EXD Strategy Change May Generate 10% Alpha

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About: Eaton Vance Tax-Advantaged Bond&Option Strategies Fund (EXD), Includes: ETB, ETV
by: George Spritzer, CFA
Summary

Eaton Vance Tax-Advantaged Bond & Option Fund has recently changed its strategy and is really a brand new fund - Eaton Vance Buy-Write Strategies Fund.

EXD currently trades at an 8.1% discount. Its new Eaton Vance "peers" will be ETV and ETB which currently trade at premiums over NAV.

The fund is lowering its expense ratio by 25 basis points.

The fund has pre-announced a 32% distribution increase in March 2019.

The Eaton Vance Tax-Advantaged Bond Options Strategy Fund (EXD) was a fairly small covered call closed-end fund with about $100 Million in assets under management. The fund performed fairly well in some time periods, but there were other periods where its performance was very poor when the "iron condor" strategy suffered big losses.

(Data below is sourced from the Eaton Vance website unless otherwise stated.)

After 8 years of mediocre performance overall, the Board of Trustees decided to completely overhaul the fund. In many ways it is like a new IPO, except you can buy it at a discount instead of paying the usual sales charge:

1) Name Change

The fund's new name is "Eaton Vance Buy-Write Strategies Fund". It keeps the same ticker symbol, EXD.

2) Revised Investment Objectives

The primary objective will be to provide current income and gains, with a secondary objective of capital appreciation. The fund will evaluate gains on an after-tax basis and will try to minimize and defer shareholder federal income taxes.

3) New Investment Policies

Instead of owning tax-exempt bonds, the fund will own a diversified portfolio of common stocks and will sell indexed covered calls (a "buy-write" strategy). The common stocks are divided into two "segments":

a) Segment 1 (50% to 75%): Seeks to exceed the total return performance of the S&P 500. S&P call options will be sold on at least 80% of the value in segment one.

b) Segment 2 (25% to 50%): Seeks to exceed the total return performance of the Nasdaq 100. Nasdaq 100 call options will be sold on at least 80% of the value in segment two.

Over time, the percentage allocated to each segment can vary based on the investor advisor's evaluation of market conditions.

For tax reasons, The new Fund will limit the overlap between its stock holdings and each of the S&P 500 and Nasdaq 100 to less than 70% on an ongoing basis. Because of this, the Fund may own stock that is not in the S&P 500 or Nasdaq 100. Here is a link to a Twenty-First Securities Corporation article that explains this tax provision in more detail:

Twenty-First Securities Corporation - Strategies For The Professional Investor

The Fund plans to sell the S&P 500 and NASDAQ 100 call options that are exchange-listed and "European style". These options may be exercised only on the expiration date of the option. Index options are different from individual stock options in several ways:

- index options typically are settled in cash rather than by delivery of securities.

- index options reflect price fluctuations in a group of securities or segments of the securities market rather than price fluctuations in a single security. Because of this, they generally have lower implied volatility.

- index options tend to be more liquid and trade with a tighter bid-asked spread.

4) Very Similar to Two Existing Eaton Vance CEFs

EXD is currently selling at an 8.6% discount to NAV which is somewhat lower than its five-year average of -10%. But remember that EXD will be changing its stripes shortly. Going forward, it will be almost a clone of two existing Eaton Vance funds:

- Eaton Vance Tax-Managed Buy-Write Opportunities Fund (ETV): Owns a portfolio of large-cap growth stocks and writes index calls on the S&P 500 and Nasdaq 100. Currently trades at a 6.78% premium over NAV.

- Eaton Vance Tax-Managed Buy-Write Income Fund (ETB): Owns a portfolio of large-cap stocks and writes index calls on the S&P 500. Currently trades at a 1% premium over NAV.

5) EXD Has Pre-Announced An Annual Distribution Increase

EXD currently pays a quarterly distribution of $0.16. But the fund will be raising the annual distribution yield significantly as part of a managed distribution plan starting in March 2019. The new fund will pay monthly distributions of $0.0708, which is equivalent to $0.2124 per quarter. That is an increase of 32.8%!

There are many closed-end fund investors (and maybe some computer bots) that are focused on fund distribution changes. The 32.8% distribution increase may "wake up" some investors who were unaware that EXD is completely changing its stripes. This could be a catalyst to narrow the discount.

6) The New EXD Will Have A Lower Expense Ratio

The investment advisory fee will be reduced to 1.00% of average net assets from the existing 1.25%. This 25 basis point reduction should be a big help in reducing the EXD discount.

Portfolio Management

The new fund will be managed by Michael A Allison, CFA and Thomas Seto. They also manage ETB and ETV, which is another reason why the EXD discount should eventually move closer to the discounts/premiums of the other two funds.

Portfolio Performance

Normally, I present past portfolio performance in my articles, but since EXD is completely changing next week, it is more like an IPO.

Here is the historical total return NAV performance of ETV which is very similar to the new EXD. The 3-, 5-, and 10-year returns are annualized.

YTD

5.48%

1-Year

1.71%

3-Year

10.66%

5-Year

9.08%

10-Year

12.32%

The discount to NAV as of February 12 is -8.11%. The one-year discount Z-score is +1.1 and the one-year average discount is -11.82% which would normally imply that EXD is slightly overvalued. But, in this case, the fund is completely changing next month, so it makes more sense to compare its discount with ETV and ETB. Compared to its new peers, its 8.1% discount is quite attractive.

Source: cefanalyzer

Some Alpha Will Be Generated by Discount + Distributions

The high distribution rate of 9.58% along with the 8.1% discount allows investors to capture alpha by recovering a portion of NAV whenever a distribution is paid out.

Whenever you recover NAV from a fund selling at an 8.1% discount, the percentage return is 1.00/0.919 or about 8.8%. So the alpha generated by the 9.58% distribution is computed as:

(0.088)*(0.0958)=0.0090 or about 90 basis points a year in discount capture alpha.

Note that this will recover most of the baseline expense ratio, so you are effectively getting the fund management for a very low cost.

Eaton Vance Buy-Write Strategies Fund will pay monthly

  • Total Assets = $102 Million
  • Annual Distribution (Market) Rate = 9.58% (starting March 2019)
  • Fund Expense ratio = 1.10% (estimated - starting March 2019)
  • Discount to NAV = -8.11%
  • Average Daily Volume = 52,677
  • Average Dollar Volume = $470,000
  • Writes Indexed covered calls
  • No leverage used

This looks like a good opportunity to buy EXD. It is not very liquid - the bid-asked spread is usually around two cents but can be as high as four cents at times. For larger purchases, you may want to split up your order into smaller sizes. The old EXD was designed for taxable accounts, but the new EXD should be a good investment in retirement accounts or taxable accounts. In taxable accounts, it is expected that a good portion of the distributions will be return of capital.

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The Power of Multiple Cash Flow Streams

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*Total return, expected forward yield, and income stream data provided by E*TRADE.

Disclosure: I am/we are long EXD. 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.