CEFs: It's Time To Beware

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Includes: ADX, BIF, BIT, BRK.B, CII, DIAX, DSL, EOS, EVN, EVV, EXG, HIX, JPC, NZF, RMT
by: Adam Aloisi

Summary

Investors continue to show interest in CEFs given their income-generating attributes.

While many CEFs may look attractive on a superficial basis, you must peel back the layers of the onion.

Attention should be paid to narrowing discounts and the prospect for future interest rate volatility.

CEFs that may be worthy of further investigation.

While closed-end funds represent a very small corner of the securities universe, the product's focus on income generation has garnered it significant interest in our current yield-starved world.

Consider the following statistics on CEFs as determined via current product-wide data found at CEFConnect.com:

  • ~80% of tracked CEFs are fixed-income or equity-income related
  • ~80% of CEFs post a current annualized distribution rate of at least 4.5%
  • ~80% of CEFs currently utilize strategic leverage to boost returns
  • ~75% of CEFs currently trade at a discount to net asset value

For the individual investor seeking higher income, on the surface, this one-stop package would seem to provide substantial convenience and elevated value relative to other income sources.

Convenience? Yes. Value? Not always.

General Things To Beware

It's easy for an unsophisticated investor to be fooled by CEF operations. If one isn't familiar with the concept of return of capital (ROC), what a covered call is, how to find out how much unrealized gain is currently embedded in a fund, or why undistributed net investment income (UNII) is important, it's possible to be easily hoodwinked when conducting CEF due diligence.

Newbies are apt to simply key to premium/discount data and distribution yield. While that's a generally good start, it's not normally going to be enough to be a successful CEF investor.

While the market discount/premium spread to NAV (net asset value) is simple enough to understand, the more important piece of that relation is evaluation of whether the market's pricing is rational given other fundamental data points in the CEF puzzle.

Though some might see it as a no-brainer to buy assets at 75-80 cents on the dollar (20-25% discount) versus paying 105 cents on the dollar (5% premium) for a comparable CEF, it's quite possible that the latter may prove the wiser investment choice over time. Counterintuitive, I know.

If the premium product is able to outperform by many hundreds of basis points on an annual basis, has significantly lower fees, or other attributes that prove more appealing, the investor may be better off paying up than settling for a second fiddle fund selling for significant discount.

Think of this in terms of the old business aphorism of "sometimes you get what you pay for."

Regardless, savvy CEF investors should constantly be on the lookout for discounts that widen for no apparent reason, as well as undeserved premiums that inexplicably build. The former is a good reason to buy, and the latter a good reason to sell.

Beware The Distribution

Though it's common for CEF investors (and analysts) to mix and match or otherwise intertwine the terms "distribution," "dividend," and "yield," investors need to differentiate. The concept of a CEF distribution should not be seen as parallel to advertised equity dividend yields or bond interest.

It is extremely common for CEFs to include ROC and long- or short-term capital gains as a portion of the fund's distribution. Some funds may also list a "managed distribution" as part of their prospectus materials. Thus the majority of what CEF investors receive from these kinds of funds are not organically generated proceeds.

It is also important to know that some CEF ROC does, in fact, represent organically generated income. For instance, CEFs that generate MLP distributions simply pass that ROC on to their investors. Funds that execute option-income strategies also distribute cash to shareholders that is generally classified as ROC.

So if you are comparing a dividend growth stock yielding 4% to a CEF with a 6% distribution and conclude the CEF as superior from an "income" perspective, you'd be wise to reconsider that analysis.

Beware Shrinking Or Non-Existing Discounts

Perhaps surprising to some, on a recent search, I discovered that over 25% of CEFs trade a premium to net asset value today. That means that investors are willing to shell out more than what the underlying holdings are worth to gain access to the fund.

As noted above, there may be a method to that madness if management is considered superior and the fund has a great track record. Still, if performance turns over or sentiment abruptly changes and investors revert pricing to a discount, that may not prove a particularly wise decision.

The trend for some fixed-income CEFs trading at a discount, particularly over the past few months, has been for those discounts to narrow considerably rather than the opposite. Take, for instance, Nuveen's Preferred Income Opportunities Fund (NYSE:JPC). As can be viewed in an YTD pricing chart below, the fund could have been purchased at as much of a 7.5% discount in March. Today, that discount has narrowed to only two percent.

Source: CEFConnect.com

The same can be said for many CEF equity-oriented funds, particularly option-income funds. Those who've read my past CEF commentary know that I've been very bullish on these funds given recent market conditions. Eaton Vance's largest option fund, Tax Managed Global (NYSE:EXG), has narrowed from a double-digit discount at the beginning of the year to just over 1% as of close of business Wednesday.

