- It's reasonable to expect flat to declining market returns for the coming months.
- Equity-income funds tend to outperform in flat to modestly declining markets.
- Option-income closed-end funds are returning 7-11% yields.
- Five option-income funds are selected on the basis of relative discount status and likely stability of returns.
I think it's fair to say that there is a broad consensus that the domestic equity market is poised for a slow-down, if not an outright decline, in the coming months. While I'm not bearish to the point that I foresee a meltdown, I'd be surprised if mid-2014 gives us anything more than quite moderate gains. With this in mind I've been looking to tweak my income portfolio toward something more appropriate to this sort of market.
I use closed end funds to provide a significant fraction of my equity income. I also tend to trade among them as market conditions and the status of the individual funds themselves change. Under the scenario envisioned in the previous paragraph, I'm inclined to look at option-income funds, which tend to do better in a flat to moderately down market than, say, leveraged equity funds.
A priority for me in selecting among closed end fund is the status of fund's market discount (or premium) to NAV. To be clear, a juicy discount alone is not sufficient reason for me to buy a fund. What I like to see is a relative discount to the fund's medium-term discount-premium status. There are several funds that can be purchased at a discounts near 10%, but many of them always sell at or near that 10% discount. Thus, one is not likely to see a move to a reduced discount any time soon. By contrast, some funds have a more volatile relationship between their market price and NAV. The charts below (from cefconnect.com) illustrate two examples.
(click to enlarge)
First is BOE's Payment History. Note how stable the discount has been. For a fund with this sort of performance, one would not expect to be able to take meaningful gains on a marked reduction of the discount.
(click to enlarge)
By contrast, take a look at STK. Here the discount has ranged from about -2% to about -11% over the past 12 months. One could have bought the fund at -11% just a few months ago and gained 5-6% on the discount reduction alone.
A second criterion I look for is a fund with a stable and sustainable distribution. One measure I use is the relation between the distribution on NAV and the overall return on NAV. A fund with a distribution that represents less than half its total return is clearly going to be more attractive than one with a comparable discount and distribution but is paying out 75% or more of its total return. Among a broad spectrum of 29 option-income equity funds distributions on NAV range from 34% to 98% of return on NAV. Let's take a closer look at these 29 funds for both of the criteria mentioned here.
- BlackRock Enhanced Cap & Inc (NYSE:CII)
- BlackRock Enhanced Equity Div (NYSE:BDJ)
- BlackRock Global Opportunities (NYSE:BOE)
- BlackRock Intern'l Grth & Inc (NYSE:BGY)
- Cohen & Steers Glb Inc Builder (NYSE:INB)
- Columbia Seligman Premium Tech (NYSE:STK)
- Dow 30 Enhanced Premium & Inc (DPO)
- Dow 30 Premium & Dividend Inc (DPD)
- EV Enhanced Equity Income (NYSE:EOI)
- EV Enhanced Equity Income II (NYSE:EOS)
- EV Risk-Mgd Divers Equity Inc (NYSE:ETJ)
- EV Tax-Managed Buy-Write Inc (NYSE:ETB)
- EV Tax-Managed Buy-Write Opps (NYSE:ETV)
- EV Tax-Managed Div Equity Inc (NYSE:ETY)
- EV Tax-Managed Glb B-W Opps (NYSE:ETW)
- EV Tax-Managed Global Fund (NYSE:EXG)
- First Trust Enhanced Equity In (NYSE:FFA)
- Guggenheim Enhanced Equity Inc (NYSE:GPM)
- ING Glb Eqty Div & Prem Opps (NYSE:IGD)
- ING Global Adv & Premium Opp (NYSE:IGA)
- ING Risk Mgt Natural Resources (NYSE:IRR)
- JH Hedged Equity & Income Fund (NYSE:HEQ)
- Madison Covered Call & Eq Strt (NYSE:MCN)
- Madison Strategic Sector Prem (NYSE:MSP)
- NFJ Div Interest & Premium (NYSE:NFJ)
- Nuveen Equity Prem Advantage (JLA)
- Nuveen Equity Premium & Growth (JPG)
- Nuveen Equity Premium Income (JPZ)
- Nuveen Equity Premium Opps (JSN)
Discounts and Distributions
The table below lists NAV, Market Price, Discount, Average Discount (1yr) and Distribution Percent for each of the 29 funds. Discounts below an individual fund's 1 yr. average are highlighted. Nine of the 29 are below their average discount, but that differential is minimal in even the best of cases. It is clear that this group of CEFs is not currently selling at bargain discounts.
