Closed-End Funds (“CEFs”) are often an income-investor favorite, thanks to their big steady dividends (often double-digit yields, many of them paid monthly). However, CEFs have some important nuances and can differ widely among categories. In this report, we share updated data on some of the most popular big-yield CEFs (the top 10 by market cap), including specific risks and attractive opportunities. We have a special focus on Guggenheim’s widely-popular 13.4% yield Strategic Opportunities Fund (NYSE:GOF), plus a few more, and then conclude with our strong opinion on how best to invest in the CEF space right now.
The following table includes the top 10 most popular CEFs (by market cap) that also offer at least a 6.5% distribution yield (and many of them much higher). We included the Morningstar categories of Global Income, Investment Grade, Multi-Sector, Sector Equity, US Equity, and Real Estate. And as you can see in the table, these CEFs vary widely in terms of performance, discounts/premiums versus NAV, leverage and more.
(PDI) (DNP) (UTF) (UTG) (GOF) (CLM) (BMEZ) (ADX) (GAB) (PDO) (PTY)
For reference, we also included the top 11 through 25, and you likely recognize at least a few of your favorites on this list. Let’s start by reviewing the widely-popular GOF, considering it’s one of only two funds on the list that has actually posted a positive year-to-date price return.
As you may have noticed in the table, GOF offers a very large distribution payment (paid monthly) and that distribution has never been reduced (only increased) since its inception in 2007. This big, steady, growing distribution income makes GOF very popular among some investors. However, others immediately express concern over its very high premium versus NAV (currently around 25%).
If you don’t know, unlike other mutual funds or exchange trade funds (“ETFs”), CEFs can trade at wide premiums and discounts as compared to the aggregate value of their underlying holdings (because there is no immediate mechanism in place to ensure the market price stays close to the net asset value, or NAV), thereby creating unique risks and opportunities. Let’s dive into the details on GOF to help explain why its big premium may not be as dangerous as some investors think.
With an inception date of 26-July-2007, GOF describes its investment objective as follows (emphasis ours):
The Fund’s investment objective is to maximize total return through a combination of current income and capital appreciation. The Fund will pursue a relative value-based investment philosophy, which utilizes quantitative and qualitative analysis to seek to identify securities or spreads between securities that deviate from their perceived fair value and/or historical norms. The Fund’s sub-adviser seeks to combine a credit managed fixed-income portfolio with access to a diversified pool of alternative investments and equity strategies. The Fund’s investment philosophy is predicated upon the belief that thorough research and independent thought are rewarded with performance that has the potential to outperform benchmark indexes with both lower volatility and lower correlation of returns as compared to such benchmark indexes.
As of 31-Aug-2022, the fund held approximately 96% fixed-income securities, and you can see a more detailed holdings breakdown below.
GOF is one of the largest CEFs with over $1.4 billion in assets. And many investors have grown to love it over the years because its big monthly distributions to investors have never been reduced (only increased), and per the following CEF Connect chart.
For many investors, it’s hard to not love a 13.4% annualized yield (paid monthly) with an impressive track record like GOF!
However, one of the most concerning characteristics of GOF is that its shares currently trade at more than a 25% premium to its NAV. That means if you add up the value of all of GOF’s current holdings, they are worth significantly less than the market price of GOF. Here is a look at the historical price premium/discount (versus NAV) for GOF.
CEFs are different than other mutual funds and exchange traded funds because there is no immediate mechanism to bring the market price in-line with the NAV. And as such, big premiums and discounts can exists (thereby creating risks and opportunities) as you can see in the chart above. We generally prefer to purchase attractive CEFs at a discount (not a premium) because it is like buying quality assets on sale (i.e. the fund gets all the income and NAV prices gains, but at a discounted “on sale” price). However, GOF has some important “uniqueness” that should be considered.
Unlike many CEFs, GOF can somewhat easily issue more shares whenever it wants. And what is particularly amazing is that they have recently been able to issue the shares at the market price (i.e. a big premium to NAV), which means people are actually willing to buy new shares at a premium—thereby instantly creating value for existing shareholders (i.e. the new share issues are NOT dilutive—they’re actually beneficial). Here is a look at GOF shares outstanding at its two most recent year ends (including a breakdown of new shares issued).
To add a little color on the share issuances, some came from shares issued for a recent fund merger (two other Guggenheim funds merged with GOF in late 2021, and investors in the old funds had their shares replaced with new shares of GOF), some came from GOF’s dividend reinvestment program (more on this momentarily) and some came simply from GOF offering new shares in the public market at a price premium (a good thing—almost a bit of an “arbitrage,” some investors might argue).
