Option-Income Equity CEFs: 10% Yields with Some Defense for Your Portfolio
For openers let’s consider the two major categories of equity closed-end funds. On one side there are the leveraged funds. These can be great in a bullish market, especially when interest rates (and, therefore, the cost of leverage) are low. But in a less bullish market or in a rising rate environment the second category, option-income funds, should have the advantage. Several months ago I was exploring leveraged equity CEFs, a category I had avoided, as I explained at the time. But in the current investing climate, I’m concerned on both counts. Has this bull run itself to death yet? Will it soon? And, how much do I want to be exposed to rising leverage costs? I’m not bailing on my leveraged equity CEFs holdings yet, but I’m beginning to think it time to pay more attention to the other side of the equity CEF coin once again.
With those thoughts let’s return to consideration of the funds. I started an examination of option-income closed-end funds with a survey of Eaton Vance’s offerings in this category. Eaton Vance leads the group with eight funds, so it demands attention. But there are an additional 19 funds from other sponsors. I want to turn my attention to those other funds now. One thing I like about the EV funds is that they are delineated into categories by defined investment strategies, and within each there are examples of domestic and global funds that employ the strategy. For the rest of the group it is more difficult to make the sorts of comparisons that set of separations allows. In addition, several are sector funds so it is often not straightforward to compare within the group.
There are 27 funds in the category as it is defined by cefconnect:
AllianzGI NFJ Dividend, Interest & Premium Strategy Fund (NFJ)
Blackrock Enhanced Capital & Income Fund, Inc. (CII)
BlackRock Enhanced Equity Dividend Trust (BDJ)
BlackRock Global Opportunities Equity Trust (BOE)
BlackRock International Growth & Income Trust (BGY)
Cohen & Steers Global Income Builder, Inc (INB)
Columbia Seligman Premium Technology Growth Fund, Inc. (STK)
Dow 30 Premium & Dividend Income Fund Inc. (DIAX)
Eaton Vance Enhanced Equity Income Fund (EOI)
Eaton Vance Enhanced Equity Income Fund II (EOS)
Eaton Vance Risk-Managed Diversified Equity Income Fund (ETJ)
Eaton Vance Tax-Managed Buy-Write Income Fund (ETB)
Eaton Vance Tax-Managed Buy-Write Opportunities Fund (ETV)
Eaton Vance Tax-Managed Diversified Equity Income Fund (ETY)
Eaton Vance Tax-Managed Global Buy-Write Opportunities Fund (ETW)
Eaton Vance Tax-Managed Global Diversified Equity Income Fund (EXG)
First Trust Enhanced Equity Income Fund (FFA)
GAMCO Natural Resources, Gold & Income Trust (GNT)
Guggenheim Enhanced Equity Income Fund (f/k/a Old Mutual/Cla (GPM)
Madison Covered Call & Equity Strategy Fund (MCN)
Madison Strategic Sector Premium Fund (MSP)
NASDAQ Premium Income & Growth Fund Inc. (QQQX)
Nuveen S&P 500 BuyWrite Income Fund (BXMX)
Nuveen S&P 500 Dynamic Overwrite Fund (SPXX)
Voya Global Advantage & Premium Opportunity Fund (IGA)
Voya Global Equity Dividend & Premium Opportunity Fund (IGD)
Voya Natural Resources Equity Income Fund (IRR)
Yield and Discount: Two Key Metrics
I'll start by reviewing the NYDP chart for the funds. I’ve marked the Eaton Vance funds in a dark fill as I have already covered them. This chart plots Discount/Premium level against NAV yield. I use it as a screening tool to identify funds that may be poised to move away from their current discount/premium valuations. Funds that fall well above the trend line show a likelihood to lose discount/premium value and those falling well below that line have a tendency to move in the other direction. As always I caution that this is nothing more than a screening device. Its value, such as it is, increases as the funds that make up the population it’s based on become more similar. And, while each of the funds here employs a fundamentally similar strategy there is a broad range of variation in how they each approach that strategy. That variation tends to blunt the value of this analysis.
