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Two months ago, I wrote an article called "Option-Income funds: Out of Favor But On The Upswing." Since that time, many of the option-income Closed-End funds (CEFs) have narrowed their discounts and some have even moved to premiums, although by no means is this across the board. Just to give readers a quick review, option-income funds perform better in choppy, range bound markets rather than ramp-up bull markets because their sell call-option strategy is more optimized when their option contracts are more likely to expire worthless. The premium the funds take in from selling the option contracts can then be passed on to investors in the form of high dividends and yields. This is in contrast to the leveraged CEF strategy which use strong bull markets to leverage their income and portfolio appreciation to offer investors high dividends and yields.

With the markets now looking more defensive, option-income funds have started to look more attractive to investors as the growth of their Net Asset Values (NAVs) begins to compete with other income strategies. However, with some option-income funds already at premiums and others overpaying their dividends already, investors need to choose carefully which funds to buy right now and which ones to avoid.

The table below lists the highest yielding equity based option-income CEFs from the four largest equity Closed-End fund families; BlackRock (NYSE:BLK), Eaton Vance (NYSE:EV), Nuveen and ING Investments (NYSE:ING). Highest yielding means funds with at least an 8% market price yield available to investors, since option-income funds tend to offer higher yields than other income strategies and yields below this threshold tend to trade at perpetual discounts. The funds include year-to-date NAV performances, current discount / premium prices and current market price yields and NAV yields for each fund, as well as averaged for each fund family.

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As you can see from this table, the BlackRock and ING funds are at premium valuations for the most part, and the Eaton Vance and Nuveen funds are mostly at discounts. The BlackRock and ING funds market prices have moved strongly to the upside recently, even if this has occurred without necessarily better NAV performance. This may be because of anticipation of better global markets, since both BlackRock and ING have more global funds than Eaton Vance or Nuveen, or it could just be because the BlackRock and ING funds are more volatile and more apt to move sooner. Nonetheless, the dramatic difference in valuations that has resulted-- particularly between BlackRock and Eaton Vance-- is extreme, and presents opportunities as well as pitfalls.

Many of the BlackRock funds have exceptionally high dividend yields. In fact, four of their funds are in the top 10 yielding of all equity CEFs. This is not without a catch, however. The higher the yield, the more pressure is put on the NAV to support the dividend and often times, NAV performance suffers. In addition, when you buy a fund at a premium, you forgo potential yield the fund is actually paying because the NAV yield will be higher for a fund at a premium. The NAV yield is a much better barometer of what the fund is actually paying since the dividend is derived from the NAV. If the NAV yield is too high in relation to the fund's income strategy, then the fund is at risk of having to adjust their distribution more in line with their income. This has resulted in most option-income funds having to cut their dividends over the past two years in a mostly ramp-up market, and just because the fund's strategy is more optimized in a choppy, range bound market does not mean that funds with excessively high NAV yields are not in danger of a dividend cut still.

At the other extreme are the Eaton Vance option-income funds, at close to an average 10% discount. Why the Eaton Vance funds are at such low valuations when many of their fund's NAV performances have been as strong, if not stronger than other funds, is a mystery. I can only guess that the dividend cuts from Eaton Vance last December have caused lingering doubts whether another round of cuts could happen again. This is unlikely in my opinion. The latest round of dividend cuts from December has contributed to the funds having much better NAV performances this year, and virtually eliminates the need of any future cuts. Then when you consider that the Eaton Vance NAV yields are at a comparatively low 9% with market yields in the 10% range due to their discounts, and the bottom line is that investors can receive a windfall yield increase with the Eaton Vance option-income funds without worrying about whether the dividends are sustainable or not.

You don't have to be a genius to realize that funds at an 11%-13% NAV yield are going to have a more difficult time supporting that yield than funds having only to support an 8%-9% NAV yield, even in a market environment that is more conducive to their option-income strategy. After two years of a mostly ramp-up market that has kept the option-income funds out of favor until recently, it is good to see many of the funds starting to attract investor interest once again. For those investors who are looking to participate in these funds, I would recommend the ones that have had above average NAV performances trading at wide discounts to their NAVs, since if the option-income fund strategy continues to attract investor interest in a choppy, range bound market, it is not a question of if these funds will finally catch up, but when.



Disclosure: I am long ETW, ETV, EXG, EOI, EOS, IGD, ETB.

Source: Which Option-Income CEFs to Buy Right Now