Seeking Alpha

Let's Learn About CEFs: Distributions And Return Of Capital

|
Includes: DNP
by: David Van Knapp
Summary

This is the 4th article in an educational series about CEFs.

There are four components of CEF distributions. Three of them are pretty straightforward.

One of the components, return of capital, is vexing to many investors.

Let's remove the mystery and learn about CEF distributions in a businesslike fashion.

This is the fourth article in an educational project about CEFs. Here are the previous articles in the series, called Let’s Learn About CEFs.

Drawing on my experiences as a stock investor, I am approaching CEFs not only as funds but also as companies with business models and operations that are capable of being understood by self-directed investors.

As companies, CEFs are unique in that they don’t make tangible products like hamburgers or offer services like waste management. Their “product” literally is money itself.

When I analyze stocks for long-term investing, the key questions invariably become:

  • How does the company make money – what is its business model?
  • Is the model sustainable – can they keep doing it for years and years?

The same two questions pertain to CEFs.

In the last article, we learned techniques that CEFs use to come up with the large amounts of cash that they distribute. The subject of this article is: What are the sources of cash distributed by equity CEFs?

CEFs Pay “Dividends” or “Distributions”

Under the Investment Company Act of 1940, the payouts made by CEFs are described by the phrase, “…any dividend, or… any distribution in the nature of a dividend payment.” Indeed, the section of the Act that controls payouts is entitled “DIVIDENDS.”

I read that as meaning that is fine to call the payouts from CEFs “dividends.” Nevertheless, many sources go to some length to distinguish “distributions” from “dividends” when describing CEF payouts.

For example, Morningstar states the following:

Closed-end funds have distribution rates, not yields or dividend rates. The distribution can be comprised of dividends, interest income, realized capital gains, and return of capital.

I think what such sources are trying to do is distinguish the dividends received from stocks held by the CEF from the total payout that the CEF makes to its common shareholders.

That is an important distinction, because CEFs pay out more than just the dividends they receive. Therefore, I am going to adopt the convention of referring to CEF payouts as “distributions” rather than dividends.

But I don’t buy the idea that it is not correct to call CEF payouts “dividends.” I have seen a couple disputes about this, and they seem silly once you read the actual law.

Components of CEF Distributions

Section 19 of the Investment Company Act of 1940 identifies what CEFs can distribute. In language that only a lawyer could love, it does so in a backward fashion by specifying what is unlawful for a CEF to distribute.

I have added italics and extra spacing to the following to make it easier to read and focus on the important words.

DIVIDENDS SEC. 19.

(A) It shall be unlawful for any registered investment company to pay any dividend, or to make any distribution in the nature of a dividend payment, wholly or partly from any source other than

(1) such company’s accumulated undistributed net income, determined in accordance with good accounting practice and not including profits or losses realized upon the sale of securities or other properties; or

(2) such company’s net income so determined for the current or preceding fiscal year;

unless such payment is accompanied by a written statement which adequately discloses the source or sources of such payment. The Commission may prescribe the form of such statement by rules and regulations in the public interest and for the protection of investors.

(B) It shall be unlawful…for any registered investment company to distribute long-term capital gains, as defined in the Internal Revenue Code of 1954, more often than once every twelve months.

In plainer English, CEFs can distribute:

  • Undistributed net income accumulated since inception
  • Long-term capital gains
  • Other monies as disclosed in an accompanying statement

The accompanying statement is known as a “19 (a)” or “19a” statement. Those are delivered to each shareholder at the time of each distribution.

Often a CEF’s monthly or quarterly distribution includes more than one component. Let’s go through them.

1. Dividends

Dividends come from stocks in the CEF’s portfolio. Dividends are direct cash flows into the CEF, and they fit the legal definition of net income.

I will continue to use DNP Select Income Fund (NYSE:DNP) as an example to illustrate principles in real life. DNP holds around 70% of its assets in utility stocks (and the stocks of “quasi-utility” companies like Verizon (NYSE:VZ)). Therefore, it is no surprise that a large percentage of DNP’s distributions are sourced from the dividends that DNP receives from its equity holdings.

In its April, 2019 semi-annual report, DNP listed its investment income for the prior six months.

The dividends that DNP received from stocks are marked by the maroon dots.

