After a bit of a divergence into looking at leverage in detail and still more detail, it's time to continue this series on building a welldiversified, highincome portfolio of closed end funds that will generate something north of 7% for the retiree (or other income investor, of course).
Let me first recap a bit for those who are new to this series. I started (here) by outlining a case for building a retirement income portfolio using closedend funds. To appreciate where I'm trying to go with this, you should understand the premises laid out in that article. My argument is that it is possible to build an income portfolio from CEFs with returns of 78% that is broadly diversified by asset class. This is key: The portfolio can and should be sufficiently diversified to protect against capital erosion. That article outlines the core of my position. If you haven't looked at it and find the concept at all intriguing, I suggest you do so to understand why I'm suggesting CEFs for highyield income.
In part 2, I started exploring CEFs in some detail beginning with leverage. Leverage is an important tool for the closed end fund manager, but I tried to show that leverage may not always be providing the returns one might expect and reasonable caution is called for, especially in the realm of equity funds.
Leverage is a key feature of closed end funds, but the most widely held opinions of CEFs probably involve discounts and premiums. This is the subject I want to take up now. In the next installment, I plan to get into some substance on diversification of the portfolio by spreading one's investments among CEF asset classes with an eye to high income on one hand along with broad diversification on the other.
If you're new to closed end funds, you need to understand that the "closed" part of the name means that a given fund has a fixed asset base. New money is not added (unless there is an expansion of the fund which requires shareholder approval and is a rare event) or removed. Investors cannot redeem shares as they can in an openend mutual fund. Consequently, managers are spared the great bugaboo of mutual fund managers: the obligation of having to sell assets to meet redemption demands at times when a more forward looking manager might want to be buying bargains. Instead, a CEF trades like a stock. If an investor wants out of the fund it must be sold on the open market. The upshot of this is that funds can, and do, trade at values well off their net asset values (again, unlike openend mutual funds where one enters or exits a position at NAV).
Thus, CEF will trade at discounts or premiums to their NAVs. NAVs are published by the funds' sponsors, daily in most cases (although some funds publish NAVs less frequently, weekly or even quarterly). On the face, this presents the attractive situation of being able to purchase a fund's portfolio at a discount. Discounts of 710% are not at all unusual. In practice, though, it may not be as appealing as it sounds for reasons I'll elaborate later. Furthermore, there are funds that trade at seemingly outrageous premiums. Two PIMCO funds, PIMCO Global Stocks Plus (NYSE:PGP) and PIMCO High Income Fund (NYSE:PHK), trade at premiums in excess of 50%. "How can that be?" you ask. The answer lies in understanding how investors use CEFs.
CEFs are, first and foremost, about income. In many cases, investors bid funds up or down, increasing premiums or decreasing discounts, based on the income yield the fund provides. Let's look at those two PIMCO funds. PGP with its premium currently pegged at 68% (gasp!), pays a distribution of 14.8% on the basis of its NAV. Market forces have bid up the price of that fat distribution to the point that on market price it now stands at 8.8%. PHK pays out 17.13% on its NAV. But its current premium of 58% brings the actual return to the investor to 10.8%. These are extreme cases. But contrast them with another PIMCO fund in the same highyield, multisector categories PIMCO Dynamic Credit Income (NYSE:PCI) which currently has a distribution on NAV at 7.5% but its 5.5% discount brings that to 7.9% to an investor at market price.
DiscountPremium Dynamics
There is another important aspect to consider with regard to discounts. Some funds have fairly stable discounts. Others have considerable volatility in their pricing relative to NAV. Compare PCI with yet another PIMCO fund, PIMCO Dynamic Income Fund (NYSE:PDI). PCI's discount has risen a bit recently, but it has been relatively stable over the past year. PDI's status over this time has swung from a discount of 10% to a premium of 2%, more than three times the range of PCI.
(All discountpremium charts are from cefconnect.com.)
For both of these funds we see a reflection of recent market activities in CEFs. There has been widespread compression of discounts across the CEF universe over the past several months.
Situations such as this present risks and opportunities. For a fund that behaved like PDI, one might have generated as much as a 12 percentage point gain on discount compression alone. Of course, buying at the wrong time, say May 2012 when the fund was selling at a 7% premium, could have generated a substantial loss as the premium vanished and the discount expanded to touch 10%.
For another example consider Nuveen Floating Rate Income Common (NYSE:JFR), a floating rate fund I've been considering recently.
Unlike the broader CEF universe, floating rate funds have seen deepening of discounts recently. JFR looks to me to be a strong fund in this area. It is currently trading at the low end of its discount range. Sufficiently so that it could be worth a close look by anyone interested in opening or expanding a position in floatingrate senior loans.
