Closed End Funds: Industry Analysis Part I

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Includes: FTF, PHF, ZF
by: Alpha Gen Capital

Summary

Closed-end funds have rallied strongly since the start of the year with general bond funds going from a discount of 5.9% to 2.3% as of June 10.

High yield and investment grade funds still offer attractive discounts averaging 7.5% compared to most other fixed-income categories.

Activism remains very strong and we detail two strong investment ideas that we think could provide solid risk-adjusted returns for investors.

Closed-end funds continue to rally supported by the accommodative Fed and the overall health of the bond market. Discounts on bond CEFs have closed to just 3.2%, down another 7 bps from the week before and 127 bps over the last three months. Equity CEFs remain at a higher spread at 8.15%, down nearly 30 bps from last week and 108 bps over the last three months.

While discounts are tighter, the number of funds at a premium are only back to where they were in April at 77 on the bond side and 28 on the equity side. Natural Resources and Real Estate asset classes performed the best while Health and Biotech-focused equity CEFs, European, and MLPs fared the worst. Munis continued to benefit from duration as long-yields continue to collapse both internationally and in the US leading to strong demand.

Bond Markets:

The treasury curve continues to slowly flatten after the FOMC meeting and weaker global markets but has realized a strong parallel shift lower. 10s minus 2s were at 88 bps compared to 90 bps last week and 95 bps last month.

Despite high yield spreads reversing a recent trend and expanding to 618 bps, high yield closed-end fund discounts tightened further to -7.1% for unlevered and -5.9% for the levered variety. The bond market continues to be highly favorable and healthy by all the metrics we track. Defaults remain extremely low and spreads are close to their long-term averages.

Activism:

Activism in May remains strong and we would characterize the current opportunities for additional alpha in the space as drinking from a firehouse. The main players are still at it with Bulldog and Saba pressuring several funds to close their discounts.

Bulldog recently targeted and filed a 13D on a new fund, the Pacholder High Yield Fund (NYSEMKT:PHF) disclosing that it had accumulated 11.7% of outstanding shares. In the filing's item 4, they noted that they "may communicate with management about measures to enhance shareholder value." The fund trades at a 7.4% discount to NAV and is a lower-risk fund in the high-yield space with a slightly lower than median average duration and better credit quality. See our write-up on the fund here.

Virtus Total Return Fund (NYSE:DCA) continues to be a focus by activist Bulldog Investors. On June 6th, the results of the proposals from the fund's annual meeting were released. While proposal two is a non-binding resolution, we do think it will result in the ultimate liquidation of the fund. The 'For' votes on proposal two exceeded the 'For' votes for either of the proposed director elections. This is a tough fight for Bulldog in that one of the two submitted directors was defeated by Thomas Mann, Andrew Dakos.

On Proposal 1, regarding the election of a director of the fund, Thomas F. Mann was re-elected as Class II Trustee of the fund for a term of three years or until his successor has been duly elected and qualified. Mr. Mann received a plurality of the votes cast at the meeting, defeating a candidate who was nominated by a shareholder of the fund. The shareholder-initiated Proposal 2, a non-binding vote recommending that the Board approve and submit to shareholders for a vote a proposal to liquidate the fund, was approved.

Lastly, the Franklin Limited Duration Income Trust (NYSEMKT:FTF) fund has been the target of activist Saba Capital Management LP, an activist hedge fund. The first filing occurred on March 4, 2016 in a 13D filing whereby it was disclosed that the hedge fund owned 14.5% of the outstanding shares. Their item 4 note stated:

The Reporting Persons may engage in discussions with management, the Board of Directors, other shareholders of the Issuer and other relevant parties, including representatives of any of the foregoing, concerning the Reporting Persons' investment in the Shares and the Issuer, including, without limitation, matters concerning the Issuer's business, operations, board appointments, governance, management, capitalization and strategic plans and matters relating to the open or closed end nature of the Issuer and timing of any potential liquidation of the Issuer. The Reporting Persons may exchange information with any persons pursuant to appropriate confidentiality or similar agreements or otherwise, work together with any persons pursuant to joint agreements or otherwise, propose changes in the Issuer's business, operations, board appointments, governance, management, capitalization, strategic plans or matters relating to the open or closed end nature of the Issuer or timing of any potential liquidation of the Issuer, or propose or engage in one or more other actions set forth under subparagraphs ((a-j)) of Item 4 of Schedule 13D.

On April 20, 2016, Saba filed another 13D stating that they had increased their stake to 15%. In response, and in an effort to stave off the attack, the board of the fund approved a series of common measures to address the fund's persistent discount. These steps include:

1) Open market share repurchase program with an authorization to acquire 10% of the fund's common shares.

2) The commencement of a discount measurement period that could result in a series of potential actions. The discount would need to be greater than 10% during the last 90 days of the period. Actions include a tender offer for a portion of the outstanding, a proposal to shareholders to reorganize the fund (merge into open-end or with another closed-end fund) or submit a proposal to convert to an open-end mutual fund.

On the same day, Saba sent the board a letter that contained a shareholder proposal requesting the board to consider a self-tender for all of the outstanding shares at or close to NAV. If more than 50% of the fund's shares approve of the measure, they state that the tender offer should be cancelled and the fund should either be liquidated or converted into an open-end mutual fund.

In mid-May, Saba then sent notice that it intends to nominate three people for election to the fund's board. If successful, and we think they will be given the large stake they currently own, it would almost assuredly mean the fund will be liquidated or open-ended.

The fund offers the potential closing of the 6.9% discount on a global short-duration income fund. The fund is already up 13.3% YTD on a price-basis with the NAV up 5%. We do think there is a significant potential for a distribution cut in the coming months which could open up a better entry opportunity. The fund last cut the distribution in early 2014 and since the IPO in late 2003, has made a cut roughly every two years. They have not cut in the last two-and-a-half years. In the last annual report dated March 31, they had average earnings per share of $0.0539, compared to their current distribution of $0.062. The UNII per share bucket is a negative $0.0754. Either the fund will need to lever up (currently 20.7%) and generate more income or cut the distribution.

(Source: CEFConnect.com)

Bottom Line:

For those unsure about the equity markets, especially given the possible bubble forming in dividend-paying and low-beta names, we think the opportunity in fixed-income CEFs are still there, despite the tight discounts, via these activist plays. Until a panic sell-off occurs, we will continue to identify pricing anomalies and potential alpha plays through the piggy-backing on activists.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PHF over the next 72 hours.

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.

Additional disclosure: We are long DCA. Positions size and holdings can change at any time without notice. Due your own due diligence.