When those dividends are passed through to you as a shareholder in the fund, your tax responsibilities are the same as if you owned the stocks yourself.

Depending on what equities they hold, some cash inflows from equities are not technically dividends.

For example, a CEF might hold shares in a master limited partnership. MLPs are themselves pass-through entities, and their payouts are considered return of capital. We’ll examine this flow-through ROC in a later section of this article.

2. Interest

Many equity CEFs – including DNP – own interest-bearing assets such as bonds. So-called income CEFs own mostly bonds and similar instruments.

The income from bonds is the second source of distributions to CEF common shareholders. As with dividends, interest is a direct cash flow into the CEF and fits the basic definition of net income.

As an illustration, DNP’s interest receipts in its April report are marked above by green dots.

When that interest is passed through to you as a shareholder, you report it as such on your own tax return, and it is taxed according to the tax regulations that apply to you.

3. Net realized capital gains

The next category of CEF distributions are net realized capital gains.

CEFs trade the stocks in their portfolios. Like all of us, when they trade, they realize gains and losses. Regulations require CEFs to distribute most of their net realized gains each year.

When a CEF’s realized capital gains exceed their realized capital losses, that results in net realized capital gains. That is not money sent to the CEF – like dividends and interest – but rather it is generated by the portfolio’s trading activities. In other words, it is an outcome of the CEF’s execution of its business model.

Here is DNP’s reporting of its distributions during fiscal 2018. The capital gains component is marked by blue dots.

As with the other components of distributions, the tax consequences of stock trading flow through to the CEF shareholder.

Whether or not to sell assets to realize capital gains for distribution is a choice that CEFs make. They don’t have to do it. But until they are realized, gains are just on paper. They must be converted to cash to be available for distribution.

Selling shares creates at least three consequences that CEF management will take into consideration in deciding whether to sell shares to augment its distributions.

  • Selling shares to realize gains creates tax liabilities for shareholders.
  • By selling shares, the fund reduces its asset base, thus pruning potential sources of future gains and income pertaining to those sold shares.
  • Opportunities to sell shares for gains come and go. Regular selling to top off distributions works well when the underlying assets are appreciating. However, extended periods of asset depreciation can have negative consequences, such as reducing the fund’s net asset value or forcing it to reduce the distribution.

You may recall that the Investment Company Act prohibits CEFs from distributing net capital gains more often than once per year. If a fund wants to distribute gains more frequently, as many do, it can apply to the SEC for an exemption. For example, DNP obtained such an exemption in 2008, and it is permitted, subject to certain conditions, to make distributions of long-term capital gains monthly if it so chooses.

That brings us to the final component of distributions, return of capital. This subject is so involved that it gets its own full section in this article. Please read on.

Return of Capital

1. Introduction

Much of the information in this section comes from Nuveen, Eaton Vance, and also from Ms. Connie Luecke, who is the Senior Portfolio Manager of the DNP Select Income Fund that I am using to illustrate principles. I also found these SA articles helpful:

The distribution components that we have seen – dividends, interest, and net capital gains – are available for distribution when they are received or realized by the CEF.

It is a fund’s choice whether to pay a distribution amount greater than is available from the first three sources.

Why would a fund wish to pay out more than it is taking in?

  • Larger distributions make the fund more attractive to investors. Most investors own CEFs specifically for their cash-generating capabilities.
  • Many funds have managed distribution programs [MDP] that target specified distribution levels. The target amount for a particular distribution may be more than the distributable cash that an ETF has on hand. For example, DNP has such an MDP. It has paid the same distribution amount ($0.78 annually per share) since July 1997, and it created the MDP in 2008 to maintain that amount.
  • As articulated by Nuveen, a fund’s strategy may involve converting its expected long-term total return potential into attractive, tax-efficient, regular distributions that exceed what the fund is generating right now. Its funds may therefore use ROC to top off a distribution when short-term returns fall short of the fund’s long-term potential.

Return of capital is an emotional subject with CEFs. I think its name is unfortunate, because it sounds like the CEF is just sending some of your own money back to you – returning principal. Terms like “destructive return of capital” heighten the emotion.

Emotion rarely helps the investor. I believe that investing should be treated as a business, with emotion sidelined, because that tends to lead to better decisions.