For an example of how this chart can be useful, notice the outlier positions for ETV and ETB. Being that far above the trendline is, to my way of looking at this chart, a strong indication that they may be overvalued. It tells me that a detailed look at those funds may be in order: Perhaps they've earned those premiums or perhaps investors have bid them up unjustifiably. As we saw in the discussion of the Eaton Vance option-income funds, ETV and ETB are, in fact, carrying questionable premium valuations. That’s not to say those valuations are going to disappear tomorrow, but there is a strong probability that it could happen soon. In fact, it does seem to be happening in ETB’s case as indicated by its three and six month Z-scores, which tell us that ETB has been giving up discount.
But our interest here is in the other 19 funds. At least three of those (STK, QQQX and SPXX) are also well above that trendline. On the other side, NFJ stands out as being the fund most distant below the trendline. Others that look potentially interesting: IGA, IGD, IRR, GPM and, perhaps, ETJ which I discussed in the EV article.
I’ll be coming back to those, but let’s look at the funds in a bit more detail first. In this overview I am only going to address two metrics, yield and discount. As I follow up in the coming days, I'll pick up other details.
This next table lists market yields and discounts for the 27 funds. I’ve included a column noting the rank of the funds as well (1 is best, i.e. highest yield or deepest discount).
Making Sense of Discounts and Premiums: The Z-Scores
Z-scores show that the discounts have been compressing over 3, 6 and 12 months for the category as a whole. This has been a general case across a broad spectrum of closed-end funds so there's nothing exceptional about that fact. There are, however, a few funds with negative Z-scores. Most notable of that small group are ETB and EOS, which I discussed in the EV article.
Above the Line
Let's start with those funds that fall above the NYDP trendline.
Two of these also have exceptionally high Z-scores as well. These are the Nuveen funds that write options on the S&P 500 and NASDAQ 100, SPXX and QQQX. Nuveen reorganized their equity-option funds with a goal of reducing discounts. That objective seems to have turned successful, especially in the cases of QQQX, which now holds a small premium, and SPXX. It’s been slower taking hold for DIAX but there too the discounts are shrinking. And may well continue to shrink behind all the attention the Dow's record run of record highs is getting these days. The third fund I called out is STK, a long-time favorite of mine. It has been heading in the opposite direction. Its negative Z-scores tell us that it has been moving away from its apparently excessive premium valuation, in essence the reversion to mean that the NYDP plot can often predict.
In my own holdings, I recently sold QQQX. It was a fund I bought into with the idea that Nuveen would be successful at reducing the discount. As that strategy played itself out, I exited the fund. For various reasons, I’ve not been that attracted to this set of funds other than to potentially take advantage of Nuveen’s commitment to move them away from their discounts. My other purchase from this group was DIAX. I continue to hold DIAX but I am looking for the timely exit there as well. For those who follow my High-Yield, Stable Captial portfolio, both QQQX and DIAX are components of that portfolio.
The third fund in this group is STK. STK is one of my oldest CEF holdings as well as one of the first CEFs I wrote about for Seeking Alpha. That article (Tax-Deferred, 12.8% Distribution: Columbia Seligman Premium Tech Fund) dates from near the time of my first purchase of the fund in October 2013. STK operates entirely in the technology sector. It is, in my view, exceptionally well managed by people who understand technology certainly but also understand option investing for income. One only has to look at their performance record to appreciate how effective STK's management has been. I’m reluctant to suggest a fund that is priced at a premium and looks potentially overvalued on some metrics and I'm not adding to my position under those conditions. But I will also point out that it has deeply negative Z-scores, perhaps reflecting the rough times technology has seen in the recent past. In digging up the citation for that 2013 article I happened to notice that the very first comment in it was from a reader suggesting that ETW would be a more advisable purchase. In response I noted the bargain price of STK relative to ETW. Some things never change. (Well, since you asked: STK has gained 98.7% on total return since that date. ETW? 32.4%. And if you bought when I wrote about a second time in Feb 2014, three years ago: STK, 74.7%, ETW, 23.8%).
Below the Line
Let’s look now at funds below the trendline.
