Gabelli Equity Trust Preferred B: When Bad Is Good

Gabelli Equity Trust (GAB) lost 48.89% in 2008 and another 25% year to date in 2009. It has also moved from selling at a premium to its net asset value to an 8% discount to NAV. All of which is joyful news to those of us who live off our investment income.

What is good about a fund losing its shirt in the stock market? The decline has wiped out the fund's store of capital gains, which means there will not be any capital gains distributions until a ton of losses have been transformed into gains. And that is wonderful for those of us who own the fund's preferred stock, Gabelli Equity Trust Preferred D (GAB Pr D or GAB-D, depending upon your quote system).

GAB-D trades regularly, though not in spectacular size, and is not in the least similar to the auction rate preferreds that have trapped many money market investors. It has a $1.46 annual dividend, which is a 6.3% yield at the current price of $23 per share. The credit rating is AAA, as it is for all Closed End Fund preferred stocks. The fund is required to maintain $2 in fund equity for each $1 of preferred stock. The manager has regularly bought back preferred shares on the market to maintain this legally required ratio. This adds to the liquidity of the shares.

6.3% on a AAA security is good, given that long term bank CDs and Treasury Bonds are yielding little more than half that rate. But, even better, since the fund has no more capital gains, most of that yield is in the form of return of capital. Unlike tax exempt income, return of capital is simply not income. It is the return of original capital. So, current buyers get to buy former owners' losses without taking the actual losses themselves. That is sweet.

Currently, 80% of the distribution is in the form of return of capital, and 20% is "investment income." The investment income can be dividends or interest, which will not be determined until the end of the year. The part that is dividends also has a preferential tax rate. All of which means that very little of this dividend is being taxed.

Why Gabelli instead of other closed end fund preferreds? The fact that the manager is a large open end fund manager and it is always possible that there will be movement to open end this closed end dud and merge it with a better performing family member. Why this preferred instead of other Gabelli closed end preferreds? Because the fund invests in highly liquid, large cap stocks that can be sold quickly. It is also well diversified. Some of the other funds are intriguing as funds, but not so much as guarantors of preferreds.

So, in an era when safe, decent rates for income investors are very hard to find, GAB-D stands out as a buy for its safe, high and tax friendly yield.

Stock position: I own GAB-D, I do not own GAB.

Comments

[agent86:]

MB - are you at all concerned that interest rates will go back up, and make this a less advantageous investment ?

Apr 05 06:27 PM

[mutual:]

I agree with you. But, I disclose that the cost price of ones shares is reduced by the return of capital. Hold it long enough and it goes to zero and then you can't reduce cost. Also, when you sell, you'll have a big capital gain - because of the reduced cost basis. This happened to me when over 25 years ago I was buying utilities with high dividends that were not taxed - as they were return of capital.

Oh, Mike, a hearty welcome to Alpha.

Apr 05 06:29 PM

[egf7:]

GAB-D is subject to rather wide fluctuations in price. The 52-week high is 24.73 on Nov 4, '08; and low the same month of 17.40 on Nov 21, '08. Then there is the risk of increasing interest rates mentioned on the first comment.

Apr 06 12:56 AM

[k45:]

AAA rated by whom? The same fools that rated other toxic assets as AAA? The ratings services have shown themselves to be worthless.

Apr 06 08:56 AM

[scott in wi...:]

Where can I get a list of all the preferred shares trading, that are the preferred shares of CEFs?

Apr 06 09:57 AM

[scott in wi...:]

Where can i find a list of the preferred shares of CEFs?

Apr 06 10:00 AM

[Michael Burke:]

Agent, Yes. I would be much more concerned if I were in Treasury Bonds, where yields stink, but higher rates can also hurt closed end fund's preferred stocks. The good news is that most closed end funds buy back a percentage of preferred shares outstanding when the price dips below the original offering price, so that offers some support. But, I need some income now. I can't live with my entire income portfolio in money markets or short term securities. So, at least part of the portfolio has to be in the sectors that offer the highest yield at the lowest risk. For me, that is closed end preferreds, AAA munis and high grade foreign debt.


On Apr 05 06:27 PM agent86 wrote:

> MB - are you at all concerned that interest rates will go back up,
> and make this a less advantageous investment ?

Apr 06 12:45 PM

[Michael Burke:]

True. There is no free lunch and I'm willing to take the volatility for assured tax advantaged income now. Others may prefer money market rates, where inflation eats your capital every day.


On Apr 06 12:56 AM egf7 wrote:

> GAB-D is subject to rather wide fluctuations in price. The 52-week
> high is 24.73 on Nov 4, '08; and low the same month of 17.40 on Nov
> 21, '08. Then there is the risk of increasing interest rates mentioned
> on the first comment.