Like many metrics, discountpremium values have a tendency to revert to mean values for given funds. By patiently choosing entry points based on unusually deep discounts, one can take advantage of this mean reversion. But how can we tell if a fund's discountpremium status is meaningfully far from its mean? There's a metric for that. It's known as the Zstatistic. Let's look at it.
ZStatistic
The Zstatistic (also called Zscore or Standard Score depending on the context) is a statistical measure of variation of a value from its mean value. For a CEF, the Zstatistic can be used as an indicator of how a fund's current discount/premium varies from its average discount/premium. For ease of discussion here, I'll consider funds with a discount only. For such funds, the Zstatistic is calculated by subtracting average discount from the current discount and dividing the result by the standard deviation of the discount:
Zstatistic = (Current Discount  Average Discount)/Standard Deviation of Discount
A negative Zstatistic indicates the current discount is lower than the average discount. The magnitude of the Zstatistic indicates how much lower. If normally distributed, the mean value for the Zstatistic is zero and its distance from zero indicates the probability of the Zstatistic. A Zstatistic of 1 would be expected to occur less than 15.9% of the time and 2 is expected less than 2.28% of the time.
Let's look at JFR. It has a current 1year Zstatistic of 0.70, which would be expected to occur less than 25% of the time. For 2 years it's 1.19, expected to occur less than 12% of the time. But for 3 months it is positive at 0.81 (occurring about 20% of the time). This indicates precisely what we see qualitatively in the chart: The discount is well below its 2 year mark and below the 1 year level, but is starting to move the other way most recently. Some might view that as a timely entry point.
Where does one find Zstats? For a long time I relied on Morningstar who publishes 1 year Zstatistics for CEFs. Useful, but only if you want data on a specific fund. For the JFR example you would have to be looking at JFR and then start examining its discount status. You'd not find it using this metric. I have recently discovered a screener for CEFs where one can screen on Zstats for 3 months, 6 months, or 1, 2 or 4 years. This is found at CEFAnalyzer.com. Registration is required, but basic access is free and it has the most comprehensive CEF screener I've found. It takes some getting used to, but it is quite powerful, much more so than CEFconnect.com's screening tool which can be frustratingly limiting sometimes.
I just ran a CEFAnalyzer screen for Zstats under 1.5 for 1 year and 6 months. One of the top (or bottom, I guess) three to turn up is a real estate fund from my portfolio that I've been watching with some frustration recently: Cohen & Steers Tot Ret Realty (NYSE:RFI). Here's a look.
First the discountpremium chart.
I first bought RFI in November 2013 when it looked like the discount was moving up, which it did for a while. Then this spring, it turned back down and we're now in the midst of another deep trough on the D/P chart.
This can be seen quantitatively in its Zstats (from CEFAnalyzer.com)
Time 
ZStat 
3 Mo. 
1.41 
6 Mo. 
1.86 
1 Yr. 
2.32 
2 yr 
1.69 
Clearly the Zstat tells us RFI is well off its mean P/D status on any time scale. The message I take from this is that this is not a time to bail on the fund. It is paying a 7.1% distribution, so while the increase in discount may be frustrating, I'm still collecting good income in anticipation of a reversion to a mean. This is something I fully expect. Sufficiently so that I increased my stake in RFI in mid June.
Another good example of what the Zstatistic can tell us may be found in looking at the PIMCO funds from above: PDI and PCI.
Time 
ZStat 

PDI 
PCI 

3 Mo. 
1.00 
0.20 
6 Mo. 
0.01  0.75 
1 Yr 
0.82  1.23 
Looking at year to date, PCI is well above its mean discountpremium status and PDI is right at its mean. But for a full year, Both are well above their mean values. PCI's Zstat of 1.23 puts it in the 11% range and PDI's 0.82 is expected only about 20% of the time, so there is some suggestion that each may be due for a bit of discount compression. That this is occurring may be seen in the 3 mo. Zstats. Nothing here suggests to me that it would be timely to add to a position in PCI right now but PDI may bear watching to see how this trend plays out.
Summary
Closed end funds are well known for selling at discount or premium valuations to their NAVs. Some will look for large discounts when buying a fund. But this can be misleading as some funds consistently sell for a large discount. That large discount will help drive distribution yield, but its very stability can make it of deceptive value when looking for an entry point.
Much like stocks, CEFs can be under or overvalued. In my view, under or over valuations are not necessarily functions of the absolute discount or premium, but a relative measure based on the funds normal discount or premium status.
The Zstatistic can be a useful metric for evaluating how much a fund's current discount or premium varies from its mean values. While certainly not the only metric to use for evaluating a purchase, a prudent investor may decide to draw a line at some negative value for Z. How negative is an individual choice to be made in conjunction with all the other factors that go into an investment decisions. Similarly, when looking to exit a fund, it may be timely to look for a positive Zstat, indicating that the fund is somewhat overvalued relative to its mean.
Disclosure: The author is long PCI, PDI, RFI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.