'Slip, Slidin Away' - What Happens To Funds That Over-Distribute Their Earnings

Aug. 31, 2021 4:31 AM ETDMO, EDF, EDI, EVG, EVV, FAM, FCT, FTF, HTY, JQC, MIN, NAV, TEI60 Comments

Summary

  • If you give away more money than you make, eventually you'll be broke.
  • The same applies to closed-end funds, but fund managers and investors have powerful reasons to want to both pay and receive distributions that exceed the fund's ability to pay.
  • Fortunately there are easy ways to spot it when this is happening, for investors willing to look for the right signs.
  • We identify some "serial eroders": funds that consistently pay out more than they earn, thus eroding the fund's asset value and their shareholders' investments.
  • Looking for more investing ideas like this one? Get them exclusively at Inside the Income Factory. Learn More »

Caution wet floor
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One of the most basic ideas in investing is that, whether you are a corporation or a fund, or just a corner grocery store, you can only pay out in dividends to your owner the amount of money you actually earn. That is, if you want to stay in business.

Paul Simon's classic song "Slip Slidin' Away" talks about what happens in life if you squander your opportunities. The same lessons apply to closed-end funds that squander their earnings paying out more money in distributions than they actually earn. If a fund pays out more than it earns and keeps doing it on a regular basis, the fund will get smaller and smaller and eventually run out of assets and disappear.

For Income Factory® investors, where our entire strategy revolves around collecting high distribution yields from our investments and using those high cash yields to create our own income growth over time (by reinvesting and compounding) it is especially important to be sure that the distributions we collect are stable and sustainable over time.

Without A Crystal Ball, We Look At History

Since we can't tell the future, the best way I know to predict whether a fund will actually earn enough in total return* to maintain its distribution level going forward, is to see whether it has done so in the past. If a fund has consistently earned X amount per year for the past 5 years, and has paid out a distribution each year that is less than X, then that shows the fund has been earning its distribution and, absent other evidence to the contrary, suggests the fund is a reasonable bet to continue doing so. In other words, the distribution is considered to be "sustainable."

*Note that total return is the amount of interest and dividends the fund collects, plus the appreciation or depreciation on its assets, minus its expenses.

On the other hand, if a fund has been earning X amount per year for the past 5 years, but has been paying out a distribution each year that is more than X, then we can clearly see that the find has been "over-distributing" its earnings, paying out more to shareholders than it actually earns (i.e. more than its total return). That suggests the distribution may not be sustainable. I say "may not" be sustainable because there are instances where a fund's prospects looking forward may be better than they were previously, because of changes in the market it participates in, changes in strategy, etc. In those cases, the burden is on the fund management to explain to us why they believe the future will be different than the past, or why the statistics we've just laid out (i.e. comparing past earnings with past distribution levels) don't tell the whole story.

Seems Straightforward To Me; What Am I Missing?

This whole sustainability issue, especially looking at history to see whether a particular fund has actually earned the distributions it has paid out in past years, seems awfully straight-forward to me. That's why I'm sometimes amazed at how much confusion the whole topic of "distribution coverage" still seems to generate whenever I write about it.

Recently I wrote an article about MFS Intermediate Income Trust (MIN), which I called the "Poster Child" for distributing more than a fund actually earns. MIN's distribution of 8%-plus while only earning between 3-4% per annum over the past 10 years is an extreme example of a destructive distribution policy that, if continued, will eventually lead to a substantial shrinkage in the fund's value.

In fact, this spreadsheet (Annuity_erosion_table.xlsx) shows the rate at which a fund's capital, as well as the size of its distribution, would deteriorate if it continued to pay an 8% distribution while only earning a 4% total return over a 25 year period.

As you see, after 25 years, the fund is only one-third of its original size, and its distribution, while still 8% of the now greatly reduced capital value, is only a small fraction of the original distribution. (On the attached spreadsheet, readers can plug in their own assumed distribution yields and earnings, and see what the results would be of various combinations for up to 80 years.)

