As we continue our High Yield Income Ideas series in search of "best-of-breed" investments for yield-seeking investors, we turn now to the world of closed-end funds, commonly referred to as CEFs. My takeaway from the expert commentary below? Make sure you do your homework before you jump into these investments. CEFs are frequently misunderstood, and what you don't know can be harmful to your wealth.
In today's installment of the HYII series, John Cole Scott, Chief Investment Officer at Closed-End Fund Advisors, helps to demystify some of the myriad complexities of CEFs. You can learn more about his impressive work and credentials by taking a look at his Seeking Alpha profile (linked above), but some of the highlights include more than 15 years' experience in closed-end fund/BDC research, analysis and trading; several interviews and appearances for noteworthy outlets such as Bloomberg, Morningstar, USA Today, Bond Buyer and many more; keynote addresses and presentations at various conferences; and of course, a long-standing track record of providing valuable insights and commentary on CEFs and BDCs on Seeking Alpha.
John had a bevy of thoughts to share on CEFs, so let's get to it. Oh, and if you missed Part 1 of the High Yield Income Ideas series, you can read it here.
Seeking Alpha: What is the current range and average yield for closed-end funds (CEFs)? What are the potential risks directly related to the sustainability of these yields?
John Cole Scott: The current average market yield for the CEF universe is 6.9%, with Equity CEFs averaging 7.8%, taxable bond funds averaging 8.4% and National municipal bond CEFs averaging 5.0%. Looking deeper at the 368 taxable equity and bond funds; 88% or 325 funds pay monthly or quarterly distributions with only 23 funds (7%) paying under 5% yield at current levels. On the other end of the spectrum, 29 funds (9%) have current yields over 12%. In simple terms, 8 out of 10 taxable funds pay monthly or quarterly at the core level of 5%-12% with the average being 8.5%.
208 (77%) of these funds employ leverage, a common feature of CEFs. They have on average 21% leverage with equity funds often having normal leverage levels of 20-30% and bond funds having 30% to 40% leverage. As we look deeper into the leverage cost, for these funds, it is an average friction or cost on the fund's NAV of only 0.5% a year.
Why do CEFs often have higher yield levels that other investments with similar exposure? CEFs have their market prices that investors can buy/sell, but they also have a net asset value (NAV) like open-end funds. CEFs can trade above/below their NAV, but often trade below. When a fund trades below NAV, the market yield is higher and when there is leverage the yield increases. When we back out the impact of discounts and leverage for this group of funds, the Leverage Adjusted NAV Yield, or what the manager has to blend to in order to meet the board of directors' distributions policy is 6.6%, or about 2% lower than the average market yield of 8.5%. This is the CEF yield advantage. Another benefit is because they do not have the potential redemption pressures of open-end funds, they can hold less liquid positions without fear of being forced to sell the asset at unfavorable prices.
The risks include the fund eroding NAV by having too high of a dividend policy or investors being caught off guard by dividend cuts, which can greatly impact a fund's market price to NAV. During 2Q16 there were 1361 dividend announcement press releases for our Universe of funds. Thirty-six (3%) were increases, 134 (10%) were decreases and 1191 were dividend maintains. The average cut was -7.1% vs. the average increase of +6.8%. We like to remind investors that a CEF's yield is a policy, not a promise, and is likely to change over time; sometimes higher and sometimes lower.
SA: Beyond investor yield appetite, what are the potential trends/risks/pitfalls to CEFs from macro-economic issues, regulations and rising interest rates? Do you believe that markets might be increasingly or less volatile later in the year, and how might that impact CEFs?
JCS: Risks for CEFs include not knowing that funds are leveraged, generally making their NAVs more volatile than peer open-end funds. Also, NAV total return, or the fund manager's results after cost is very important as the market price or discount/premium is anchored off the NAV, so poor NAV results can erode the benefits of good discounts.
