CEF Premiums: Getting All The Risk, But Only Some Of The Reward

by: Steven Bavaria

As readers know from my articles and comments, I love closed-end funds. I started dabbling in them a number of years ago and now they make up the bulk of my investment portfolio. What I like most is: (1) that you can buy assets at a discount from their net asset value, and (2) that you can get the advantage of leverage (albeit limited to one-third of the value of the assets in the fund) at institutional borrowing rates (i.e. the fund can borrow a lot more cheaply than I can). This leverage can sometimes add considerably to the yield of the fund, compared to what an ordinary unleveraged open-end fund holding the same assets would yield. (For more on this topic, see this article.) In an IRA, of course, which is the vehicle in which many of us hold our major investments, closed-end funds are the only way I know of to obtain leverage.

It seems obvious - other things being equal - that we'd all rather buy our closed-end funds at a discount than at a premium. But there are well-known highly regarded funds that seem to sell constantly at large premiums, in particular the two PIMCO funds, PIMCO Global Stocks Plus (NYSE:PGP) and PIMCO High Income Fund (NYSE:PHK), selling at premiums of 55% and 46%, respectively. The market yields on these two funds are 9.8% for PGP and 12.7% for PHK.

The willingness of some investors to pay high premiums for closed-end funds (especially where similar ones are available at par or even at discounts) has always mystified me. I can see intuitively why some yield-chasing investors might pay a big premium for the PIMCO High Income Fund, since its 12.7% yield is 4% higher than the next highest yielding high yield fund of similar market size, BlackRock Corporate High Yield (NYSE:HYT), which yields 8.1% and sells at an 8.7% discount. PHK's yield is also more than 2% higher than the next highest yielding high yield fund, Credit Suisse High Yield (NYSEMKT:DHY), which yields 10.3% and sells at a 1% discount, but is only a fraction of either PHK's or HYT's market capitalization.

It is harder to see the appeal of PIMCO Global Stocks Plus Fund at a premium of 55% when its yield at 9.8% is nothing extraordinary when compared to yields of similar multi-sector income funds or stock funds selling close to or below net asset value. Even within its own Allianz/PIMCO family there are two similar funds, AGIC Convertible & Income (NYSE:NCV) and AGIC Convertible & Income II (NYSE:NCZ), each with yields about 1.5% higher and relatively tiny premiums by comparison.

I won't try to play psychologist and explain why investors pay so much more for certain high-yielding funds than their apparent intrinsic worth. But I would like to suggest a simple method that I use for analyzing and quantifying the cost of buying at a premium, or alternatively, the value of buying at a discount.

The key to evaluating the value or cost, respectively, of buying a closed-end fund at a discount or a premium, is the difference between the "market value yield" and the "net asset value yield" (Assume for the purposes of this analysis that the distribution is actually earned, and is not a destructive return of capital. If it is the latter, than that will be a further reason NOT to pay a premium to buy the fund, apart from the issues raised in this discussion.)

Start with the net asset value, or NAV, yield. This is the yield you would receive on the fund if you bought it at its precise net asset value. In theory, this is the yield you could pay yourself as an investor if you went out and bought the exact same portfolio as that held by the fund, after paying expenses, including a reasonable fee to yourself for managing your portfolio. Assuming rational and efficient capital markets, the yield on this portfolio would reflect the risk of the assets comprising it. Taking PGP as an example, its NAV yield is 15.2%. I would regard that as the "natural" yield on its portfolio of bonds, options and other derivatives. Other things being equal, an investment with a "natural" yield of 15.2% would carry a lot of risk. For example, other investments with yields of that magnitude typically can be highly volatile, like mortgage REITs (Annaly (NYSE:NLY) etc.) or business development companies (NYSEARCA:BDCS), or complex specialty financial funds (Oxford Lane Capital Corp. (NASDAQ:OXLC), etc.) The point is that risk and reward tend to go together, so investors should expect firms and funds paying dividends in the mid-teens to be risky.

So the NAV yield, as the "natural" yield on the underlying portfolio of assets, essentially "signals" the amount of risk in the portfolio. In the case of PGP, the 15.2% NAV yield is a good indicator of the risk a buyer of PGP is taking. Unfortunately, buyers of PGP at its current premium are not being paid to take that risk. The market price yield that they receive is only 9.8%. So while they are taking the risk of owning a 15.2% yield portfolio, they are only being paid to take the risk of a 9.8% yield portfolio. I would submit there is a huge difference in the average risk of a portfolio that yields 15% versus one that yields just under 10%. The difference - in this case 5.4% - represents the amount of risk the PGP investor is taking but is not being paid to take.

This "risk/reward shortfall" can be significant where there are large premiums on closed-end funds. In the case of PGP, as mentioned earlier there appears to be no reason to absorb this sort of shortfall, since there doesn't seem to be anything unique about PGP, with other funds in the same fund family offering similar asset class and yield at no premium whatsoever (actually at discounts, where you get paid to take more risk than you are actually taking.)

PGP's sister high-yield fund, PHK, is another good example of investors taking a lot more risk than they are being paid to take, because of the huge (46%) premium. As a high yield fund, PHK has an even higher "natural" portfolio risk than PGP, as indicated by its NAV yield of 18.4%. Any way you slice it, regardless of how good its portfolio managers may be, a portfolio of assets yielding 18.4% is going to involve a lot of risk. In this case, PHK's investors are being compensated with a market yield of 12.6%. That's a very good yield in absolute terms. But is 12.6% a sufficient yield if you're taking an 18.4% level of risk? The difference between the risk PHK shareholders are actually taking (18.4%) and the risk they are being paid to take (12.6%) represents a risk/reward shortfall of 5.8%, even greater than the PGP shortfall.

Clearly PHK shareholders are receiving more absolute yield than if they held other high yield closed-end funds like HYT (8.1%) and DHY (10.4%). But in both those cases, the shareholders are taking considerably less risk (as measured by their NAV yields) than PHK, and in both cases they are actually getting a bonus (because they sell at discounts to NAV) in that their market yield is even higher than their NAV yield. When that happens it is the opposite of the risk/reward shortfall discussed above, because when you buy the fund at a discount you are actually getting paid for more risk than you are actually taking. (See chart.)

I do not expect this analysis will persuade investors that have their favorite funds and favorite management teams that it is not worth paying a premium to get what they may regard as superior insight, investment skill and (hopefully) performance. But I hope it may provide some readers an additional "mental template" or paradigm for thinking through and quantifying what you are actually giving up when you pay more for a given set of assets than the market says they are actually worth.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in HYT, DHY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long OXLC.