Why A CEF Distribution Cut Or NAV Declines Should Not Be A Surprise

|
Includes: ERC, MIN, NHF, PCI, PTY
by: Maks F. S.
Summary

A discussion of why investors need to understand the factors that influence closed-end fund pricing and operations.

A look at the factors that go into the fund's distribution and the underlying NAV.

Warning signs investors need to look for that will precede a catastrophic failure.

Some time ago I ran across a closed-end fund article where both the author and readers were surprised that a particular closed-end fund did not pay out that annual special distribution which they got used to receiving over the previous years.

What made it quite peculiar was that the lack of a special distribution WAS NOT even remotely a surprise to anyone who understood closed-end funds or where the distributions are derived from.

While closed-end funds may seem like an overly complex investment product, the reality is, much like a car, it can be as simple or as complex as you make it.

When you last had a major repair on your car, were you surprised or did you expect it?

One of my guilty pleasures is is browsing Reddit and YouTube for mechanics showing the various catastrophic repairs that come in which are results of people either not bothering with basic maintenance OR not paying attention to the warning signs.

While I would not expect everyone to go out and change their own oil, brakes and tires, everyone should have a basic understanding of how a car works, if so, such catastrophic failures would either not occur or at least would not be a surprise. At the very least, if you had a ticking time bomb, you would get rid of it before it blows up in your hands.

What Does It Have To Do With Closed-End Funds?

Much like a car, closed-end funds and their resultant distributions and general performance can be fairly well predicted if you understand both how CEFs work and the components which make them tick.

Investors who are surprised by distribution cuts and an eroding NAV in a general up market (for that asset class) are much like car owners who are surprised at a major repair bill after ignoring the noises, engine lights and maintenance reminders and saying, "But it drove fine."

In this article, let's take a look at the key components that go into "CEF Maintenance" which have a strong correlation to the long-term health of a closed-end fund.

The Distribution

One of my pet peeves as it relates to pass-through investments such as closed-end funds is when both authors and investors refer to closed-end fund distributions as dividends, when in fact in many times they are not.

A dividend implies that the distribution was earned, either from income or gains. With many closed-end funds, a good chunk of that distribution is simply return of capital.

As pass-through investments, in order to avoid double taxation, mutual funds, BDCs, REITs and partnerships must pass on substantially all of their gains (income and capital gains) to investors.

There is nothing, however, that prevents such funds and investments from giving you back your own money.

While income and gains can be certainly considered "dividends", I highly doubt anyone would willingly consider return of your own money a "dividend."

This is why ALL CEF distributions are distributions. All DIVIDENDS are distributions, but not all distributions are dividends.

Why does this happen?

Distribution Policy

As we have discussed before, one of the key selling points of closed-end funds is the distribution. This is why closed-end funds are so popular with retired investors who are now looking for income.

At the minimum, due to their tax nature, the funds MUST pass through 90% or more of their Net Investment Income.

There is, however, no maximum amount that they can distribute.

Over the years, we have run across numerous funds such as the Wells Fargo Multi-Sector Income Fund (ERC) and the MFS Intermediate Term Income Fund (MIN) which pay out an above average distribution, 9.81% and 9.07%, yet have been on long-term downward pricing trajectories. The reason for this is simple, it is the fund's distribution policies.

While most CEF investors will look at the distribution rate, or as they wrongly call "dividend rate," very few will actually look at the fund's annual reports or prospectus. In those reports and tax documents, they would learn that the fund may have been paying out significantly more than what it earns.

Simply put... a fund CANNOT pay out 9% when it only earns 4% without paying the difference from the invested capital.

Every CEF investor MUST KNOW, and why we take a detailed look in every Income Idea article,

  1. The fund's Distribution Policy.
    1. Is it a fixed % policy such as ERC and MIN? Or a fixed per share amount?
    2. How often is the policy adjusted?
    3. How often is the distribution policy set?
  2. The fund's sources of income for the distribution.
    1. Is the fund predominately distributing strictly from income?
    2. Is the fund dependent on capital gains to support the distribution? (huge RED FLAG for Income/bond funds)
    3. Or outright returning capital? (Red Flag for Income funds, Okay for options income funds)
  3. Percentage of Investment Income that is Available for distributions.
    1. Is the fund paying itself as much in management fees as there is left over for your distributions?
    2. Is the fund paying more in leverage expenses than it earns incrementally?
    3. How much more will the net investment income decrease now that LIBOR rates have substantially increased over the last year?

Over time, as we have seen with numerous closed-end funds with unsustainable distribution policies, the Net Asset Value will decline as funds resort to returning capital.

There was, however, huge help from the lower interest rates that covered up many of such faults.

The "Magic Band Aid"

For me, CEFs tend to fall into one of two categories. The first is close-end funds which have great transparency and an easily to understand and follow strategy. These funds are all those that I would tend to implement with clients. The bulk of the CEFs which I discuss on Seeking Alpha would tend to fall into this bucket.

The second category of CEFs are those that may be riskier, perhaps either due to a less transparent strategy or funds which due to their trading may be a better "Trade" than an investment. One such example is the NexPoint Credit Strategies Fund (NHF) which was best described by one of my readers as a "Hedge Fund in a CEF wrapper." I would typically not recommend any such funds as long-term investments for clients and why I traditionally do not write about them.

Certain PIMCO funds would certainly fall into that second category and others which I would not even consider for myself. This is also why I do not typically write about them unless asked to.

