Are CEF Investors Getting Suckered Into High Yields?

by: Adam Aloisi


Elevated yields tend to make CEFs an attractive income choice, albeit with frequently elevated leverage risk.

What is a "Sucker Yield" in general terms?

Since "sucker yield" may be subjective, the onus is on the investor to understand CEF nuance and avoid becoming the sucker.

Commentary on BIF - a fund that has generated some interesting recent CEF commentary.

Closed-end funds, or CEFs, continue to be an alluring income product for investors, with fixed-income yields continuing their roughly 35-year death spiral. The ability to purchase assets at a discount and buy into typically cheap added leverage can add up to serious comparative value for both stock and bond investors.

Unfortunately, the cost of entry is usually quite high when compared to an ETF with a similar strategy. Pick a fund with subpar, overpriced management and the attractive discount you thought you were getting might turn out to be more than well deserved.

"Sucker" Defined

Fellow REIT writer Brad Thomas coined the term "sucker yield" a few years ago to describe the lofty yields endemic in the mREIT space. Basically, an offshoot of the notion that "if something is too good to be true, it usually is," Brad's definition typically applies to high-yield companies with erratic payouts, deemed unsustainable payouts, as well as payouts that can be seen as demonstrably uncovered.

The term can be seen as highly subjective in my view. I'd argue that one shouldn't necessarily discount "sucker-type" situations so long as the risks and nuances behind the payout are clearly understood. Valuation, as always, has to be part of the analytical mix. At times it may make more sense to opt for a weak-dividend security trading at a handsome, dirt-cheap value as opposed to a more durable yield trading in the nose-bleed valuation section.

This would lend itself to the philosophy that great companies can make for lousy investments, although we should also refer to Warren Buffett's iconic advice that states,

It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Are CEF Investors Suckers?

Closed-end funds are pooled investment vehicles that have complicated analytical quirks, making them somewhat of a due diligence nightmare for the newbie or unseasoned investor.

While about 2/3 of the CEF universe is populated with bond dedicated funds, there are several hundred with equity-dominated portfolios. Still, most of those equity funds have an income bent, options overlay, or managed distribution that throws off plenty of cash to its investors. Investors are generally expectant of an income-value proposition when looking at CEFs.

It should be understood, however, that a high advertised rate of distribution, especially in conjunction with an equity CEF, may or may not be indicative of the organic income generating capacity of the fund. More times than not, the "yield" of an equity closed-end fund may be composed of capital gains distributions, non-taxable returns of capital, tax deferred option-income premiums, and other income classifications that may or may not be a result of organic fund operations.

Closed-end funds often times manage their distributions, meaning that there is clear intent to return money to shareholders at an "at-least" specified rate. Even if a growth & income CEF only generates a 2% yield on account of its dividend paying holdings, if it has stated a 6% managed distribution, it will return 4% more of its assets to investors.

This forcible excess of distribution is usually accomplished through capital gains distributions and/or return of capital, or ROC. In unqualified accounts, capital gain will be taxable, while ROC characterization is generally tax-deferred - lowering the cost basis of your shares until you sell a portion or extinguish your entire position.

The only sucker here would be the investor that fails to understand the tax consequence of a managed distribution. Another sucker would be the investor that thinks an advertised 6% "yield" is the organic result of whatever it is the fund is investing in.

Are High Fees For Suckers?

Compared to garden variety exchange traded funds (ETFs), CEFs tend to have exponentially higher fee attachment. There are a number of reasons for this, one being the voluntary leverage expense that a majority of CEFs take on. Generally, there are a couple of schools of thought regarding CEF fees.

  1. It doesn't make any sense to invest in a CEF with a fee of greater than X percent.
  2. It doesn't matter what the fee is, so long as the fund's NAV and/or other performance metrics meet personal expectations and/or beat comparative benchmarks or ETFs with similar end-of-the-day goals.

Opinion #1 would be a typical value shopper attitude, but with the caveat that sometimes you get what you pay for.

Opinion #2 would seem to make sense, except for the problem that we need to assume that past performance is predictive of future CEF results. As in all other investment matters, that's an impossible premise to make, save for possession of a proverbial crystal ball.

My personal view would be that a combination of fee limit and past performance analysis should generally lead investors in the right direction in terms of fund selection when comparing various options. Of course, when combined with other analytical factors.