Current distributions and their relationships to return on NAV are tabulated below.
1yr Rtn on NAV
These two metrics are summarized in this chart where it is clear that more than half are selling at or above their average discount:
(click to enlarge)
Filtering on a current discount below the 52 week average and distribution on NAV less than 50% of the 1 year return on NAV returns three funds: FFA, BOE, BDJ. Increasing the allowable distribution on NAV return to 60% adds STK and JPG. Let's look at these 5 funds more closely sorting on distribution relative to NAV return.
All five are unleveraged and all five make quarterly distributions. Four of the five are domestic equity funds. BOE is a global fund with 39.5% of its assets being US securities.
My preference is for a greater differential between current discount and average discount for the past year, but the only funds that approach an attractive target for this metric fail to make the cut on the basis of distribution sustainability.
FFA has the lowest distribution rate for the group but that is only moderately below BDJ and JPG. Although the fund has an attractive -12.5% discount, it also does not have the history of wide swings in its discount that some funds do. Its distribution has been stable at $0.225 since March 2009 and was increased to $0.230 for the March 2014 payment. The distribution regularly includes a moderate level of return of capital (which I'll discussed briefly below, but I'll add here the comment that this is not necessarily a red flag for an option-income fund). The fund is reasonably competitive in its category, especially on a NAV basis where it has outperformed every year since 2010.
BOE is the only fund of the five that looks beyond US equities for opportunities. Its portfolio extends to Japan and Europe. Although the current discount is slightly below its average, the fund is similar to FFA in maintaining a fairly stable discount so one would not likely expect a marked change here as a catalyst for capital gain. The fund lowered its distribution twice in 2012 going from $0.5688 to its current $0.3117 quarterly payout. The distribution includes a relatively high level of return of capital.
BDJ is the second fund from Blackrock in the list. Similar to the previous two it is selling slightly below its average discount, but it has relatively little volatility in its pricing relative to NAV so, again, one should not expect a significant change here. Distribution amount has been declining on a regular basis since 2009. The current distribution of $0.14 has included about $0.10 return of capital for most quarterly payments.
STK is a favorite of mine and a fund I have written about previously (see here and here). It has the highest distribution rate among all option-income funds and regularly sells at a discount to NAV. At -6.44% the discount is not as attractive as it has been in the recent past, but it remains slightly below the 52 week average. Unlike the other funds mentioned, STK's discount shows a lot of movement. The fund has a managed distribution policy and has paid $0.4625 quarterly since its inception in 2011. Performance vs. its category has been erratic but recent returns have been attractive. Most distributions comprise a significant fraction (up to 100%) of return of capital.
JPG is yet another fund that does not show great fluctuations in its discount over the past few years. The distribution was reduced from $0.28 quarterly to $0.2610 for the first quarter 2014. Return of capital has comprised about 2/3 of each quarterly payment. Performance history has been mixed over recent years.
A word in closing on ROC
Along with others who write here on the subject of closed end funds, I have commented regularly on return of capital as a component of CEF distributions. Some observers have a knee-jerk negative reaction to ROC. This response is, in some cases, quite justified; there are high-ROC funds that the prudent investor will want to avoid. I submit, once again, that this does not apply to funds such as those discussed here. Briefly, option income is considered return of capital by the IRS. This has the advantage of deferring taxes on the ROC portions of distributions until the fund is sold at which time those distributions are deducted from the basis and taxed as capital gains. Hold a fund for a year or more and they are taxed as long-term cap gains. Keep in mind that I am not an expert on taxes and this is merely my understanding of the issue. You will want to confirm the details with your tax adviser.
When is ROC not attractive? When it truly is a return of your invested capital. One clear way to see if this is the case is to look at distribution rate on NAV vs. Total return on NAV. If the fund is distributing more than it is earning, extreme caution is advised. If not, it is likely that the return of capital is an advantage rather than a detriment.
I was a bit disappointed to have not turned up more attractive bargains relative to average discount levels. Although I have pulled out five funds here, none offers the exceptional discount I'd hoped to find and, in fact, one might find better choices among those funds with somewhat lesser relative discounts.
Of the five, I currently hold BOE and STK. I am expecting further declines in STK's discount given its high current yield and reasonably strong recent performance, so I may add to my holding there. I also like the looks of FFA, particularly its solid performance and stable distributions over several years. I would like to see a slightly higher yield, so I'll be watching this one closely to see if the discount moves lower for a more attractive entry point over the coming weeks.
Disclosure: I am long BOE, STK. 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.