We see new CEF investors often make the following mistakes: 1. assuming any deep discounts can and will always narrow over time. Sometimes a fund has a discount because it is an outdated idea, not liquid enough, or has poor management/results vs. peer funds. 2. We also see people not fully comprehend that bond CEFs are equities that derive their value from bonds and generally have more volatility in many time periods than their open-end fund peers. 3. Buying a CEF without seeing how it fits into their asset allocation mix and investment profile. CEFs are not a sector - they are a 40 Act investment fund structure - and each group of funds will often act differently because of market trends and investor sentiment.
Eighty-eight of the 208 funds (42%) report a duration figure that averages 3.9. Outside of investment grade bond, muni bond and preferred equity, there is little fundamental duration risk when we see rates eventually rise. Many CEFs are built to perform well in rising rates and did the last time rates increased about 4% from 2004-2007. The 361 CEFs had an average market price total return of +28%, with only 6% of funds showing negative performance. 97% of funds changed their dividend policy and it was an average of -2.5%. Half the funds were municipal bond CEFs with an average -17% dividend reduction. Other CEF groups had less painful cuts and there were even increases in groups like Sr. loan, multisector bond, MLP, REIT and utility CEFs.
We think that markets will continue to be volatile in 2016, though CEFs have already been experiencing two years of above-normal volatility. One benefit of CEF volatility is that it provides the opportunity to potentially buy a little cheaper and sell a little higher with patience and diligence.
SA: What opportunities do you see in terms of specific CEFs? Which funds, if any, are you steering clear of right now, and why?
JCS: In 2016, the following sectors have traded wide vs. their 10-year average discount levels. So far this year, MLP funds have averaged -5% discount vs. historical +0.9% premiums. One fund we like here is the Tortoise MLP Fund (NYSE:NTG). It trades about a -6% discount to NAV, with much better performing NAV (1 year) vs. most of its peer funds. It holds 96% MLP investments; about 80% are transportation MLPs, and only 20% are gathering and production MLPs. It currently yields 9% with only 29% leverage. Another benefit is both on a 1-year and 3-year basis, 100% of the income was return of capital, which is treated as deferred long-term gain rates and only when the fund is sold vs. having the income taxed each year at your marginal tax rate. Also, unlike individual MLP ownership, there are no K-1s or UBTI in the CEF version, so it can live in an IRA or other qualified account.
Sr. Loan funds have been trading at about -10% discounts vs. their 10-year average of -4.5%. One fund we like here is the Invesco Credit Opportunities Fund (NYSE:VTA). It has a -11% discount, about -3% wider than the peer group average, and has about 70% loans in its portfolio. It currently yields 8% with over 100% dividend coverage and 33% leverage. There are loan funds with higher loan percentages, but with coverage and a wide discount, we think this is a good option for some investors.
REIT funds have been trading on average -13% discounts vs. their 10 year average of -7.5%. A solid choice in our experience is the Cohen&Steers REIT&Preferred Income Fund (NYSE:RNP). It is a blend of REIT (51%) and preferred securities (32%) with a -12% discount, 7% yield and 25% leverage. However, the NAV shows a 2-year Beta of only 0.56 to the S&P 500, offering some equity exposure in a potentially less volatile investment option.
It is hard to write an article on CEFs and not discuss the municipal bond category as there are almost 200 funds in that grouping. They have been performing very well with the national fund grouping, having a 20% 1-year market price total return. The group has averaged a -3% discount for the past 10 years vs. a recent average of only -2%. One fund we like in the sector is EIM. It trades at a -5% discount, yields 5%, with 38% leverage. It has a duration of 8, 99.8% investment grade bonds (79% AAA or AA rated), 0% AMT exposure and only 5% call risk on the portfolio. They also have 101% dividend coverage. One item of note is they have 16% zeros in the portfolio.
