Check Out These 2 Covered Call Closed-End Funds

Summary

• Covered call funds generate more income when the VIX is higher.
• This article discusses two covered call CEFs that look attractive now - BDJ and NFJ.
• BDJ invests about 80% in US equities which are strong dividend payers.
• NFJ invests in a global portfolio of about 70% equities and 30% convertible bonds. About 65% is invested in the US companies.
• This idea was discussed in more depth with members of my private investing community, Yield Hunting: Alt Inc Opps. Get started today »

Why Are Covered Call CEFs Attractive Now?

Covered call portfolio managers hold a portfolio of stocks and write call options against a portion of the portfolio to generate additional income.

The covered call segment of the closed-end fund market tends to outperform when:

- Implied volatility is relatively high. I use the VIX indicator to estimate whether option premiums are above or below average. The VIX is currently around 38, which is considerably above average for the last few years. As a general rule, when the VIX is 30 or higher, it is often a good time to consider writing covered calls.

- In a sideways or a down market. You generally give up some upside, but get some downside protection with these funds.

Most of the covered call funds write slightly out-of-the money call options, which allows them to enjoy some upside potential before the strike price is reached. But there is a trade-off since they get less downside protection compared to writing at-the-money or in-the-money call options.

In general, the relative downside to the covered call strategy occurs during very strong bull market cycles when a good portion of the upside gains can be lost when stocks are called away.

The NAV of the covered call CEFs were hurt in March in spite of their option hedges. One reason for this is that the VIX was under 20 in February and rose to 40 or higher in March. A rising VIX increases the implied volatility of short option positions. This causes short-term mark-to-market drops in NAV.

But this can also work in reverse. For example, if the VIX were to suddenly drop from the current 38 back down to 20, the option premium implied volatility would also fall which would benefit the NAVs of the funds.

For this report, I've selected two covered call closed-end funds from the following sponsors- BlackRock and AllianzGI.

1) BlackRock Enhanced Equity Dividend

• Ticker: NYSE:BDJ
• Inception Date: Aug. 26, 2005
• Total Investment Exposure: 1,442 Million
• Total Common Assets: 1,442 Million
• Baseline Expense ratio = 0.87%
• Leverage: None
• Discount = -9.57%
• Average 6 Month discount = -5.95%
• Annual Distribution Rate (market price) = 8.24%
• Current monthly distribution= $0.05
• Annual Distribution = $0.60
• Special 2019 year-end distribution = $0.221
• Three-month NAV Correlation with GDV = 99%
• Three month NAV Correlation with NYSE:NFJ = 99%
• Three month NAV Correlation with CII = 99%

Investment Objective: The primary objective of BDJ is to provide current income and current gains, with a secondary objective of long-term capital appreciation. The fund invests in common stocks that pay dividends and potential for capital appreciation. It uses an option writing (selling) strategy to enhance distributions paid out.

Sector Breakdown (as of March 31, 2020)

Under normal market conditions, BDJ writes options on 30% to 40% of its net assets. But this can vary with market conditions. As of March 31, 2020, 53% of the portfolio was overwritten.

Top 10 Holdings (as of March 31, 2020)

Institutional Ownership

Institutional investors own about 18.5% of the shares outstanding. The top two institutional investors are Wells Fargo (WFC) which owned $22 million and Morgan Stanley (MS) which owned $19 million as of 12/31/2019. These were most likely shares held by financial advisors in managed accounts. There are no activist investor with large holdings, and it is unlikely any would get involved unless the discount widens to 15% or greater.

Source: Nasdaq.com

Investment Performance NAV Return as of 04/24/2020

• YTD -21.55%
• 1-Year -12.41%
• 3-Year +0.07% annualized
• 5-Year +3.09% annualized
• 10-Year +6.35% annualized

NAV performance has gotten off to a rocky start in 2020, largely because of poor performance in some financial and energy stocks. Some of its top 10 holdings that have been hit especially hard are: JPM, C, WFC, BAC, AIG. If there is some reversion to the mean, some of these holdings should do better going forward.

