It's been a disappointing last few years for many of the high yielding option-income strategy Closed-End funds (CEFs) from BlackRock (BLK), some of which is deserved and some not. It was back in late May of 2011 that I first gave notice to income investors that many of the BlackRock option-income funds had too high a Net Asset Value (NAV) yield and that BlackRock would either have to cut the distributions or the funds would probably see continued NAV erosion and poor NAV total return performance. You can read that article here, Which Option-Income Funds To Buy, and I would call your attention to the table in the article which compared the valuations of option-income funds from the four major sponsors, Eaton Vance (EV), ING (ING), Nuveen and BlackRock.
The crux of the article and subsequent articles was that funds that had too high an NAV yield, generally 12% or higher, were going to be vulnerable to distribution cuts or continue to see destructive Return-of-Capital (ROC) in their distributions. Option-income funds generally have a lot of ROC in their distributions because of the way they are managed, and that is one of the tax advantages of these funds, but that doesn't mean ROC has to be destructive. In fact, many of the option-income funds from Eaton Vance and Nuveen I was recommending at the time because they had already started cutting their distributions down to more manageable 8% to 10% NAV yields (not to be confused with market price yields) and I felt these funds would be the first to start showing improved NAV performance.
In retrospect, this is exactly what happened. At the time I wrote the article in May of 2011, it was the Eaton Vance and Nuveen option-income funds that traded at the widest discounts and lowest valuations because the fund sponsors had made the hard decisions early on to start cutting distributions beginning in 2010. In response, investors sold off these funds, particularly the Eaton Vance funds, and instead gravitated to the BlackRock and ING funds, which were still trading at premium market price valuations and trying to maintain their ultra high yields, though that would not last much longer.
I argued in article after article in 2011 that income investors should get ahead of the curve and buy the Eaton Vance option-income funds because they traded at the lowest valuations (i.e. the widest discounts) but were in the best position to grow their NAVs after their distribution cuts.
A Brief History Of The Option-Income Strategy CEFs
Just to give readers a little history, option-income CEFs are defensive by nature because they use a covered-call option strategy on their stock portfolios, i.e. they sell options against their stock portfolios, thus receiving large amounts of option premium in exchange for giving up some future portfolio appreciation potential. This is what allows the funds to offer much higher yields to investors than what they could find with ETFs or mutual funds.
Most option-income CEFs came public in the 2004 to 2007 time frame and were very well received due to their 9% or so inception yields coupled with large cap stock exposure. It was the best of both worlds it seemed but low trading volumes and misconceptions about how the funds worked meant their market prices could be much more volatile than their NAVs. During the financial crisis from late 2007 to early 2009, option-income fund's NAVs did indeed prove their worth and held up far better than the broader market averages but their market prices dropped to -25% or more discounts for brief periods during the worst of the bear market. This is one of the great features that make CEFs so opportunistic and investors who took advantage of these option-income funds that were being tossed out even while their NAVs were holding up, saw the fund's market prices quickly recover and 100%+ total return gains in 2009 were not unusual.
However, during the ensuing bull market recovery, option-income funds were not able to capture nearly enough NAV upside to cover their uber high NAV yields they were saddled with after the financial crisis. Though the funds looked very attractive to investors with market price yields as high as 15% to 18% in some cases, the fact was that the yields were unsustainable and more and more of each distribution was resulting in destructive Return-of-Capital. Thus began a series of distribution cuts for most option-income funds beginning in 2010 and the fund sponsors that got started the earliest, i.e. Eaton Vance & Nuveen, would be the first to recover.
The Hard Fall For The BlackRock Option-Income CEFs
Fast forward to today, and virtually all option-income funds have been forced to cut their distributions from one to three times, including the BlackRock funds. The major difference, however, was that for fund sponsors that got started late, like BlackRock, distributions were still be cut over the past year. As a result, investors are still penalizing the funds and all of the BlackRock option-income funds listed in my article link above have gone from premium valuations to wide discounts. The following table shows where they were back in late May, 2011 and where they are now.
As you can see from the highlighted Premium/Discount columns, the fall from grace for the BlackRock option-income CEFs has been dramatic though poor NAV performance for some of their funds is partly to blame as well. But as often is the case with CEFs, investors throw the baby out with the bath water and give up on good funds at exactly the time they should be accumulating them. The trick is to find which funds are in a position to turn things around.
I should first point out that the above table of BlackRock option-income funds represents their diversified equity based CEFs though BlackRock also offers option-income funds that are more sector specific. Obviously, sector specific funds are highly dependent on the sectors they invest in, whether it be energy, utility, commodity, etc. but for purposes of this article, I'm going to stay away from making sector specific recommendations and stick with the more broad based option-income funds.
Why Option-Income CEFs Make Sense Now
I would also like to point out why the option-income CEFs make a lot more sense now after recommending the leveraged funds for all of 2012 and up until earlier this year. I first made the call to start overweighting the option-income funds in April in this article, Time To Overweight Option-Income Funds?
The reason why I feel option-income funds make a lot more sense now is threefold. First, option-income funds generally have all stock based portfolios and no bonds or fixed-income investments. In a rising interest rate environment, stocks have been the preferred investment over bonds. Higher interest rates should also mean higher option premium as well. Second, the broader market averages have made strong moves over the past couple years and I anticipate more modest gains going forward to even down market periods. If that's the case, a trendless up and down market environment is actually ideal for option-income funds to maximize their income strategy. And third, all the option-income funds I follow have now cut their distributions down to levels where they should be able to sustain their distributions while growing their NAVs. This is not to say that if we go into a correction or bear market environment, that option-income funds will not see their NAVs reduced and some option-income funds may even see their NAV yields drift back up to the red flag 12% or more level, but they are certainly in a much better position to maintain their distributions now than ever before.