When discussing funds or sectors we are avoiding, we are underweight preferreds and investment grade bond funds. We have avoided funds where the manager has to blend 9%+ leverage adjusted NAV yield, as we think this level is hard to maintain in the current environment for almost any fund's portfolio. We are cautious on funds with 1% to 5% premiums to NAV, but can't see any reason to own the premium funds as long as there are other suitable options in their asset class or sector at discounts.
Three funds we would like to highlight with issues we see as potential risks for investors are Western Asset Mortgage Defined Opportunity Fund (NYSE:DMO), PIMCO GlobalStocksPLUS&Income Fund (NYSE:PGP) and the Cornerstone Total Return Fund (NYSEMKT:CRF). DMO is a CEF with a focus on mortgage bonds with 94% of the portfolio. It trades at a 10% premium to NAV and has a current 12% yield. I think there is potential risk in the premium going away and with the manager having to blend to 9.6% returns at the portfolio level to meet the current dividend policy (lev adj NAV yield). While we are not experts in the mortgage backed securities market, the CEF risks keep us away from this fund.
PGP is a PIMCO fund that gets a lot of attention from the press and investors. It has a 107% premium to NAV (yes, investors pay more than double its liquidation cost to access this fund). It shows 11% yield, but its leverage adjusted NAV yield is 16% and its 5-year NAV total return is +7.6% (its 10-year is +3.7%). Investors have seen premiums in this fund as low as only 18% in the past three years and as high as 113%. The potential risk of the premium falling to even a lofty 50% and buyers today losing around 57% of their principal outweighs the notion that the fund is not expected to cut the dividend. In my opinion, when you pay out twice as much as your performance and trade above NAV, I am not comfortable holding the shares. The fund may never fall, but I am paid to avoid risk for my clients and this is a big one in my opinion.
Another fund that gives CEFs a bad flavor and reputation, in my opinion, is CRF. It only has a current 20% premium to NAV vs. PGP's 100%+, but it has a "yield" of 20% and a leverage adjusted NAV yield of 25% with a 5-year NAV total return of only +7.3% annualized (10 year is +1.3%). The policy that the fund follows to keep from losing its principal and going out of business is regular rights offerings above NAV to increase its capital. They disclose all the information to investors, but we see way too many people buy it thinking the fund is a "magic bullet" for their retirement income needs. I fielded a call from the SEC a few years back on this fund. I shared that they were not breaking the rules by my analysis, but the rules should not allow this type of investment to exist. I see risk in PGP, but they have not yet needed to raise capital to fuel their distribution policy.
SA: What are the primary differentiators of quality CEF investments? As CEFs are notorious for being off their NAV, what metric do you prefer to lean on when you evaluate these investments? What are your "buy" and "sell" criteria?
JCS: Our firm uses a Trifecta Analysis as the starting point for CEF investing. It is basically balancing discount direction, dividend sustainability and NAV total return. Then each sector can have additional screens and portfolio holding reviews to select a fund to meet a client's needs. In our experience, getting one of these wrong can negate the benefits of the other two factors. We have found our clients also ask us to add some secondary considerations: to increase after-tax yield, raise or decrease the portfolios' beta, overweight low correlating asset classed or build a higher than normal yielding portfolio. Sometimes we are asked to build a monthly dividend policy only portfolio. As of July 19th, our diversified models are showing a blended yield of 7.8% to 10% depending on the allocation and client needs. One important note is we don't suggest investors take out 100% of the dividends in a CEF portfolio, but typically 4.5% to 5.5% of the leverage adjusted NAV yield. Our diversified models are showing this data point at the 6% to 7.5% level. In this case, we suggest they take out 75% to 85% of their income and reinvest the rest to help protect principal over time. This allows the portfolios' yield to be looked at independent of discounts and leverage, which can change significantly over time.
