CEF investors who were not paying attention to fundamentals were surprised by Alpine CEFs monthly distribution cuts for its Alpine Total Dynamic Dividend Fund (AOD) and Alpine Dynamic Dividend Fund (AGD) of 54.2% and 45.5%, respectively.
Prior to their dividend cut announcements, AOD was yielding 19.3% and trading at a premium of 31.7% and AGD was yielding 15.3% and trading at a 36.5% premium. With regard to a sustainable CEF distribution, a high yield and high premium is an oxymoron. The stocks prices of AOD and AGD have subsequently plunged 32% and 30%, respectively. This does not bode well for the efficient market thesis for CEFs.
Reasons for Distribution Cuts: There are lots of reasons for CEFs to cut their distributions. The one that you can’t protect yourself against is fraud. Therefore, dealing with reputable organizations can significantly cut the potential for fraud. However, one cause of a CEF distribution cut that is highly visible is when a CEF pays out more than it earns—you know, like the United States Government.
High Premiums: For the sake of simplicity, when a CEF is trading at a premium it is trading for more than the current value of its underlying assets.
Simple Example: Let’s take the simple example of an unleveraged CEF that owns a bond series that is trading at par and generating a 7% yield. Let us also assume market returns are in equilibrium. Let’s assume its expense ratio is 1%. Therefore, the CEF advisor takes in 7% as gross revenues less the 1% it pays itself and distributes to its shareholders 6% (7% - 1%). The stock trades at par to its NAV (both stock price and NAV are valued at $10 per share) and all is right with the world.
Tweaking Returns: Therefore, the net yield on NAV and the distribution yield are the same: 6%. If an investor were to pay more for the stock than the NAV, he/she would be receiving less of a yield. (In this example, 6% on a $10 stock price would be $0.60 distribution; if an investor paid $11 for the stock, the yield would be lower, 5.5%) With the market returns in equilibrium, that wouldn’t represent a rational investment.
High Yield/High Premium: So, how can a stock yield be greater than a return on NAV and also trade at a premium? In our example, the asset owned is a fixed-income investment. Therefore, there is little chance of increasing income.
The way that a CEF can increase its distributions is to sell off portions of its holdings and distribute it to its shareholders in the form of a return-of-capital (ROC) distribution.
So, Back to Our Example: the advisor sells off an equivalent of $.20 per share of NAV and now the total distribution is $.80 per share ($.60 per share of return on NAV and another $.20 per share of ROC NAV.) The distribution yield on our $10 stock is now 8% while the return on NAV is still 6%. So, as shareholders, we’re receiving more than we’re earning.
As a result, our NAV is now $9.80 per share ($10 original NAV less the $.20 per share of original capital sold and paid out to shareholders). Now, the stock selling at $10 is selling at a premium to its $9.80 NAV (a 2% premium). Over time, an investor can see how this erodes the NAV and significantly increases the premium.
So, in the following case this is the circumstance where a CEF can have a high yield and a high premium. Over time as you erode the capital base, you’ll have less gross income coming in and the same number of shareholders forcing the distribution to be cut.
Potential Suspects: The following is a list of CEFs with high yields and high premiums which may portend—but not guarantee—a future distribution cut. You can’t own a stock that distributes more than it generates without the expectation of the distribution being adjusted downward at some future point.
Quick Comments: Three of the high premium high yield CEFs are Cornerstone related. All have managed distribution policies, i.e., they pay out ROC distributions, have previously cut their distribution and will likely have to cut them again at sometime in the future.
Two are PIMCO related funds. PIMCO is the largest bond manager in the world with deep pockets. In theory it could shift investment internally from its proprietary accounts to the CEFs to make the CEFs whole.
Cushing MLP Total Return is less of a concern as its NAV is valued on less frequent basis and its depletion expense is a non-cash charge. Obviously, I’d prefer to buy it closer to par.
However, the analysis of these relationships is the job an experienced CEF investors. For the most part, CEF investors are retail investors looking for attractive yields and don’t do the detailed analysis that should be done prior to investing. The evidence is apparent in the significant drop in AOD and AGD.
If you own a CEF that has both an unusually high yield and its stock is trading at a significant premium, you should ask yourself the question, why? And if you can’t answer that question, then you should move on. Let the traders “game” each other when it comes to this sector of the CEF market segment.
Disclosure: No disclosure