But MIN is far from the only closed-end fund that over-distributes its earnings, resulting in an unsustainable payout that erodes the value of the fund as a whole and the value of its individual shares. Here is a list of 15 closed-end funds that all have been paying distributions at a rate that is higher than their annualized earnings rate over the past 5 years.

To make it on to this chart, a fund had to show a "gap" between its distribution yield, measured as a percent of its market value as well as its net asset value ("NAV"), over the past 5 years. That would mean that its market value and its NAV must have decreased over the past five years in order for it to pay distribution yields at its current level. Looked at another way, if it were to continue to pay out a distribution yield like it currently does, and its earnings remained at the rate they have been for the past 5 years, then its market value and/or NAV would have to fall.

"Serial Eroders"

There are some funds in the list where the erosion of value has been so obvious that, in my opinion, it would be hard to justify owning the fund, assuming one wanted to maintain the value of one's investment while collecting the distribution. These funds I would regard as "serial eroders" that I would probably not touch with the proverbial ten-foot pole.

There are a few other funds on the list where, even though the distribution rate is less than the earnings over the past five years, there might be some glimmers of hope or other sort of "redeeming" reasons for optimism that could justify holding the funds despite their record of not earning their distributions over the past five years.

Let's examine the list and see which ones fit into which of the two categories. I'll be surprised if this discussion does not elicit some readers' comments.

In the "serial eroders" category I would put:

  • Templeton Emerging Markets Income (TEI) - which pays a distribution of 11% on its market value (10.4% on its NAV) but has earned less than 1% per annum over the past 5 years calculated on it market value, and has even lost money over that time period on its NAV. That means, as a holder of TEI, you've only earned what little return you have because the discount has shrunk, not because the underlying assets actually made any money.
  • Stone Harbor Emerging Markets Income (EDF) - which pays 10% on its market value, which is far less than the 11.8% it pays on its NAV. That difference reflects the fact that EDF sells at a 17% premium, despite its dismal record over the past 5 years of earning just under 3% per annum on its market price; even less (2.3%) on its NAV.
  • Franklin Limited Duration Income Trust (FTF) pays 9.9% on its market value and 10.1% on its NAV (i.e. sells at a small premium), yet has only earned 6.5% per annum over 5 years, even less (4.2%) on its NAV.
  • First Trust/Aberdeen Global Opportunity Income (FAM)- which pays out 9.4% on market value, 9.2% on its NAV, and yet has only earned an annualized return of 6.1% at market and 3.5% at NAV over 5 years
  • Another Stone Harbor fund, its Emerging Markets Total Income (EDI), pays out a generous 9.2% on market value, 10% on NAV, while only actually earning 5.8% on its market price and 2% on its NAV for the past 5 years.
  • And finally, MFS Intermediate Income (MIN), which we have already described in detail, with its 8.7% distribution on price (8.6% on NAV), yet only earning 4.9% (market price) and 3.2% NAV over the past five years (and slightly worse over the previous five), which is why I selected it for "poster child" for destructive distributions in my recent article.

These "serial eroders" make the decision to avoid them a relatively easy one. Some of the others on the list present a more complicated picture, providing investors more of a rational reason to invest in them, despite their past records, if they choose to do so.

One such example is John Hancock Tax-Advantaged Global Shareholder Yield (HTY), which pays a distribution of 9.52% on market value and an almost identical 9.47% on NAV, and yet has only earned an annualized total return of 1.9% (market price) and 3.1% (NAV) for 5 years, and if you dig a bit deeper, it turns out has only earned in the 4.5% range on average for the past 10 years. Despite this, a recent article here on Seeking Alpha expressed confidence that HTY should be able to sustain future distributions because it had managed to do so for the previous 6 months (!) without ever mentioning the dismal 5 and 10 year records (or the fact that the reason the past 6 months looked so positive was because the previous year (2020) had been so negative with huge realized and unrealized losses, that were merely reversed during the most recent 6 month period).