When I did write about one, "PCI - Not For Me" which was subsequently blamed by a few for "crashing PCI," I highlighted a number of key reasons why I would personally avoid [[PCI]] and its sister funds, declining distribution coverage, over distribution and the future headwinds to be faced by the fund due to increases in borrowing costs and decreasing prices on the underlying securities.

One of the most common responses to that article was along the lines of...

"If the fund was over-distributing and things were bad, the NAV would NOT increase!"

And THAT is a terrific observation.

While I did discuss this in my article, "Are You Sitting On A CEF Time Bomb?", let's take another look.

As we know, as bond yields go down, prices on them increase.

Very simply, let's say you own a bond paying 5% which you purchased for $100. Two years later, the same company/government is issuing the same bonds but paying merely 4%.

Are your 5% bonds worth more today or less?

Obviously more.

Thus, almost ANY bond which you purchased more than a few years ago has increased in value today. This holds true for both government...

Chart
20 Year Treasury Rate data by YCharts

...and Corporate debt.

Chart

US Corporate AA Effective Yield data by YCharts

As such, many poorly performing closed-end funds were able to maintain their net asset values by simply "being in the market" and when needed, using leverage.

Obviously, you are not going to be able to cover up paying twice what you earn in an leveraged, high quality bond fund such as MIN...

Chart

MIN data by YCharts

but... it surely helps a fund such as PIMCO Corporate & Income Opportunity Fund (PTY) which has recently started paying Return of Capital to stabilize its distribution and was overdistributed as of last year.

Chart

PTY data by YCharts

Source: CEF Connect

Source: CEF Connect

This is not about one fund in particular, but applies to the majority of closed end funds out there.

Now, more than ever, if we are to believe that the bond markets are about to enter a rising rate environment, the underlying NAVs on the bulk of income focused CEFs will be in for a rude awakening.

How will this show up?

The first and most immediate trouble signs and those which are already evident are,

  1. Deteriorating Distribution Coverage
    1. Funds which have a variable distribution policy are lowering their distributions (like a car going into "limp mode" because it detects a problem. By going into "limp mode" it allows you to get home and avoid a major catastrophic issue).
    2. Funds show either a. declining UNII balances or b. Negative UNII balances (over-distributions) (like a car burning more gasoline in order to maintain performance, this will of course more quickly burn out ignition components and eventually clog up your catalytic converters).
  2. Increased Fund Expenses
    1. As a result of increased cost of leverage (like diluting gasoline with water, will only compound to make other problems worse).
  3. Capital Gains Being Paid Out
    1. Either as a part of distribution for the first time, or (again, for equity funds, capital gains is what you expect, for INCOME funds, it is NOT if it is not a trading fund. Often times, instead of paying return of capital, a fund manager will sell bonds (at a long-term profit) in order to cover the gap between the interest income and the distribution. While this covers the gap this month, you now have less money invested and earning you income in the future).
    2. As an increasing part of the distribution.

To discuss point 3.1 in more detail. There is NOTHING WRONG with earning capital gains. Buy low, sell high is the entire name of the game for equity investing and for trading.

To give an example and let's stay in our car theme, think of the tire business. There are plenty of people out there who buy and sell USED tires. They will buy tires for $10 to $15 each or get them from crashed vehicles. They will then sell them for $25 to $50 each to shops or on Craigslist or Facebook. They made money, capital gains.

This would be what you want in an equity fund.

The issue is for income funds. Income CEFs which pay a steady distribution need to earn it from investment income.

The tire example would be you selling brand new tires off of your car for $50 and replacing them with worse tires for $15 each because you need money to put gas in your gas tank. Yes, your car still runs but will need new tires that much more quickly.

Bottom Line

Even junk cars become more valuable once a year at tax time as people get their refunds and have some money to buy a new car.

Just as so, even mediocre fixed income closed-end funds will seem better than they are when interest rates decrease. Unlike tax time that comes around for a few months per year, we have been in a low and decreasing interest rate environment for the past 10 years. That environment covered up many mediocre closed-end funds through an increase in the underlying demand for the asset class ("NAV").

In summer of 2013, we saw our first "tantrum" which is now dubbed the "Taper Tantrum."

On the mere notion that the Fed ended one of the quantitative easing programs, bond yields jumped. As a result, many closed-end funds declined 10% or more.

Chart

PCEF data by YCharts

The catastrophic failures (for current investors) in many closed-end funds would come from a few sources.

Impacting Net Investment Income

  1. Increasing leverage expenses and management fees eat into the available net investment income.
  2. Continued maturities of legacy assets (i.e., mortgages being paid down in mortgage funds) decrease the amount of higher income sources which have to be reinvested in lower yielding securities. This would be offset however by interest rate hikes going forward.

Impacting Net Asset Value

The big risk going forward will actually be to the Net Asset Values as investment incomes have already been hit.

  1. If bond yields go up, NAVs will decline. The band aid would be ripped off as bonds would be repriced for a higher rate environment.
  2. With the lower investment income, NAVs will take a further hit from funds returning capital as part of the distribution. (OR the funds would be forced to cut distributions which would then surely have an impact on the price per share.)

Does it mean that every CEF should be avoided?

Of course not... but just like there is a better car for every purpose, there are certain closed-end funds that are better positioned than their peers.

Investors need to fully understand what makes their funds tick and find the ones that will work best for them.

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.