Apr 06 12:47 PM

[Michael Burke:]

But this is an easy case for the dopey ratings agencies. Any security that is required to be backed by more than a 2 to 1 ratio in quality stock holdings (and most closed end funds are backed by much more than 2 to 1) is going to be AAA by anyone's measure.


On Apr 06 08:56 AM k45 wrote:

> AAA rated by whom? The same fools that rated other toxic assets as
> AAA? The ratings services have shown themselves to be worthless.

Apr 06 12:51 PM

[Michael Burke:]

Good luck finding one. I have looked. One of the reason these shares are such a good value is that they are sold like crazy at their IPOs and then ignored for the rest of their lives. Which is true of the underlying closed end funds, too. However, there aren't all that many of them. Gabelli Funds has several. Royce Funds have several. General American Investors, one of the country's best managed investment funds since 1927 (though they did not do well in this downturn) has one. Tricontinental, a very old closed end fund, has one that rarely trades. Most other leveraged closed end funds are using auction rate preferreds, which I do not recommend buying.


On Apr 06 09:57 AM scott in wisconsin wrote:

> Where can I get a list of all the preferred shares trading, that
> are the preferred shares of CEFs?

Apr 06 12:55 PM

[Michael Burke:]

Mutual, The price of the common is reduced by the return of capital, not the preferred. And what we are concerned about are the cost of the underlying securities in the fund's portfolio, not the price of the shares of the fund's common. I am looking at the amount of the distribution that is return of capital, not the price when I sell. I expect to sell when the fund forces redemption of the preferred, which looks like a long time in the future. Though, an open ending of the fund could occur at any time. Then I would have to suffer with an 8% gain overnight. Life is tough. lol

Thanks for the welcome.


On Apr 05 06:29 PM mutual wrote:

> I agree with you. But, I disclose that the cost price of ones shares
> is reduced by the return of capital. Hold it long enough and it goes
> to zero and then you can't reduce cost. Also, when you sell, you'll
> have a big capital gain - because of the reduced cost basis. This
> happened to me when over 25 years ago I was buying utilities with
> high dividends that were not taxed - as they were return of capital.
>
>
> Oh, Mike, a hearty welcome to Alpha.

Apr 06 01:04 PM

[DuffBeer:]

Mike , welcome aboard
You will get a nice following since your focus is monthly income !
I am in the process of doing just that because of the lost of my r/e income. I however am in a completely new investment area but have gotten so much help from SA posts and the those that leave comment. I look forward to your future articles regarding income
investing.
As for places to find listings- Google these sites Dividend Detective, CEF association,perferred stock guide,Quantum on line,Wall street news network. Mnay of these you will find mentioned in other posts and comments.
Now feel free to share your favorite brew pub with me !
Cheers, DuffBeer

Apr 06 08:39 PM

[Thrill:]

MB - These securities are very similar to APS and I think GAB even has some APS outstanding. However, the diference between CEF APS and the APS that hit the skids was that CEFs never defaulted nor did they ever loose their AAA status (Moodys and S&P). Yes, they are the same fools that rated the other toxic assets - but the difference is when GAB gets into trouble (value of their portfolio goes down) they MUST redeem shares at par ($25).

Apr 07 10:00 AM

[Michael Burke:]

Duff, I don't drink beer, unless one is availible. <G> I don't really go to beer pubs, per se, but I do hang out a lot at the bars at Sam Houston Race Park. Very friendly, but not a huge selection. I am a fan of India Pale Ale and most bars don't carry it.


On Apr 06 08:39 PM DuffBeer wrote:

> Mike , welcome aboard
> You will get a nice following since your focus is monthly income
> !
> I am in the process of doing just that because of the lost of my
> r/e income. I however am in a completely new investment area but
> have gotten so much help from SA posts and the those that leave comment.
> I look forward to your future articles regarding income
> investing.
> As for places to find listings- Google these sites Dividend Detective,
> CEF association,perferred stock guide,Quantum on line,Wall street
> news network. Mnay of these you will find mentioned in other posts
> and comments.
> Now feel free to share your favorite brew pub with me !
> Cheers, DuffBeer

Apr 10 01:06 PM

[Zandro:]

Hi Michael,

I would like to ask, why do you not own GAB itself? The dividend rate right now seems fairly high. Are there any issues with the CEF itself?

thanks,
Zandro

Apr 22 01:49 AM

[robamo:]

Maybe I don't understand the whole situation. First off if I buy the preferred or the common it would be in my IRA and it would not matter if the cost was reduced to zero. As a matter of fact it would mean that I got all my cost money back to invest in some other worthy stock. Second thing is that if I bought 2000 shares of common stock at approx. $4.00 per. share it would cost me only $8000.00. If I used the same $8000.00 to buy the preferred shares, I would only be able to buy 348 shares. My feeling is that within two years GAB will probably be in the $6.00 range, even if it's not I'm still getting 10 % on my investment.

May 08 10:20 PM