Equity CEF Preferreds As Better Income Assets

Summary

• Sharp moves in asset prices have shined the light on the behavior of leveraged equity CEFs that have issued senior securities like preferred stock.
• In times of distress, these funds focus on protecting senior security holders at the expense of common shareholders.
• We compare common and preferred shares of leveraged equity CEFs from an income investment perspective using GUT as a case study.
• While there is nothing wrong with leveraged equity CEFs as a structure, income investors may prefer to hold their senior securities, which behave much more like income investments.
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The last few months have seen extreme moves in asset prices. This kind of outsized market volatility has underlined the fragility of certain asset classes and investment vehicles. In this article, we compare the behavior of common and preferred shares of leveraged equity CEFs, using the Gabelli Utility Trust (GUT) as a case study.

Our main takeaway is that investors should be careful about owning highly volatile assets in leveraged CEF wrappers. This is because of the likelihood of CEF deleveraging during periods of sharp drowns, potentially locking in permanent capital loss to investors. This is a consequence of the fact that fund managers will shift their focus on prioritizing protecting holders of senior securities at the expense of common shareholders.

This has two important implications for common holders. First, even if the asset prices fully recover, the NAV of the CEF will remain below its starting point. And secondly, because the deleveraging will tend to lower the earning capacity of the CEF, it is likely to be forced to cut its distributions. This can result in an odd situation where common holders end up holding a fund that generates a lower yield on their original cost basis than the yield of senior securities.

For this reason, we prefer holding exposure to volatile asset classes either through open-end funds that have no leverage or through senior securities of CEFs.

We maintain the following CEF preferreds on our Focus List:

• GAMCO GGN Trust 5% Series B (GGN.PB)
• GAMCO GNT 5.2% Series A (GNT.PA)

Both series are investment-grade rated and have stripped yields of around 5% and asset coverage of over 500% in both cases.

Source: Systematic Income Focus List

CEF Leverage Recap

We often read comments here and elsewhere that say something like "CEFs must maintain their leverage below X". A quick

Analyst’s Disclosure:I am/we are long GGN.PB, GNT.PA. 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.