Eaton Vance Enhanced Equity-Income II (NYSE:EOS), which was trading at an 8% discount, actually sits, for now, at a mild premium to NAV. I mentioned the fund in an article earlier in the year.

Though not all CEFs have experienced a short-term boost, it has been fairly rare to see a widening discount, with a flat line situation much more likely. Two of the more interesting birds in the CEF equity space - Adams Diversified Equity (NYSE:ADX), f.k.a. Adams Express, and Boulder Growth & Income (BIF), which has nearly a quarter of its portfolio in Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) - have had good years in terms of NAV appreciation. Yet their renowned, chronically wide discounts remain - at around 14.5% and 17%, respectively.

Besides the wide discount, another commonality between the two funds is a managed distribution, making both funds a very tax inefficient choice.

The one space I identified with wholesale widening discounts was the floating rate income funds. Hopes for a sustained higher interest rate environment have fizzled and along with that, demand for floaters. On average, it appears these funds have seen discount widening of between 3 and 5 percent since the spring.

All said, discount value in the CEF space is becoming rather sparse as investors seem to be hunkering down for a continued spate of yield starvation.

Beware The Ghosts Of Interest Rate Past

Following the now infamous "Taper Tantrum" that started in May of 2013, the 10yr. Treasury yield roughly doubled to 3% by the end of the year.

This caused rate sensitive CEFs to plummet as bond prices cratered. Unlike today, however, many high-yield bond CEFs were trading at double-digit premiums to NAV in 2013. Consider the peak and valley of market price in the following chart for Western Asset High Income Fund II (NYSE:HIX).

Source: CEFConnect.com

If you were unlucky enough to purchase this fund in the summer of 2012 at a 15% premium, and sold at the trough in the fall of 2015, you would have lost more than a quarter of your capital, simply due to price movement around NAV. When you factor in the simultaneous drop in NAV, the loss would have been magnified to nearly 44 percent. While this is an extreme example of what occurred, it is illustrative of both the risks involved in buying at a premium and the price volatility endemic to CEF bond funds.

Given that HY funds mostly trade at discounts today, there is certainly a greater margin of safety built in. Still, investors need to consider what kinds of credit, leverage, and duration risk any given bond-related CEF is taking.

Should You Beware Everything?

The short answer is no. But like elsewhere, I'd suggest treading very carefully. The macro environment with frothy equity valuations and near basement interest rates isn't exactly conducive to robust forward-looking returns.

The covered call funds, which I mentioned earlier, aren't as attractive as they once were on a discount basis, but are still a good trade in my view. My cursory screen points toward BlackRock Enhanced Capital & Income (NYSE:CII) and Nuveen Dow 30 Dynamic Overwrite (NYSE:DIAX) as being two reasonable options right now from a blended performance and discount basis.

Aforementioned ADX and BIF, assuming you can own them in a qualified account, are certainly attractive ways to buy large-cap equities for 85 cents on the dollar. Both have good near-term track records. A more contrarian thought might be Royce Micro-Cap (NYSE:RMT) at a 10% discount. However, it has a poor near-term track record and also bears the managed distribution logo.

On the fixed-income side, plenty of muni. funds are trading at double digit discounts. However, with municipal coffers frequently being stressed by pension obligations, you'd be wise to consider just how healthy the finances are of the state you are considering. A better choice may be a national fund that can be a bit more discerning in the states and specific municipal authorities it chooses to take positions in.

Eaton Vance Municipal Income (NYSE:EVN) has one of the better near-term track records and trades at a 4% discount and 5% yield, but it is also one of the higher levered funds. For a bit higher yield, there's Nuveen Muni. Credit Income (NYSEMKT:NZF) that yields roughly 5.8 percent.

On the taxable side, virtually every fund with a good track record is trading at a premium right now. A couple funds that stuck out from a cursory check include BlackRock Multi-Sector Income (NYSE:BIT) at a 7.5% discount and 7.6% yield and Jeff Gundlach's DoubleLine Income Solutions (NYSE:DSL) at a 4% discount and 8.7% yield.

If you think rates are going higher, the floaters are a good idea as well as something like Eaton Vance Limited Duration (NYSEMKT:EVV) at an 8% discount and 7% yield.

Summary

This is not the time to be aggressively buying closed-end funds. If you're new to the space, don't make knee-jerk buy decisions based on small pieces of data that you may not completely comprehend. If you're more of a veteran, while I don't think you need to go into hibernation, the attractive pickings are continuing to dwindle. If your expectations are reserved, there may still be some pockets of value to take a stab at, however.

Still, I'd opine that there's perhaps more to beware than embrace on a collective CEF basis in today's market.

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Disclosure: I am/we are long BLK, JPC, NZF.

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.