IGA and IGD have moderate Z-scores for 6 and 12 month, but these have turned more positive for the 3 month time frame. Z-scores with absolute values below 0.5 are essentially in a normal range as they vary from their mean values by less than half of a standard deviation. But for the past three months the funds have jumped to 1.55 (IGA) and 1.92 (IGD) which can be seen as worrisome territory. These are both international funds from Voya. They have performed well against the category for several years although IGD did falter in 2015 and IGA missed in 2016. But in this category they are up against many purely domestic equity funds, and domestic equity has been outperforming international equity over those time frames. Thus, one may take their performance as good, even impressive given the handicap that the international mandate has been. I’ll add that there may be a recovery trending in international equity although there are also strong headwinds as well. In any case, I would not be uncomfortable expanding my allocation in developed markets equity, perhaps less so that I would be in expanding in the overheated domestic equity market. Each of the two has a portfolio comprising about half domestic and half international, nearly all developed markets, equity. For an investor considering a high-income position in international equity, either could be a good choice. I’ve put both on my list for a more detailed look.
NFJ is well positioned on these metrics as well. It has the deepest discount (-11.9%) and its market yield is at the upper third of the category. NFJ is also the outlier of the group in terms of its portfolio which goes beyond option-writing and dividends from common stock to include about 27% in convertible securities. It too is an international fund although the current breakdown by countries is not clearly stated either on cefconnect or the Allianz website. It uses an index call strategy in its option writing. In its stable of CEFs Allianz has several hybrid funds that include convertible securities as a part of their portfolios. It is an intriguing strategy that is something of an Allianz specialty. Convertibles tend to perform well in difficult markets, so it is an approach that adds a second defensive slant to the already defensive option-income approach. There may be an appeal in that combination for someone concerned about the sustainability of the bull market.
IRR is also well positioned for yield and discount. It ranks 5th for distribution and 10th for discount, 10.3% and -8.6%, respectively. IRR's investing arena is natural resources, especially energy. One point that I find noteworthy is that IRR has reduced the distribution twice since June 2015. The quarterly payout was cut from$0.2520 to $$0.2020, -20%, for the July 2015 payment and from there to $0.1620, another -20%, for Jan 2017. That’s a total decline in the distribution of -36% over a year and a half. This was, of course, during a time when the energy sector was suffering deep cuts across the board. Presumably these cuts have left the fund with a more stable and more sustainable distribution at this point. If you think there's still upside left in the energy sector's recovery, IRR could be a good choice although I'm inclined to think there are more attractive income opportunities available in the sector.
Finally there’s GPM. It ranks second for distribution and has a mid-pack discount which at -6.2% ranks 15 of 27. It’s an interesting fund in that it only holds indexes and writes calls on them. But GPM is a changing fund. On 13 Feb shareholders approved a merger of three Guggenheim closed-end funds with GPM slated as the acquiring fund. Guggenheim Enhanced Equity Strategy (GGE) and Guggenheim Enhanced Equity (GEQ) will be merged into GPM effective 20 March. Discounts have deepened for all three funds since the announcement. I have not seen a clear indication from Guggenheim on how the revised fund will operate.
Of this lot, IGA, IGD and NFJ generate the most interest for me on the basis of the metrics I’ve looked at here. Each is worth a deeper look. Furthermore, it's my view that each offers an attractive alternative to the Eaton Vance funds I discussed yesterday.
Once again, I remind readers that I've only looked at two parameters here, discounts and yields. There is, of course, a lot more to consider in evaluating a CEF for purchase or sale. I've tried to give a capsule version of the funds' flavors, but there is a lot that has gone unnoted in this survey. In addition, there are funds that don't stand out on that one chart and I've ignored here. There may well some interesting opportunities in that set as well. If you have a fund there that you favor I invite you to pass your thoughts along in the comments.
Disclosure: I am/we are long EOS ETY DIAX GGE STK.
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.
Additional disclosure: I am not an investment professional and this article does not constitute investment advice. I am passing along the results of my research on the subject. Any investor who finds these results intriguing will certainly want to do all due diligence to determine if any security mentioned here is suitable for his or her portfolio.