CEF School: Distributions 101 - Distributions Are NOT Dividends

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Includes: NHF, UTG
by: Maks F. S.

Summary

Discussion of distributions and how they differ from dividends.

A look into the 4 main sources of distributions.

A look into the Return of Capital concept.

Over the last few weeks, I have had a number of readers ask me about closed-end fund distributions. After writing an article on the Reaves Utility Income Fund (UTG), it became apparent that there was a major problem with retail investors confusing distributions with earned dividends. "UTG: Good Trade, Issues As An Investment"

The 60+ comments on that article inspired me to do a follow-up taking a deep dive into the fund's distributions to illustrate my original thesis, that UTG's distribution was not safe. That follow-up was "It's About The Quality - UTG Dividend Case Study."

The distribution quality article also generated a response with over 60 comments, many of which appreciated the breakdown yet there were still many who were not concerned.

One of my goals for Income Idea, my Seeking Alpha marketplace service, besides providing quality research is to provide education that will give investors the ability to perform their own due diligence on closed-end funds and other investments. As such, we started developing "CEF School," a series of articles and audio resources devoted to the various aspects of researching closed-end funds and ETFs.

Because I am realizing this is as big of an issue as it is, I wanted to publish the article and audio that I have done covering CEF distributions.

This article was originally published for Income Idea subscribers on 9/23/2017.

CEF School - Distributions 101 - Distributions Are NOT Dividends

Distributions are like drugs to income focused investors, and closed-end funds ("CEFS") and sponsors are the drug dealers.

One heck of an opening sentence, right?

There is a huge problem in the financial services and investment industries. This problem does not only affect retail investors but also affects many financial professionals, both novice and experienced.

The problem that I am talking about is the confusion around and confusing "distributions" with "dividends."

Financial professionals with experience dealing with private investments and non-traded REITs, BDCs and CEFs are typically knowledgeable about this issue after numerous lawsuits within the industry, and are extremely careful to use the correct language.

Inexperienced professionals and most retail investors are oblivious to the simple fact that not all distributions are the same, especially for closed-end funds. Many sponsors who depend on large management fees for continued income may focus on showing a large distribution, knowing that a large part of the retail investors will mistake it for an earned dividend. Seeing this confusion in fund articles and comments only cements this and calls for further education on this topic.

What is a Distribution?

Unlike incorporated entities such as stocks, investment companies and organizations such as REITs, BDCs and mutual funds of most kind (including closed-end funds, interval funds and open-end funds) are formed to be taxed on a "pass-through" basis. As such, any money that is paid out to you is a distribution on which you will pay YOUR tax rates based on the final gain breakdown as reported at the end of the year on the fund's 1099.

To maintain their "tax free" status, the funds must generally pass through,

  • 90% or more of their net investment income from dividends and interest payments.
  • 98% or more of their net realized capital gains.

What makes up a distribution?

This is the key question that investors should be asking themselves.

There are 4 sources of distributions for most funds and we will focus on CEFs.

  1. Interest payments on fixed income holdings such as bonds and senior loans,
  2. Dividends from equity holdings, such as common and preferred stocks,
  3. Realized Capital Gains,
  4. Return of Capital (tax concept).

Please note "Return of Capital," also known as RoC is a tax concept, and not an economic concept. Many people confuse "Return of Capital" with "Return of Principal." We will discuss this later; however, the best way to consider it is just like distributions vs. dividends.

There are generally three sources for Return of Capital.

  1. Pass-through distributions from investments like Master Limited Partnerships ("MLPs")
  2. Unrealized Capital Gains
  3. Return of Principal (getting your own money back)

So as we can see, all "Return of Principal" is "Return of Capital" but not all "Return of Capital" is Return of Principal."

Quality Of The Distribution

The most important part of the discussion is to be able to determine from where the distribution comes from and what it is made up of.

For fixed income funds, the vast majority of the distribution should come from "Income," predominantly bond and loan interest.

If it is a multi-asset fund, you may also see some "dividend" income.

Both "interest income" and "dividends" are higher quality earned incomes and what you want to see. Just below that is income that is generated from realized capital gains.

This is where things get interesting and the discussion splits up.

For a fixed income fund, such as the majority of high yield, senior loan, investment grade corporate and municipal bond funds, you SHOULD NOT see capital gains as a regular part of the distributions. If you see it, this means one of two things. First, the fund manager is buying and selling bonds, which is okay but it should not be the main goal of the fund unless it is stated as such. The second is that the fund is DEPENDING on locking in capital appreciation in the drop in bond yields in order pay out distributions. This will reduce the underlying NAV over the long term as the base of income generating assets is sold off.

For an equity fund, realized gains will likely make up a portion of the income IF the fund is actively managed and has higher turnover, buying and selling equities for a profit. This would be 100% okay for funds such as the NexPoint Credit Strategies Fund (NHF) which actively seeks total return, but it is NOT okay in my opinion for an equity income fund such as the numerous utilities funds or those funds designed to invest in dividend payers, such as the Reaves Utility Income Fund.

At the end of the day, both "Income" and "Capital Gains" distributions are good; however, while you can more or less rely on the "income" distributions, you CANNOT rely on "capital gains" to come. There is NO reasonable guarantee or certainty that the fund can continue to buy and sell to lock in gains. There is, however, some certainty that income payments will come for bonds as long as the companies do not go into default.

The last type of distributions are the "Return of Capital" distributions.

As we now know, RoC comes in a variety of flavors, some good, some not so good.

Generally speaking, outside of covered call funds and funds invested in MLPs, there should not be any Return of Capital.

For a covered call fund, it is completely okay. To generate income, the fund writes call options on which they receive income upfront and distribute. Those transactions are later closed out for a gain or loss. This is essentially "unrealized capital gains." Gains that the fund is expecting will come in the future and will be recategorized as realized gains. Of course, there is no guarantee that it will happen, and if it does not, it will simply be return of capital, over-distributing the fund's earnings.

For an MLP fund, it is pass-through income and in many cases, due to tax treatment, RoC of RoC. =)

In any other funds, Return of Capital is either "unrealized gains" which we just discussed or simply Return of Invested Capital, which would be return of principal.

The best way to judge the "quality" of RoC on an ongoing basis is in the performance of the fund's NAV, or net asset value.

Bottom Line

After reading or listening to this lesson, I hope you now understand that the distribution alone is NOT what matters. What matters is the health and quality of that distribution.

Often times what may start out as a great fund with a great strategy may turn into an investment with an unsustainable distribution.

Fund managers will have to either cut that distribution to maintain its durability OR maintain the distribution which will have a destructive effect on the fund's net asset value.

In future lessons, we will go further in depth on measuring distributions and their impact on the overall health of the fund.

Audio Version can be found on Soundcloud.

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Disclosure: I am/we are long NHF.

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.