So, let’s walk through return of capital, demystify it, and remove as much emotion as we can.

2. Definition of return of capital

Let’s start with a general definition. I looked at several sources, and to be honest, I am not satisfied with the definition of ROC from any of them. They are often complex, confusing, and loaded with examples and exceptions rather than being a simple direct definition.

So let’s create the following basic definition of ROC.

Return of capital is any portion of a CEF distribution that does not come from dividends, interest, or net realized capital gains.

Note that the definition does not say that your principal is being returned to you. It doesn’t say that ROC is necessarily destructive of NAV or anything else.

ROC is an accounting concept, part of a systematic process of identifying and classifying financial information. When part of a distribution exceeds the cash generated from the sources described earlier, the fund will identify that portion as return of capital.

On its face, ROC is neither good nor bad. What it means to you will be a function of your goals and preferences. As DNP says in its most recent semi-annual report, “A return of capital distribution does not necessarily reflect the Fund’s investment performance.”

3. Common sources of ROC

(A) Pass-through ROC

If the CEF receives a distribution from a pass-through entity, that distribution is re-passed through to the CEF’s shareholders as ROC. Nothing is destroyed.

Ms. Luecke told me that most of DNP’s fiscal 2018 ROC was from the fund’s investments in MLPs.

(B) Gains from options

We saw in the last article that some funds sell options to increase the amount of money that they distribute. Doug Albo’s recent article explains in some detail how “option income” strategies work. Option strategies typically involve writing calls on the stocks held by the fund.

Option premiums paid by the buyers of the calls satisfy the definition of ROC. Money is passed along to shareholders by the CEF. Nothing is destroyed.

(C) Unrealized capital gains

As I have learned from dividend growth investing, the best dividend growth companies have strong businesses that support annual dividend increases. The longest streaks now run beyond 60 years. Such companies clearly must have not only the financial performance but also a policy commitment to increase their dividends every year if they possibly can.

In a similar sense, CEFs that target steady uncut distributions must manage their funds skillfully to maintain consistent distribution records over time.

For a particular distribution, a fund may not have generated enough investment income or net realized capital gains to meet the targeted distribution. So, in this case, the fund may choose to add some ROC to hit the target.

As stated earlier, Nuveen articulates this as converting a fund’s expected long-term total return potential into attractive distributions that sometimes exceed what the fund is generating right now. They illustrate the situation like this:

[Source]

The interesting layer in that stack is the aqua one, Unrealized Capital Appreciation. It is part of both Fund Capital and Total Return.

  • It’s part of Fund Capital, because being unrealized and undistributed, the money is still in the fund.
  • It’s part of Total Return, because funds mark everything to market value. While the gains are unrealized, they nevertheless count when the fund’s assets are accounted for in this way.

Note that as long as the fund’s distribution component based on unrealized capital gains do not exceed unrealized gains over the long term, the initial capital contributed by investors in the fund remains untouched. Nothing is destroyed.

For funds with sufficient and recurring unrealized capital gains, using ROC to top off the distribution has positive aspects.

  • The fund isn’t required to sell investments before they achieve their full potential.
  • The CEF shareholder is not subject to immediate taxation. Instead, ROC reduces the cost basis of the CEF. This in turn creates more capital gain (or less capital loss) when the investor sells their shares in the fund.

(D) Other sources of ROC

ROC may come from other financial management strategies that are too detailed to get into here. Examples would be currency hedges and interest rate swaps.

Also included would be distributions based upon anticipated dividends that have not yet been collected by the CEF. Since that income is not yet in the CEF’s hands, it would fit the basic definition of ROC.

Is Return of Capital Bad?

1. In general

Some investors believe that all return of capital is bad. They equate ROC with a decline of the capital in the fund – thus, a loss – even though we have seen that some ROC does not represent losses in the funds’ assets.

In reality, return of capital can be either good or bad.

We saw above that Nuveen sees ROC as a tool to convert the expected long-term total return potential of a fund’s portfolio into its current distributions. The risk of doing that is that the CEF may pay out distribution amounts that are badly judged and do, in fact, exceed the sustainable returns of the CEF.

