Income Closed-End Funds: Best To Check Under The Hood

by: Downtown Investment Advisory

Closed-end funds have many attractive features for the income investor.

However, many investors simply choose funds based on yield and trading discount.

Know what's in your fund - examine credit quality, duration, dividend coverage, etc.

This article will discuss some of these aspects, with a sole focus on fixed-income closed-end funds.

The are hundreds of Closed End Funds (CEFs) available to the investor, with many in the fixed income space, both taxable and non-taxable. There are many attractive aspects to a CEF:

  • Many funds trade at discounts, allowing the investor to pay less than net asset value, boosting yields.
  • CEFs utilize leverage, thereby boosting yields. While this aspect also increases risk, a good fund manager will be able to take advantage of low borrowing rates with modest added risk. I consider the yield generated by the leverage as effectively an offset to the high management fees many CEFs charge.
  • As a "closed" fund, the fund manager is never forced to sell assets in a panicked market, in direct contrast to mutual funds and ETFs like HYG and JNK. This is an important feature in my view.
  • CEFs offer diversification, and entry into niche fixed income areas not accessible to most investors (e.g. mortgage securities).

As a high income focused Registered Investment Advisor, CEFs are certainly and important part of my "toolbox," although individual bonds form the core basis of my portfolios. I have recommended CEFs on Seeking Alpha, including this article on TSLF (up nearly 15% since recommended) and invest in several others (including some term CEFs, that liquidate on a date certain). I have also seen many recommendations for CEFs on Seeking Alpha, but without much detail about what is "under the hood." This is where investors can get into trouble. Before buying any CEF, I consider the following:

1. Examine the underlying holdings for credit quality.

Many CEF buyers neglect this aspect. The first thing to do is examine the top 10 holdings. Anything of major concern? I typically spend some time examining the credit quality of some of the top positions. Here are some examples of concerning issues:

  • As most municipal bond investors are aware, the State of Illinois is in trouble. Many muni bond CEFs are overweight Illinois. Just like with Puerto Rico bonds, funds load up on lower quality munis to boost yields. This article explains what is happening. Well known muni CEFs are overloaded with IL bonds. NEA has 13.3% and NVG has 14.1% exposure, and I am sure there are many others. As a muni bond CEF holder expecting high safety, are you sure this is what you want?
  • Dreyfus High Yield Strategies (DHF) might seem like an attractive fund, sporting a 9.2% yield and trading at a 3.3% discount. It has done well in the last 10 years, with an 8-9% annual return (both at price and NAV). However, I see dangers ahead. There is heavy exposure to overleveraged borrowers like Sprint and cable companies related to Altice (Neptune Finco and Numericable). Scientific Games is leveraged nearly 8x. Not surpisingly, DHF has 16.5% of its assets in CCC rated bonds. This is a fund to avoid in my view.

2. Check fund duration.

It's commonly understood that longer dated bonds have higher yields. In order for many CEFs to boost yields, they extend maturities. In today's current environment where long term rates appear to have reached a bottom and the Fed is likely going to continue to raise the Fed Funds rate, pressuring longer term rates (which are set by the market, not the Fed), now is not the best time to buy CEFs with long dated holdings.

Here is one example of a fund recently pointed out to me. Nuveen Build America Bond (NBB), a popular fund due to its high credit quality, decent distribution for this credit quality (nearly 6%) and 4.5% trading discount. However, a quick scan of the top holdings shows bonds maturing in the 2030s and 2040s. I have not examined each bond and considered possible earlier call dates, but overall the underlying holdings are long dated. The fund reports a leverage adjusted effective duration of 10.2 years (so average maturity is even longer) -- which means the fund is very vulnerable to a sharp rise in rates, which could easily wipe out 1 to 2 years of income in a flash. Long durations are especially an issue for high grade fixed income CEFs, as usually the only way to make these yield attractive is to go very long dated. These funds may still fit an investor's needs, but be sure you aware of the risks being incurred.

3. Examine actual dividend coverage

This one seems obvious, but few investors take the time to check the financial statements to see if actual net investment income (NYSEMKT:NII) covers the distribution. Remember to remove the noise of changes in the market prices of the underlying holdings, which does not affect interest income earned. Also, do no rely on the fund website or a website like CEF Connect which shows income and ROC (Return of Capital) amounts.

Here is an example of a fund that was not covering it's dividend and did not actually report any ROC in its distribution on CEF Connect. The financial statements foretold an eventual distribution cut, and more cuts are likely. Western Asset High Income Opportunities (HIO) is a popular CEF trading at about a 10% discount and 7.1% yield. But the distribution is not being covered by NII. For the six months ended 3/31/17, NII was $22.6 million but the distribution was $24.9 million -- a nearly 10% shortfall. Unrealized gains, which do not represent income and are not recurring, masked the shortfall and NAV actually rose over this same time period. The distribution was recently cut from $0.0305 per share per month to $0.03, but it seems more cuts are likely. A $0.027 rate seems more appropriate. HIO may still be worth considering (although I am not a buyer), but future distribution cuts must be factored in.

At the end of the day, I typically find only a handful or two of income CEFs at any one time that meet all my criteria, after careful analysis of the underlying fund holdings, duration, and income coverage. Of course I still like to buy funds at a discount (I loathe paying a premium and typically avoid any premium above 1%) and earn a decent distribution yield. Duration risk (i.e. interest rate risk) is my number one focus in fixed income investing right now.

Author's note: Please consider Downtown Investment Advisory's subscription service through Seeking Alpha, The High Yield Bond Investor. The newsletter offers deep analysis of three recommendations per month and constant, real-time follow-up, including High Yield Bonds, Exchange Traded Debt, Preferred Stock and Closed End Funds. In fact, the newsletter has recommended three CEFs in the past few months. The newsletter focused on yields in the 6-8% range, with maturities of four to seven years, for the buy-and-hold investor. We seek to uncover undervalued and "off the radar" opportunities. The newsletter does not recommend high dividend stocks. Read subscriber reviews here. Please see our profile page for important disclaimers.

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: DIA holds TSLF in both personal and client accounts