Chance Carson

Income ETFs vs. CEFs

Joetown has asked about the impact of Auction-Rate Preferred Securities (ARPS) in Closed-End Funds. Great question! Recent ARPS related settlements by UBS, Citicorp, Wachovia, Merrill Lynch and others certainly highlights the importance of Joetown's question. The ARPS market is far from dead, however.

Leverage in Closed-End Funds is commonplace. Leverage in the form of bank loans, debt issuances and the placement of ARPS, allows the fund managers to borrow at very low rates and invest the proceeds into much higher yielding investments. Capturing these yield spreads, less expenses, boosts CEF distributions substantially. Until recently, the low rates, liquidity and safety of ARPS, had been the CEF's leverage strategy of choice. Claymore, as is the case with many other CEF sponsors, actively rolls over its ARPS weekly at LIBOR plus 1.25%, a generally mandated rate in the event of auction failures.

Claymore's ability to issue AGC's (Advent/Claymore Global Convertible Securities & Income Fund) ARPS at 3.66% (as of August 8, 2008) and invest the proceeds at rates 3-4 times greater, is an excellent benefit to its Closed-End Fund common shareholders. The preferred shareholders aren't as lucky. In fact, at the moment, they are rendered essentially illiquid, receiving no more than the mandated rate. Since Claymore must represent the rights of both its common and preferred shareholders, they are actively seeking (as are all sponsors of Closed-End Funds) other suitable leverage strategies to replace their ARPS issuances. Much progress has been made to date. Claymore itself has already replaced $466 million, or 27% of its ARPS, since May, 2008. Nuveen and Eaton Vance have recently issued several innovative "Variable Rate Securities" as replacements for their ARPS. Industry experts believe these new securities may rapidly become a model for other issuers as well.

The important thing to remember is that Closed-End Funds will continue to leverage their holdings to improve their distribution rates to their shareholders, even after the ARPS crisis subsides. What types of leveraging strategies will emerge from the ashes of the ARPS debacle will be exciting to follow.

Joetown, regarding your concern about AGC's usage of ARPS, it presently holds only $170 million of these securities, representing 28.3% of its portfolio holdings. Furthermore, AGC's "1940 Act Asset Coverage Ratio" is 354%, well above the Act's minimum requirement of 200% coverage of senior securities, which are beneficial interests in any fund's portfolio. AGC's coverage is also well above the industry average of 300%.

You also mentioned AGC has had "negative earnings for the past two quarters." Indeed, AGC's share price has declined 20% this year through July 31, 2008. But, interestingly, its NAV has declined only 4.6%, which is quite remarkable given the S&P 500's 14% drop. Furthermore, AGC's distribution rate has remained a steady $0.1458 per share monthly since August 2007. This monthly rate does, however, include a 51% return of capital. We will be watching AGC's distribution policy carefully, as return of capital distributions can sometimes lead to potential distribution cuts.

Even when market prices are volatile and net asset values are declining, considerable benefit may often accrue to Closed-End Fund traders. One such trading strategy involves purchasing CEFs when their discounts spike significantly above their historical norms, and then selling them when their discounts contract back to "normal levels." A successful strategy for AGC, using this concept, is to purchase AGC whenever its variance exceeds the fund's normal discount by 20%. You would then sell the fund when its variance contracts back below 20%. This strategy would have generated eight roundtrip purchases and sales in the past 12 months netting a 39.3% gain, excluding commissions and taxes. All sales were short term. This strategy is extremely complex, volatile and risky, and should only be utilized by short term traders and speculators able to withstand potential losses in principal.

Income ETFs vs. CEFs

J'Adoube makes an excellent distinction regarding the use of words like "yields" and "distribution policies" by Exchange-Traded Funds and Closed-End Funds. Other financial journalists use "yield," "income," "dividend rate," "distributions" and "return" interchangeably. As J'Adoube correctly points out, there certainly are semantic differences. By not understanding these terms, an uninformed investor could easily land in hot water.

Both ETFs and Closed-End Funds constructed for income investors purchase debt and equity securities such as common and preferred stocks, Business Development Companies (BDC), Master Limited Partnerships (MLP), Royalty Trusts, Bonds, Convertibles, etc. These individual holdings pay periodic interest and dividends to the fund. The fund then declares its monthly or quarterly distribution rate based on the investment income it receives from the underlying securities. The Distribution Rate is not guaranteed, however, and the fund may increase, decrease or potentially eliminate its distributions at any time. The fund's Distribution Rate (sometimes referred to as its "Dividend Rate") is expressed as "x" cents per share for each period declared. The fund's "Current Yield" is calculated by dividing its annualized distribution rate by its current market rate.

The distinction that I believe J'Adoube would like clarified is that while a fund's "Distribution Rate" usually only includes its net investment income from portfolio investments, it may also include the fund's realized capital gains. More importantly, the fund may also distribute "Return of Capital." Making such distributions erodes the fund's "Net Asset Value" (NAV) performance over time. Moreover, including Return of Capital in its distributions gives the fund a false perception of being a higher performing investment than is actually merited.

When a fund's performance is declining (either it's market price or Net Asset Value), the fund's managers will sometimes resort to distributing return of capital to avoid reducing the fund's distribution rate. This perception of a "high dividend rate" may often catch uninformed investors off-guard as to what the actual fund is returning.

To learn whether your fund is returning capital in its distributions, I would recommend investors go online to the fund's "Section 19a-1 Letters" to be alerted to any distribution sources other than the actual net income. Caveat Emptor!

Income ETFs vs. CEFs

Dunn makes an excellent point. Investors who seek to entirely avoid principal risk should indeed never buy Closed-End Funds, ETFs or any other investment without a fixed maturity. A "laddered maturity" portfolio of US Government Treasury Bonds or Bank Certificates of Deposit would be much safer to one's principal. With today's miniscule yields on CD's and Treasuries, however, perhaps investors needing greater monthly income might still want to investigate alternatives, such as income-oriented ETFs and deeply-discounted Closed-End Funds.