds that they feel will make their payments and return investors principal over time. Managers also trade bonds based on mis-pricing of assets and try to net a profit on bond sales and higher future income for shareholders, while managing duration and credit risk in some capacity.
We like to equate bond CEFs to an equity investment that derives its cash flow and value from bonds - but not as a pure bond holding. Because of leverage and market inefficiency the funds are by nature more volatile than many traditional bond investors may be accustomed to experiencing. This is why you should be more risk tolerant to own a CEF and can expect to receive a higher dividend payout.
CEF's & Leverage
Currently 380 of the 600 U.S. listed closed-end funds are bond focused. This is over 63% of the CEF offerings. There are 342 closed-end bond funds or 90% that utilize leverage in some way shape or form. There are 323 or 85% that utilize more than 10% leverage. These funds borrow at lower rates than they invest and this helps them give shareholders a higher dividend amount per share based on the spread between the cost of leverage and the yield of the bonds in the portfolio. This will eventually need to be watched as interest rates rise when selecting a closed-end bond fund.
Selecting a Closed-End Fund
When reviewing a CEF, we recommend the three pronged approach of balancing: 1. Entry Point Risk, 2. Dividend Confidence and 3. NAV Total Return Performance. We wrote an article covering these in more detail. We find the challenge in balancing which data to prioritize when analyzing a CEF. It is rare one fund in a grouping is best in all three areas.
This is why CEF analysis is still a human-based process vs. simply spreadsheet screening. I relate this to my limited experience in music theory or cooking. You need to understand the rules before you can consistently break or bend the rules and have great success. The best CEF investors know where to break the rules, however, many CEF investors get hurt not following basic principles. Also, as with all investments, there are always going to be surprises and market changing news items that will be hard to plan for in your portfolio.
Investors Dislike Dividend Cuts
We find that investors shy away from funds that have recently cut dividend levels and they end up trading independently from NAV. Since September 2012 there have been 87 dividend cuts in the municipal bond grouping of 100 funds. Some funds have cut more than once, but this is a still a very significant level of cuts. When we reviewed the cuts there were 47 averaging -6% in last fall, and the most recent carnage on March 1 had 33 cuts averaging -7%. This is not an experience investors enjoy from funds in their portfolio.
Our point here is that looking at a closed-end bond fund and determining the likelihood of a dividend cut can help improve total return performance for investors in a way that worrying about a future yet-to-be-realized tax liability muddles the overall point of basic fund analysis.
CEFs trade on factors unrelated to the portfolio manager's success or investor sentiment to the underlying sector. This is not to say that NAV performance is not important, just not the only factor investors consider. We track this with a 90 day correlation figure between a CEF's market price and NAV movement. To the left we show the graphical trend since June 2012 for the two bond groupings. Currently taxable bonds have a 54.8% correlation and national muni bond funds have a 59.0% correlation - roughly half-way between their 9 month peak and valley levels.
We reviewed current data on all municipal closed-end funds (3/1/13) and grouped them into three categories: those that 1. Cut Dividend 2. Maintained Dividend or 3. Increased Dividend levels during 2012. The table below should hopefully prove my point.
Investors are currently paying premium for funds that haven't cut their dividend levels recently and even more for those that raised their monthly payouts. But it is important to note that they are also bidding up CEFs to higher levels in their own discount range over the previous 52 weeks in roughly 10% increments.
This relationship is further confirmed by seeing the fund's current market prices vs. its 52-week range (Relative Price) in roughly 5% increments. This disconnected trading between performance and fundamental behavior can be seen in the 90 Day Mkt Pr / NAV Correlation with funds that reduced their dividend tracking NAV at about a 73% level (high for a muni bond fund) but only 57%-65% for those that did not pinch investors last year.
UNII Trend - It Does Exist
The Undistributed Net Investment Income (UNII) data point is a balance sheet item equated to an future income "cushion" and in our published interviews with closed-end portfolio managers, we have come to learn that UNII is an important item to consider and one they know investors are watching.
