If ever there was ever a time in the discount/premium cycle of high-yielding equity Closed-End funds (CEFs) for investors to jump on board, this would be it. Many investors may not realize that CEFs can often run in discount/premium cycles and timing those cycles can be very profitable. In late 2009 and 2010 during the market recovery period when many equity CEF market prices rose to premium prices over their Net Asset Values (NAVs), I was bearish on these funds, calling for investors to sell and even short some of the more extreme cases of overvaluation. Fast forward to today and with many funds now trading at bear market discounts even with outperforming NAVs, I believe we are coming close to going full circle and investors should anticipate a better 2012 for many of these funds.
Though it is hard to predict the bottom of a cycle, and I certainly have been early on many funds in my past CEF articles even if I have been right on their income strategies outperforming, considering the overall market environment as well as the interest rate environment, these funds present some of the best CEF valuations that I have seen since the bear market lows back in 2008.
One would think that in a near zero interest rate environment, funds that are offering 11% to 12% annual yields would be in high demand since in a more normalized interest rate environment, that would be the equivalent of 14% to 16% annual yields! Investors may believe that those are unrealistic yields and market prices are discounting potential distribution cuts but actually these yields are absolutely sustainable. The reason is because when these funds' market prices drop to -15% discounts, their NAV yields may be only 9% to 10%. The NAV yield is the true yield the fund is paying and for equity based high yielding CEFs, 9% to 10% NAV yields are not difficult to achieve when their income strategy is optimized. The higher windfall market price yield is the bonus that investors can receive by buying funds at steep discounts.
So which funds present the best opportunities? I believe the best opportunites still lie with some of the most defensive CEFs, which are clearly earning their large distributions in this volatile up and down market. I hate to sound like a broken record, but the Eaton Vance Tax-Managed Buy/Write Opportunities fund (NYSE:ETV), the Eaton Vance Tax-Managed Buy/Write Income fund (NYSE:ETB) and the Eaton Vance Global Buy/Write Opportunities fund (NYSE:ETW) are quite simply being given away at these market prices in this market environment. All 3 of these funds sell index options (mostly S&P 500) on about 95% of the notional value of their large-cap stock portfolios, which brings in an immense amount of option premium each month to each fund. The more volatile the market, the greater the premium the funds can bring in, and the more the markets vacillate up and down, the better the odds that these funds are able to keep most of their option premium each month. This strategy has been working for most of the year and that is why their NAVs are outperforming their benchmark indices even with large distributions taken into account. Here are the funds' vital statistics as of November 14, 2011.
(Click charts to expand)
Though ETW's NAV is negative on the year, it has still outperformed its benchmark index as a global fund with about 45% exposure to International stocks. And how have these funds' market prices performed with outperforming NAVs? Let's take a look at their 1-year discount/premium graphs, which still reflect a downward trend.
Eaton Vance Tax-Managed Buy/Write Opportunities fund
Eaton Vance Tax-Managed Buy/Write Income fund
Eaton Vance Global Buy/Write Opportunities fund
Obviously, these are not attractive graphs but I believe a big reason for the continued weakness in most equity CEF market prices this year has been due to a market that has been driven by technical trading where technically strong stocks and funds receive the strongest inflows while technically weak securities are sold and even shorted. Because high yielding CEFs continually pay large distributions every month or every quarter, their graphs don't look technically strong even if their total return performance has been fine. End of year tax-selling may also be contributing to this but I believe 2012 is setting up to be a much better year for these funds.
Before I hear from readers as to the negative side of the argument, let me address a few concerns that I know are coming;
- Distribution cuts in 2010 mean these funds are vulnerable to more cuts. I would argue that the reason for the distribution cuts for many option-income funds over the past couple years was due to the ramp-up market we saw from early 2009, to early 2011, in which these funds' income strategies were not optimized. Most option-income funds were forced to re-balance their distributions with their incomes due to this. A ramp-up market is the only market environment in which option-income funds NAVs will lag other strategies, but on the other hand, a volatile up and down market like we've seen this year is probably the best market environment for the option-income strategy.
- High Return of Capital (ROC) in their distributions means these funds are just giving back my money. What most investors don't realize is that many of these funds are managed to maximize ROC for the tax benefits. Frankly, it would be easy for the fund managers to minimize ROC if they so choose to and the option-income strategy is the only strategy that can do this. All the managers would have to do is take realized capital gains either in their options or in their stock positions and not offset with realized losses and voila, ROC goes down. Intuitively, these funds' NAVs would not be outperforming their benchmark indices either year-to-date or over the life of the fund if they were just giving back an investor's initial investment. Both ETB and ETV have far outperformed the S&P 500 (NYSEARCA:SPY) since inception when distributions are added back.
- Analysts are negative on Eaton Vance (NYSE:EV). It's true that Eaton Vance has had a horrible 2011. Earlier this year, Barron's wrote an article pointing out Eaton Vance's poor mutual-fund performances and just yesterday, Citigroup downgraded Eaton Vance from a Neutral to a Sell citing lagging cash flows and retail market share loss to mutual-fund heavyweights such as BlackRock and T. Rowe Price. But that has nothing to do with Eaton Vance's Closed-End funds and frankly, their equity CEFs have been some of the best performers this year. I also hear alot from readers quoting Morningstar so I would just like to say that Morningstar recently raised ETB from a 4-star fund to a 5-star fund on November 2. Morningstar also has rated ETV and ETW as 4-star funds. Though it cites "destructive" ROC in all of the Eaton Vance option-income funds, I believe this is more attributable to the time period prior to this year in which the funds' NAVs underperformed.
To conclude, if you are nervous about the market direction and feel that volatility in an up and down market is here to stay, then these high yielding defensive funds are extremely attractive. Though market prices of CEFs can be subject to the whims and emotions of investors, the funds' NAVs are only subject to the performance of their underlying portfolio and so far this year, these funds' NAVs have seen some of the best performances of all the funds I follow. Think about it for a moment...where else can you buy a diversified fund similar to the S&P 500 at $0.85 cents on the dollar and get paid an 11% to 12% yield while you wait?
My next article will take a look at leveraged equity CEFs that will outperform in an up market environment.