Three-Year Discount History

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2) AllianzGI NFJ Dividend, Interest & Premium Strategy Fund

• Ticker: NFJ
• Inception Date: Feb. 23, 2005
• Total Investment Exposure: 1,139 Million
• Total Common Assets: 1,139 Million
• Leverage: None.
• Baseline Expense Ratio = 0.96%
• Discount = -13.33%
• Average 6 month discount = -11.01%
• Annual Distribution Rate (market price) = 8.39%
• Current Quarterly distribution = $0.225
• Annual Distribution = $0.90
• Three-month NAV Correlation with FFA = 100%
• Three-month NAV Correlation with CII = 99%
• Three-month NAV Correlation with BDJ = 99%

Effective April 30th, 2020, the fund will be renamed to AllianzGI Dividend, Interest & Premium Strategy Fund. (e.g. removing NFJ from the name).

Portfolio Allocation (as of 03/31/2020)

Common Equities	65.19%
Convertible Securities	30.96%
Cash and Equivalents	4.40%
Derivatives	-0.56%

Click to enlarge

Sector Allocation (as of 03/31/2020)

Information Technology	24.64%
Health Care	15.86%
Financials	11.90%
Consumer Discretionary	8.80%
Communication Services	8.34%
Industrials	8.30%
Consumer Staples	5.39%
Utilities	5.32%
Real Estate	4.62%
Materials	3.44%
Energy	3.39%

Click to enlarge

Investment Objective: NFJ seeks current gains with a secondary objective of long-term capital appreciation.

NFJ differs from many of its covered call peers because it uses more of a value approach when selecting its portfolio. It invests about 30% of the portfolio in convertible bonds which provides some downside protection.

Investment Process Option Strategy

• The Fund ordinarily will write call options on some or all of the individual stocks held in the Equity Component of the Fund, depending on market conditions and other factors, and with respect to generally 70% or less of the value of each position.
• As part of the Option Strategy, the Fund will generally write call options with a strike price that is "out-of-the-money" at the time the option is written. In addition to providing possible gains through premiums, out-of-the-money call options allow the Fund to potentially benefit from appreciation in the underlying security held by the Fund up to the strike price, but the Fund forgoes any appreciation above the strike price.
• The Option Strategy is designed to generate gains from option premiums in an attempt to enhance amounts available for distributions payable to the Fund's shareholders.

Top Ten Holdings (as of March 31, 2020)

Johnson & Johnson (JNJ)	2.66%
Microsoft (MSFT)	2.65%
JPMorgan Chase (JPM)	2.02%
McDonald's (MCD)	1.71%
Lockheed Martin (LMT)	1.46%
Stryker Corp (SYK)	1.40%
Alphabet Inc-A (GOOGL)	1.36%
Apple (AAPL)	1.35%
Citigroup (C)	1.31%
Medtronic PLC (MDT)	1.30%

Click to enlarge

Institutional Ownership

Institutional investors own about 30% of the shares outstanding. The top two institutional investors are Morgan Stanley which owned $44 million and Relative Value Partners which owned $27 million as of 12/31/2019. These holdings were likely spread over many managed customer accounts. I would not expect any serious activist activity with NFJ, unless the discount stays above 15% for a period of time.

Source: Nasdaq.com

Investment Performance: NAV Return as of 4/24/2020

• YTD -14.80%
• 1-Year -8.96%
• 3-Year +0.30% annualized
• 5-Year +0.40% annualized
• 10-Year +4.28% annualized
• 15-Year +4.01% annualized

Three-Year Discount History

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Both funds covered in this report have large, well-diversified portfolios. NFJ holds some convertible bonds and is more value oriented. BDJ focuses primarily on dividend-paying stocks. Over the last three months, the NAV correlation of the two funds has been quite high at 99%.

As of April 29, NFJ was trading at a -13.3% discount, while BDJ's discount was around -9.6%. In both cases, the current discount is well below the six-month and one-year averages.

Given the volatile markets we have now, the discounts to NAV can vary quite a bit on a day-to-day basis, so it is worthwhile to monitor these funds in a watch list before making a purchase. For example, NFJ closed at a -21% discount on March 12, and as recently as April 3 traded at a -16% discount. On March 18, BDJ actually closed at a -23% discount before it snapped back.

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Analyst’s Disclosure: I am/we are long NFJ, BDJ. 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.