Again, the only sucker here would be the investor that doesn't realize the comparative depth of the underlying fee or the severe underperformance they might be suffering as a result.

Case Study

Boulder Growth & Income (NYSE:BIF), which has been written about a number of times recently on Seeking Alpha, is a prime example of a fund with interesting attributes and polar opinion. Amongst the attributes: a managed distribution policy enacted 10 months ago, a 20% NAV discount, a quarter of its assets in one company - Berkshire Hathaway (NYSE:BRK.B), a third of its assets in two companies - BRK.B and Yum Brands (NYSE:YUM), and a 1.4% annual cost.

The pro case cites the discount, the quality Berkshire holding, and the attractive distribution received at the discount, amongst other generally beneficial CEF attributes. The pessimist case cites its concentrated portfolio, quality of management and interest alignment, disingenuous yield, and lack of catalyst for a narrowing of discount.

Yours truly sees this as a middle-of-the-road situation, and sees merit in both sides. The discount is unquestionably attractive, but you must have conviction that Warren Buffett's outfit will outperform going forward. Still, you're getting into Berkshire on a notional level at $120 a share, not the current $150 market. Of course, more than 1% of that benefit evaporates annually as compensation to management. Plenty of give and take.

All told, I see reason that the discount may narrow in time, but probably no better than the 10-15% level. As I commented in the thread to the pro-article however, there may be equal reason to believe that a large-cap index fund priced with nominal fee will outperform BIF in terms of long-term TR performance.

At the end of the day, there's generally little reason to own an equity CEF earmarked for growth if you believe that a simple ETF index fund is capable of equal or better total return over the long haul. While BIF's managed distribution policy at the deep discount offers some beneficial income rationale for ownership, i.e. 5% for a "real" 4%, it may well prove more of an empty, sucker-type gesture looking longer term.

Strategy Session

Late last year, I opined that both corporate/muni bond CEFs looked particularly attractive given the depth of discount I saw. Two that I mentioned, MUI and ERC, have seen their discounts move from 12% and 16%, to 6% and 9%, respectively. Given the decline in rates combined with the discount narrow, most bond funds have been banner total return holds over the past year.

On the flip side, both of these funds have seen a drop in distribution rates over the past several months as well. That continues to be a risk in the fixed-income space as rates stay depressed for longer amounts of time. Bonds that are coming due in portfolios are going to be replaced with inferior yield paper when looking at constant duration.

At this point, I see little CEF value in bonds today, and barring a vision that sees the 10-year Treasury gravitate to one percent, I'd be careful with the amount of duration risk taken at this juncture. The deepest discount on the muni side of the CEF universe is about 7 percent, compared to 15% at the end of last year.

On the taxable side, one can find deeper discounts and potentially higher after-tax yields - albeit with generally higher credit risk. And don't discount that if we have a taper tantrum-like, out of the blue move higher in rates, longer duration funds will likely get price gouged.

If a gun were to my head, I'd probably recommend something like BlackRock Multi-Sector Income (NYSE:BIT) at a 9% discount and 8.15% yield - yes, the fee is very high, but the performance is very good. For access to rockstar money management (Jeff Gundlach) talent there's also DoubleLine Income Solutions (NYSE:DSL) available at a 5% discount and 9.25% yield.

I should not neglect to mention that both funds are levered, approximately 39% and 32%, respectively.

On the equity side with the perma-salty market commentary, I think the case continues to grow for owning option-income funds. However, their existence is not quite the secret it was several years ago, with discount narrowing occurring somewhat across the board. And ETV, one of retail investors' favorites, sells at a 6% PREMIUM. I have a hard time justifying that despite the fund's better than average performance through the years.

Instead, I might opt for something like EOS, also from Eaton Vance. It sells at a 5% discount with a great recent track record, although you'd have to settle for a full percent reduction in yield.

Given the relative lull in the biotech space, I'd perhaps take the opportunity to buy into the two Tekla healthcare funds (HQL, HQH), with an understanding that capital gains forms the majority of the distribution here.

All-in-all, the going continues to be tough when searching for income value in today's market. The CEF space provides some level of alpha-opportunity for quick thinking investors that can identify mispricing, and aren't afraid to churn an account. On the other hand, CEFs can also be a veritable mine field for investors that fail to understand all of their operational intricacies and get sucked into thinking they're buying something totally different than what it is they're actually getting.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.