We sell a fund when a replacement is more attractive after considering tax consequences. With many CEFs having an average range in their discount low and high over the past three years of being 15% to 25%, it makes sense to us to trade at least occasionally. This means many funds trade at levels below and/or above NAV with a significant peak and valley. We see good reason to sell when a fund is expensive and buy when it is cheap. The CEF wrapper allows investors to be contrarians and potentially increase their returns from picking a fund or sector when Mr. Market is puking shares and selling or reducing their position when everything is rosy and perfect. But as experienced CEF traders know, be careful of stop and market orders as you can get a price well off the current bid/ask, even in 1000 share lots.
As a short commentary on discounts, in my opinion, unlike some of the commentary we read, discount risk isn't that the fund will always trade at a discount and investors "will never see NAV!", but that the discount widens and never returns the level or range you paid for the fund. We love it when a fund narrows its discount as we get extra performance on top of NAV total return from the manager. However, if a fund traded at a -10% for 1000 years, investors still control a $1 of assets with $0.90 of capital. This equals free leverage and if the sector and manager perform well, it can be very powerful. The reality is most funds have ranges and cycles for their discount behavior, but I think people look at discounts and volatility wrong for CEFs. If you don't like a CEF, you can trade any day. It is hard for a $1B hedge fund or firm to do well in the space, but it can be far easier for individuals, advisors and small to medium sized RIAs. Some large firms do well, but in my experience it is with use of good human capital, data and focus. I tell prospects all the time, we are happy to wait until they are ready to invest as we have always found something worth buying during any given quarter and we have no idea where the stock and bond markets are going. CEF investors have access to fixed capital, active management and daily liquidity. When used correctly, this can be a powerful tool to build a diversified portfolio.
SA: Similarly, what types of due diligence do you think are critical for investors before investing in CEFs? What are your best resources you use to accomplish this?
JCS: There are a few free data sources for CEFs: cefa.com, CEFconnect.com, Morningstar.com and our site, CEFdata.com. We remind investors that the fund sponsor web page is always worth reviewing, as are press releases and SEC filings. No one can easily know a fund better than its management and the sites often have useful commentary that can help an investor understand the data reported by the fund. The Morningstar discussion group on CEFs has about 8-12 retired investors that post and reply regularly to the forum. In my opinion, they deserve the "CEF Medal of Valor" for their ongoing comments and gentle guiding of CEF newbies. There is a CEF-focused conference in NYC every fall run by Pristine Advisers that offers web access for individual investors and live access for investment professionals. We have been a strong supporter/sponsor of the event and are pleased to see how much the attendee count has grown over the years. As a parting note, do your research on the data, stick to an asset allocation mix prudent for your risk and tax needs, and be patient and diligent in your process.
Note: Data is from CEFData.com as of July 15, 2016 unless otherwise stated. Past performance is not indicative of future results and it is important to note yield is not the only factor in performance and CEFs can change their dividend policies at any time.
Now it's your turn to weigh in. Do you have any allocation to CEFs in your own portfolio? What are your favorite CEFs? Do you find CEFs confusing or difficult to understand? Have you been "burned" by a CEF or other complex high yield investment in the past?
And now, on to the week's Dividends & Income news and analysis:
My 80 Stock Portfolio Review: Revealing All Account Types - Taxable, Roth And Other Holdings In Vanguard by RoseNose
We Have Never Seen A REIT Preferred Issue Like This One by Brad Thomas
Teekay Offshore Partners: A View From The Perspective Of A Preferred Investor by Norman Roberts
Omega Healthcare: Cheap And Quality by Dane Bowler
Retirement Strategy: 5 Dividend Aristocrats To Buy Here by Joe Springer
Royal Dutch Shell: Huge Dividend And Long-Term Growth Ahead by Wayne Duggan
Annaly Capital Management Can Make A Great Dividend Investment... If You Keep These 3 Things In Mind by Dividend Sensei
Ford And GM: Detroit's Old Stalwarts Are Solid Pick by Kevin H Li
Consumer Staples: Finding Value In An Expensive Sector by Eric Landis
My Retirement Portfolio's 2-Year Performance Update: My Strategy For The Next 2 Years by Dividends#1
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.