Buybacks For Bonds, Equities And mREITs, But What Of Closed-End Funds?

Includes: ACG, CEF, EOT, EVG
by: Louis Ng

According to FACTSET as of December 17, 2013, 2013 Buybacks advanced to Pre-Crisis Highs:

"Aggregate share buybacks in the S&P 500 grew 32.0% year-over-year to $123.9 billion in Q3. While this represents a sequential decline of 0.1% from Q2, S&P 500 companies have been more active over the trailing year than in any period since the financial crisis. The trailing twelve-month sum of $448.1 billion is the highest since Q2 2008 ($526.9 billion)."

Even though it is logical to believe that buybacks do create some form of a tailwind, it was quite surprising to me to find such a strong correlation between the buyback magnitude and the performance of the underlying index, in this case S&P 500.

An equity specific example would be the "Icahn" effect on Apple. Even mReits are doing buybacks and some are even doing "incestuous" buybacks.

One buyback effect which is somewhat at odds would be the performance of US Treasuries ever since the FOMC decided to scale back its QE purchases in December 2013. The much advertised and consensus belief in bond weakness has been anything but. 30 year Treasuries have rallied 25bps from 3.91% to 3.66%. Having said that, it is somewhat my personal belief that the bond market tends to price things in much sooner in this case as early as May 2013 as typified by the "buy the rumor sell the fact" argument. Or maybe people are now watching the $4 trillion worth of fixed income securities sitting on the FED's balance sheet.

With Closed-End Fund (or "CEF") discounts having widened considerably over the past year, I have become more interested in CEFs in general and have been using as the go-to website as the starting point for any CEF research. My first observation was that there are way more CEFs that trade at a significant discount that I would have imagined and this did not only span the interest sensitive CEFs but also some stock CEFs. So even though I could have made an argument that sentiment can dictate the premium/discount of CEFs, the existence of discount for equity CEFs would be at odds with that argument.

Some of the academic research trying to explain the existence of discount points the finger squarely at the existence of management fees and expenses. I am somewhat skeptical of that argument as in the case of some CEF's trading at a 10% discount due to a yearly 1% management fees, this would be equivalent to paying 10 years of fees upfront. Like any other person, I have a strong aversion to anything "fees" but sometimes it is a necessarily evil if I cannot have access to the underlying asset class in the size that would be suitable for my portfolio and hopefully management would be able to do a better job at asset picking and hence earn their keep. In that same vein any passive index fund should only charge minimal fees.

Of course, there is a strong value proposition of being able to buy a CEF at a significant discount but this value can only be crystallized if the discount tightens, for which I unfortunately do not have a good sense of what the catalyst could be. So even though buying equity CEFs at a significant discount sounds like a great idea, until the discount tightens this would just be equivalent to owning Mr Market.

However, even though the same argument would apply to income CEFs, one could argue that bond CEFs should be viewed in a different light.

Assume you have a choice of buying a 4% coupon bond at par $100 or buying a CEF that owns only that bond for a 10% discount. Implicitly you will be buying that bond for $90 and receiving the same coupon of 4.0% which would make your current yield 4.4% vs the market's 4.0%. Even if the discount does not tighten you will be earning 10% more income. In a perfect world with no fees, when the bond matures the CEF will unwind itself and return 100 to the shareholders.

Clearly the math starts breaking down when we start adding fees. In the case of 0.50% annual fee, the example then becomes paying $90 for a coupon of 3.50% (4.0% - 0.50%) which would be a yield to maturity of 4.80%, still higher than owning the bond for 4.0% yield to maturity.

The above framework coupled with the fund holdings can then be used in evaluating CEFs, taking care to adjust for leverage - the CEF Alliance Bernstein Income Fund (NYSE:ACG) looks interesting on that metric with holdings of at least 50% in US Treasuries and very liquid.

What if we could buy some of the significantly discounted income CEFs with some potential of buybacks?

Eaton Vance has been active on the buyback front. From one of their recent press releases:

As such, I have recently added to my holding in National Municipal Opportunities (NYSE:EOT) and have purchased Short Diversified Duration Income Fund (NYSE:EVG) given the still wide discounts and minimal shares repurchased.

A similar press release was issued by Nuveen:

This is more personal observation rather than scientific method but it appears to me that some buyback may have already occurred in ACG, NCA and NCB just looking at the price action on particular days. Of course this is only a small subset of the CEF universe and as such would welcome any observation.


I have made a case of why buying income CEFs at a significant discount can enhance yield income and possibly to look for those CEFs where management has some "loose" form of stock buyback in place. But at any rate, these still remain interest rate sensitive assets where the interest rate risk has to be managed depending on your view of interest rates going forward.

Disclosure: I am long ACG, EOT, EVG, EMJ, NCB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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