I use this example to emphasize the importance of looking at the broader historical picture and not just a brief recent snapshot in determining the likelihood of a fund continuing to sustain its earnings and distributions.

While HTY may be an extreme example of over-optimism and/or incomplete analysis, there are other examples here where it is genuinely difficult to know how sustainable the current distribution is or how risky it is to hold the fund in spite of the warning signs presented by a historically-based analysis. Two examples are the Eaton Vance funds, Short Duration Diversified Income (EVG) and Limited Duration Income (EVV). Both pay distributions in the range of 9% (EVV) or 10% (EVG), and have only earned 7.4% (EVV) and 6.7% (EVG) for the past 5 years. So based on their history there is no particular reason to expect them to maintain distributions of 9-10%. The reason many investors are finding them attractive right now is the concern about inflation and the expectation that low duration, floating rate funds like these will likely benefit from rising rates, if inflation persists and interest rates rise with it, as they always do. (Disclosure: I own both funds in my personal account, as well as FCT, mentioned below, in one of our Inside the Income Factory model portfolios.)

Similar thinking may be driving investors to hold on to or acquire other shorter duration funds, like Nuveen Credit Strategies Income (JQC) and First Trust Senior Floating Rate (FCT), which are both perceived as potential hedges against inflation and higher interest rates. Similarly for Western Asset Mortgage (DMO), which has had a very strong year-to-date, and many investors may feel will benefit from rising rates in the future.

Conclusions, Anyone?

I take away several things from this discussion/analysis:

  • Cash distribution yields are very important to many of us who follow an Income Factory® or similar strategy.
  • Fund managers know that, and also know some investors hardly look beyond yield in making their decisions on what funds to buy.
  • So there can be an inclination among some fund managers to "pay beyond their means" knowing that will attract some investors who fail to notice, or who even ignore, the erosion in the value of their investment while they are enjoying the cash dividends (some of which are "phantom" or unearned).
  • So we have to really examine closely whether a seemingly generous distribution is real or not.
  • Fortunately that is easy to do, since Total Return equals just two things: cash dividends received, plus appreciation or depreciation in price.
  • So, by definition, if the distribution is more than the total return, for any period, then the price must have dropped, to make up the difference.
  • At the same time, there may be cases where it is reasonable to think the future will not be just like the past, if a fund's prospects look better going forward than they were previously.
  • The problem is that every analyst who likes a particular fund is likely to argue that their fund is special and the future will be different, etc.
  • So be skeptical.


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This article was written by

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Steven Bavaria publishes a boutique marketplace service - Inside the Income Factory® - here on Seeking Alpha, which helps members implement the strategy outlined in his book "The Income Factory: An Investor’s Guide to Consistent Lifetime Returns" (McGraw Hill, 2020).

  

Bavaria introduced the Income Factory philosophy in his Seeking Alpha articles over the past ten years, drawing on his fifty years experience in credit, investing, journalism and international banking. His earlier book "Too Greedy for Adam Smith: CEO Pay and the Demise of Capitalism" exposes the excesses in the CEO pay arena. Both books are available on Amazon. 


Bavaria began his career at the Bank of Boston, handling international credit workouts that included managing a fleet of ships, chasing a Vatican-owned bank in Switzerland, and leading the turnaround of troubled branches in Australia and Panama.

Later he worked at Standard & Poor's, where he introduced credit ratings to the leveraged loan market, helping to open the loan asset class to pensions, mutual funds and specialized investment vehicles like CLOs.

Bavaria graduated from Georgetown University and New England School of Law. He lives in Ponte Vedra, Florida.

Disclosure: I/we have a beneficial long position in the shares of EVV, EVG, FCT either through stock ownership, options, or other derivatives. 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.

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