Going back to basic stock investing principles, remember that when you buy shares in a CEF, you are not just buying a slice of its assets. You are buying a slice of everything the CEF owns and does. You are buying into its business model and investment strategy as well as its assets and liabilities.

You are also buying into how well they execute. Strategy and model are one thing, execution is another.

And the fact of the matter is that some CEFs pay distributions that are not prudent. They are too high. While that might help the CEF to market itself in the short term, over long time periods, the strategy may not be sustainable. That would happen if a CEF’s distributions are consistently eating into its net asset value.

2. Assessing ROC by examining NAV and distribution levels

The prevalent ways to assess whether ROC is “destructive” are to consider what has been happening to the CEF’s net asset value and its record of maintaining its dividend.

While past performance is no guarantee of future results, the rules of thumb are:

  • If a fund’s NAV has been generally staying flat or going up, then its ROC distributions have not been destructive. The fund is not slowly liquidating itself to make excessive short-term distributions. If a fund’s NAV increases over time, the fund has been earning its distributions. If not, the fund has not been earning its distributions.
  • If a fund has recent distribution cuts, management probably pushed past their safe distribution rate. The cuts indicate that management had to reduce the payout rate to a more sustainable level.

Going back to my retirement analogy, a fund cannot keep topping off distributions with ROC while its NAV falls, because eventually there will be no assets left in the fund.

In retirement planning, that would be called exceeding the portfolio's safe withdrawal rate. A prudent retiree would probably cut back his or her withdrawals to maintain the longevity of their retirement funds, just as funds will cut their distribution levels for the same reason.

3. A couple of examples

In later articles, I will get into examining a number of funds’ records to find the “Aristocrats” among them. Here, I just want to provide a couple examples of the points being made.

The first example is the fund I have been using to demonstrate general principles: DNP Select Income Fund.

The above charts start in 2007, which is YCharts’ maximum range for the fund, even though DNP has been around longer than that. It is easy to see that DNP’s net asset value has held pretty steady except during the Great Recession 2007-09 (indicated by the gray band).

Even through the recession, DNP was able to adhere to its MDP-designated distribution rate.

[Source]

The next example shows a fund that has not compiled a performance record like that: BlackRock Energy and Resources Trust (BGR).

BRG has reduced its dividend a number of times, and it is now much less than when it started.

4. Tax consequences of ROC

I am not a tax expert, and this is not a detailed analysis. So I will just quickly summarize the most important point: Return of capital is not considered a taxable event and is not taxed as income.

Instead, ROC lowers the investor’s cost basis in the investment under federal tax law. In other words, it lowers the effective amount that you paid for your CEF shares in the eyes of the IRS.

Thus, if and when you sell the CEF, your taxable gain will be determined by the adjusted cost basis – what you paid minus the accumulated ROC over your time of ownership.

If you never sell the CEF, some would say that the ROC represents tax-free income.

Most investors consider ROC to be a tax benefit, because taxes are deferred until you sell. Anything that defers taxes is usually considered good.

The bottom line is that a fund’s decision to distribute some ROC can be a desirable tax-management decision for the CEF’s common shareholders.

Summary

  • It is not incorrect to call CEF payouts “dividends,” but the convention is to call them “distributions,” because stock dividends are but one component of the payouts made by equity CEFs. Oddly, some CEF experts are didactic or patronizing about this issue.
  • The four sources of equity CEF distributions are dividends, interest, net realized capital gains, and return of capital.
  • Return of capital is an accounting label for distributions that come from sources other than dividends, interest, and net realized capital gains.
  • Return of capital can come from or be supported by several sources, including pass-through distributions received by the CEF (primarily from MLPs), option premiums, unrealized capital gains, and anticipated dividends and interest.
  • Return of capital is not always bad or destructive. Most investors consider the deferred taxes on return of capital to be a good thing.
  • The primary ways to deduce whether return of capital is ultimately going to damage the fund are to examine the fund’s long-term record of maintaining both its net asset value and the level of its distributions.

Please use the comments to correct any mistakes I made, pose questions, and share your own knowledge.

I haven’t finalized the topic of the next article, but I am leaning toward examining the valuation of CEFs. In other words, how do you identify when you can buy one at a favorable or fair price, or when one is overvalued?

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.