Which BlackRock Option-Income Funds To Buy
So if pure stock based option-income CEFs are the place to be, which ones do I like? In my article from April of this year, I was still recommending the Eaton Vance option-income funds and they still represent my largest CEF holdings. But based on valuations, many of the BlackRock option-income CEFs have become very oversold in my opinion and trade at some of the widest discounts of any CEFs. If this sounds like a broken record to what happened to the Eaton Vance option-income funds back in 2011, it should because the BlackRock funds seem to be following in the same footsteps.
Of the BlackRock option-income CEFs, I would recommend investors start to accumulate or add to their positions in the BlackRock Global Opportunities Equity Trust (BOE) and the Enhanced Capital & Income fund (CII). Let me first show you their 3-year premium/discount graphs to show you just how far down the valuation scale these funds have fallen. 3-years ago, back to September of 2010, these funds were still trading at premium valuations and it would be another several months before I wrote my first article warning investors about their unsustainably high NAV yields. The first 3-year premium/discount graph is of BOE.
And the second 3-year premium/discount graph is of CII.
Pretty ugly, huh? Now in all fairness, most of the BlackRock option-income CEFs have similar graphs and even most CEFs are seeing widening discounts in a rising interest rate environment, particularly the leveraged CEFs, but sometimes you'll see funds that are getting thrown out just as they are starting to turn things around and I believe BOE and CII are two such funds.
Let me first give you each of the fund's vital statistics. BOE is a large global stock based CEF with $1.07 billion in assets currently trading at a -12.8% discount and offering a 9.3% market yield paid quarterly. BOE's portfolio is 46% US based large cap stocks with most of the rest spread among developed countries in Europe, Asia and Japan. BOE sells individual stock options against roughly 50% of the value of its portfolio which generates more than enough income to cover its 8.1% NAV yield if all of the option income were realized. Though that's not usually what happens in the real world, as long as the gross option premium generated by the fund could cover the NAV yield, that's all I'm interested in seeing. BOE's current market price is $13.37 as of August 30, almost $2 below its $15.33 NAV.
CII is a nice complement to BOE because CII is mostly a US based large cap stock fund whereas BOE has more overseas exposure. The only common top 10 holding is Google (GOOG) but otherwise the fund's stock portfolios are quite different. Compare that to the Eaton Vance option-income CEFs which have a lot of overlap in their top holdings. CII's top sector exposure is Information Technology whereas BOE's is Financial. I don't try and analyze a fund's holdings, preferring to compare its historical NAV performances with its benchmarks and then to see how the fund's current valuation, income strategy and yields (NAV & market) stack up to other funds. Since most option-income funds focus in large cap stocks anyway, it's hard to pick one fund over another based on their holdings.
Like BOE, CII writes individual stock options (i.e. not index options) against roughly half of its portfolio value, leaving the other half of its holdings to appreciate (or depreciate) unencumbered. CII currently trades at a -12.3% discount and offers a 9.4% market yield paid quarterly with the next distribution in mid September. CII's current market price is $12.76, also well under its $14.55 NAV.
Option-Income CEF Performance Comparisons
Performance is a touchy issue because both BOE and CII have not had great NAV performance compared to their benchmarks recently and their market price performances have been even worse due to the distribution cuts over the last couple years. A big part of my recommendation is the turnaround story that I see based on the fund's low valuations combined with their more manageable NAV yields today, with BOE at an 8.1% NAV yield and CII at an 8.3% NAV yield. This should allow the funds to see better NAV growth going forward and thus better total return performance in both their market prices and NAVs. Note: The reason why an excessive NAV yield is so damaging to CEFs is because each distribution that the fund can't cover reduces the capability of the NAV to cover the next distribution, and so on and so forth. It's a vicious downward cycle that can get worse over time.
Let me bring this all together by comparing all of the option-income funds from BlackRock, Eaton Vance, Nuveen and ING sorted by their total return NAV performances from December 30, 2011 or exactly 20 months. Note: Total return includes fund appreciation plus all distributions added back but not reinvested. Total return NAV performances are shown in green or red (if negative) along with other relevant information including total return market price performances.
Here you can see clearly how much better the Eaton Vance and Nuveen option-income funds have performed over the BlackRock and ING funds over the past 20 months. In fact, all of the top 12 funds come from either Nuveen or Eaton Vance. Note: For comparison, the S&P 500 was up 29.85% over the same 20 month period.
Now ING includes mostly global funds and Nuveen includes only U.S. stock based funds so that has to be taken into consideration but even then, it's clear that the fund families which were the first to get their NAV yields down to the more manageable 8% to 10% range are the ones showing the benefits first.
The BlackRock option-income CEFs used to enjoy the highest valuations as measured by their premium market prices, but not anymore. What income investors need to realize, however, is that in the world of CEFs and the valuation cycles they often go through, that can be the best time to own these funds, particularly when a change in income strategy, distribution and/or management can turn the fund around. It can sometimes take a year or so before the funds start to realize the benefits and you have to be patient to see the valuation improvements which may come even later. I recommended the Eaton Vance option-income funds at a time back in 2011 when everyone else was giving up on them and I believe the BlackRock option-income funds, particularly BOE and CII, are at a similar inflection point as well.
Part of my thesis is predicated on a more trendless up and down market environment in which the option-income strategy thrives. But even if a ramp-up bull market or a correction in the market ensues, the valuations of BOE and CII are at such a level where it makes a lot more sense to hold or add to your positions rather than give up on them now.
For more information on BOE, including top 5 holdings, go here.
For more information on CII, including top 5 holdings, go here.