Closed-end funds ((CEFs)) can be lucrative investments, but have come under pressure as the market has become concerned over rising interest rates. For investors in these funds, several scenarios may occur and should be considered independently in order to determine if the market may be over-discounting the threat to CEFs at the present time.
Scenario One: Normalization of Interest Rates
In the first scenario, imagine that interest rates normalize in a manner consistent with the largest rate hike of the past 20 years. This occurred in 1994, when the LIBOR rate increased from 3.30 percent to 6.30 percent and the rate on a 10-year Treasury jumped from 5.40 percent to 7.9 percent, an increase of 2.5 percent. Clearly, this would be the worst-case scenario for investors in CEFs, however, the probability of such an occurrence happening before the end of the year is most likely less than 10 percent.
If such a scenario occurred it seems likely that the 10-year Treasury would revert in price to nearly 4.0 percent, while the overnight rate might move back to approximately 3.0 percent. This would be consistent with previous cycles in which lower lows and higher highs were made during the course of each cycle. It should be noted that this scenario expects the Federal Reserve to do more than simply taper its purchases.
Scenario Two: A Slower Normalization of Interest Rates
For the second scenario, let us assume that the Federal Reserve will gradually taper, but not raise the overnight rate. Bond yields are expected to normalize by half what would be expected in the first scenario and the 10-year Treasury might average closer to a 3 percent yield.
Scenario Three: Status Quo Remains Unchanged
In contrast to the jawboning that is currently being conducted, the Federal Reserve may realize that the economy is still too weak to allow rates to rise. The current rate of purchases being conducted under the quantitative easing program would then be continued while the overnight rate remains near zero and the 10-year yield stays in the 1.5-2.0 percent range.
It is expected that scenarios two and three have approximately equal likelihood. Readers are free to insert their own probabilities depending on their expectations, but for the purpose of this analysis a 10 percent probability of the first scenario and a 45 percent probability for each of the two remaining scenarios seems reasonable.
What would be the Effect of These Three Scenarios on NAV Prices of Various CEF investments?
It must be noted that in the short term it is impossible to predict the market price of CEFs. Instead, this analysis will focus on the expected NAV price change and then anticipate a reversion to the mean that will bring the market price to revert to a price that it has enjoyed relative to NAV historically.
For CEFs and individual bonds a quick rule of thumb is that for every 1 percent increase in interest rates the bond or fund will lose an equal percentage to its duration in principle. In other words, if you hold a bond fund with a 10-year duration and interest rates rise by 1 percent, you can expect to lose 10 percent of your principle in the short term.
Below is the price performance and comparisons for five closed-end funds. These funds are: The BlackRock Income Opportunity Fund (BNA), Nuveen Build America Opportunity Fund (NBD), PIMCO Dynamic Income Fund (PDI), PIMCO Muni Income Fund III (PMX) and PIMCO High Income Fund (PHK).
As can be seen from the chart below, the effect on market prices for these funds has been significant. Dynamic Income, which was profiled in a previous article, is the clear winner in the past year for NAV and market price performance.
Now given the assumptions that have been made above, consider what the impact on market price will be once a new equilibrium has been established. There are a number of assumptions being made and these should be highlighted.
- For each 1 percent rise in the 10-Year Treasury rate, the NAV of each fund will fall by its average duration in percentage terms. Given the price action thus far, this assumption may be unduly harsh. Rates have increased by 50 basis points and the decline in NAV value for each fund has been less than would be expected, with the exception of PMX.
- For the first scenario, interest rates should rise by 2.50 percent or two additional percentage points from here. The 10-Year Treasury should then yield approximately 4 percent (10 percent probability).
- For the second scenario, interest rates will rise by another 1 percent (45 percent probability).
- For the third scenario, interest rates will revert back by 0.50 percent (45 percent probability).
Under each of these scenarios further pain or gain could occur for the NAV values of each CEF. The implied NAV value is the average of these three scenarios. Because market prices have declined by more than NAV values, the market has already discounted the likelihood of a rise in rates. The current narrowing premium to NAV is greater than the likely decline in NAV value for the assumptions above, thus the current market prices seem to be a buying opportunity, but not yet a huge overreaction. Both the BlackRock Income Opportunity Fund and PIMCO's Dynamic Income Fund are good buys and seem fairly discounted relative to the likely outcome even if rates rise in a manner consistent with the second scenario. However, investors must be aware that a 1994 scenario could mean the bottom is not in yet.
The sharp decline in CEF prices over the past months seems to be at least fairly discounting the probability of rising rates in the near term. My favorite investment in the space is still the PIMCO Dynamic Income fund, which has declined by 3.30 percent in its NAV value over a period in which the Ten-Year Treasury Rate increased by roughly 50 basis points. As such, even for a relatively pessimistic interest rate scenario it seems unlikely that the NAV value of the fund will decline very much below the current market price.
Another conclusion is that the duration of CEF investments is a factor that must be carefully monitored. The PIMCO Muni Income III Fund has had a precipitous decline in market price, however, the NAV value has declined quite a bit as well. Therefore, the Dynamic Income still seems preferable at the present time, even though the Muni fund has fallen further and offers a higher yield once taxes are taken into account.
CEF funds give investors the chance for increased returns in this period of low interest rates. However, they also increase the level of risk to the point that they must be viewed in a similar manner to equity investments. While the present decline is a reasonable buying opportunity, it is not a huge overreaction to the threat of rising rates. Thus while it is not advised to sell all CEF investments, raising exposure to these funds is not necessarily a desirable move at the present time either. The present decline should remind CEF investors that the threat of rising rates is quite real and will have a considerable effect on market prices when it finally occurs.