What we did notice was that UNII over time can be well above or below zero and yet it does not result in a dividend change like we would have initially suspected. In fact, it is often at 18%-25% levels in a muni bond fund when they announce cuts in their dividend payments. We also see that when funds--, in this case, muni bond funds-- cut dividends they had about 94% of those funds showing a UNII trend of negative (see table below).
Remember though that the trend of UNII needs to be used in conjunction with average earnings coverage and earnings trend can help avoid painful dividend cuts. The date of the UNII is also important. We prefer UNII data that is no more than three months old and our firm has been known to avoid a potential good bond fund in order to wait for updated financials.
It is important to note that UNII is a fraction where the numerator is the cents per share and the denominator is the current dividend yield. This means it trends up when UNII increases or if yield is cut. Cuts have been the driving change from our research in the past few months. To show the importance of UNII trend using real-life data we looked at all the muni bond funds that cut dividend on March 1, 2013 based on previously collected data. The table below also shows the importance of both trends' analysis to predicting dividend cuts.
This data point is simply looking at if the fund's average earnings are trending up, down or remaining flat. If coverage is near 100% (95%-105%), we have seen a very high correlation with cuts stemming from down trends. You can see that 97% of the funds that cut their dividend had Earnings Trend "Down" based on the fund's data.
This actually makes a lot of sense in my opinion, as you can think of a closed-end bond fund like a closed-system of income and payouts. Of course there are fees and costs taken out of the equation, but if a fund is earning less than before and its relative UNII level is trending down (no matter if it is positive or negative) then the board of directors has to 1. Believe the fund's income will increase over time or 2. Decide to pay-out Return of Capital if they don't reduce the dividend amount.
It should be noted that other factors to consider are portfolio manager alpha, sector trends (like the direction of interest rates or good credit work in assessing bond default probabilities) and potential activist activity, though this is less likely in a bond fund due to generally narrower discounts. (See this CEF Activism article.)
Return of Capital in Bond Funds:
It was suggested in the other article that investors would rather have RoC payments over dividends classified as income or high UNII levels. We agree that from a purely tax perspective this is true - however RoC dividend are historically low in bond CEFs.
From the data we track on this figure we see only 5%-8% of taxable bond fund dividend levels classified as RoC dividends and for municipal bond CEFs it is even lower at 0%-0.7% of the dividend classifications. We find RoC more common amongst closed-end equity funds. Our data is a 90 day look back on dividend classifications by the fund sponsor.
I think the comparison between UNII in a closed-end fund and body fat is weak and misses the two main components of total returns: change in the fund's market price and the paid dividends. Taxation is an important issue; however, after talking with thousands of closed-end fund investors over my twelve year career, my experience shows that many CEFs investors are managing inside a tax-deferred or tax-free account. Therefore, this is less of a pressing issue than Steven Pikelny suggests.
I also know that the perceived value of a CEF and the inefficiencies of the market price almost always trump tax-adjusted performance. This is a measure better suited to open-end fund and exchange-traded investing where you don't have a different market price vs. NAV. Even though some ETFs can trade off NAV it is less common or significant because of the ability to create units or redeem units of an ETF at the institutional level.
Closed-end bond investors need to track more than one data point and should also remember that data is backward looking and never perfect by definition. Where we feel data is important is to understand where a fund currently lives vs. itself and its peers over time (normal data ranges).
If I told you that 95% of closed-end bond funds that cut their dividend recently showed both UNII and Earning Trends as "Negative" would you want to own a bond fund with negative UNII and Earnings Trend? Does this make you believe that this data is somewhat useful as part of your due diligence? We hope you agree that it does.
We believe closed-end bond funds as a whole have a challenging market ahead. This is both for the underlying bond portfolio and a general reduction in net investment income as leverage costs trend up and reinvested bonds yield less to the portfolio. We think you will fare better with an active approach to monitoring your current CEF positions and trying to avoid fund reducing dividends, as well as buying funds when they are generally cheaper than normal. We are not suggesting this is always going to be easy to do, but we believe your total return prospects are much higher with this perspective.
Additional disclosure: This is not a recommendation to buy or sell any CEF or CEF sector grouping, simply an attempt to educate investors on data and trends we see in the current market environment.