GOF offers a dividend reinvestment program (“DRIP”) whereby shareholders receive shares of GOF instead of cash dividends (unless they opt out, and instead actively choose the cash—in most cases). And what is impressive about the DRIP is the “dividend shares” come from the open market when they are trading at a discount (a good thing—buy existing shares on sale) or from newly issued shares when they trade at a premium in the market (also a good thing—free premium money as compared to NAV). Here is how Guggenheim describes it in their annual report.
We encourage shareholders to consider the opportunity to reinvest their distributions from the Fund through the Dividend Reinvestment Plan (“DRIP”)… When shares trade at a discount to NAV, the DRIP takes advantage of the discount by reinvesting the monthly dividend distribution in common shares of the Fund purchased in the market at a price less than NAV. Conversely, when the market price of the Fund’s common shares is at a premium above NAV, the DRIP reinvests participants’ dividends in newly-issued common shares at the greater of NAV per share or 95% of the market price per share. The DRIP provides a cost-effective means to accumulate additional shares and enjoy the benefits of compounding returns over time. The DRIP effectively provides an income averaging technique which causes shareholders to accumulate a larger number of Fund shares when the market price is depressed than when the price is higher.
This impressive common-sense DRIP program makes the current large price premium a little easier to swallow in our view.
Of course there are other risk factors investors should consider when investing in CEF’s, such as those described for GOF below:
Another risk factor for CEFs is the use of leverage (or borrowed money). CEFs commonly borrow money to help boost returns and income. This can be attractive in the good times (i.e. when the market is up), but painful in the bad times (i.e. when the market is down—like this year).
Leverage is typically limited to 50% for bond funds and 40% for stock funds. GOF’s leverage ratio was recently ~25%, which we view as acceptable (and actually a bit conservative) for a fund like GOF. You can see in the chart below, GOF shares are down ~12.3% this year, which really isn’t that bad as compared to many of its peers (such as PIMCO multi-sector funds which use higher leverage and are down more). And this year’s declines don’t really bother some investors at all considering the big steady monthly distribution payments just keep rolling in.
CEFs can source income for their distributions through a variety of places, such as interest income on the underlying holdings, capital gains and return of capital (“ROC”). You can see the recent breakdown for GOF in the table below.
It would be great if fund’s could source all their income from income on underlying holdings and long-term capital gains, but from time-to-time they recognize short-term gains and ROC in order to maintain the big steady distribution payments that investors love.
If you hold CEFs in taxable accounts, it’s important to know ROC can reduce your cost basis in the fund, which means you could be surprised with a large capital gains tax if/when you do sell your shares.
Overall, we view GOF’s sources of distributions as prudent and attractive given the long-term total return goals and the big steady monthly distribution payments.
Management fees and expenses are another factor investors should keep in mind. GOF’s annual expense ratio was recently 1.83% which may seem high (and it is considering it detracts from your gross returns), but it is reasonable. Keep in mind, the expense ratio includes the fund’s management fees, operating expenses (including interest expense on leverage). GOF’s expense ratio, based on common assets, excluding interest expense was 1.51%.
Also know that GOF invests in bonds that you probably couldn’t get access to on your own (because they trade in massive quantities or require special legal expertise—such as bank loans), and GOF is likely better able to manage leverage (and borrow at a lower rate) than most individual investors could.
If it is big steady monthly income you seek, GOF remains a decent option. The fund appears well managed and positioned to keep delivering those big steady distributions. And the large market price premium (as compared to NAV) is not as risky as some investors may think (because of GOF’s ongoing “at-the-market” offerings and its well-executed DRIP program). We’d prefer to buy at a discount (or at least a smaller premium), but wouldn’t fault anyone too much for buying now, and we also understand those that have owned shares for many years have likely done very well in achieving their goal of big steady monthly income. You can read more about GOF here.
Having reviewed GOF gives us a decent overview of important things to consider when reviewing a CEF. With that backdrop in mind, let’s get into a few other names on our list.
With a massive 13.0% yield and a massive $4.4 billion in assets, this PIMCO multi-sector bond fund is revered by many. Often times, investors don’t mind that it trades at a premium to NAV (although current premium is significantly smaller than its all-time highs) and because the fund has a track record of delivering. For example, it’s never reduced its distribution payments to shareholders (only increased them) and it just recently announced another special year-end distribution. We recently shared more details about our views on PDI as compared to individual bond opportunities (which are increasingly very attractive right now with yields rising), and you can read that report here.
If you like the idea of investing in bond funds, but prefer to avoid the big price premiums of PDI and GOF, you might consider BTZ. It offers a healthy yield, a more conservative use of leverage than PDI and trades at a significant discount to its NAV (currently -9.2%). It also has a lower expense ratio. Some investors consider BlackRock to be a second-rate manager compared to PIMCO, but the reality is BlackRock is a massive well-established organization with tons of resources to support its CEFs (there are a handful of them on our list). We don’t currently own shares of BTZ, but we have owned it in the past. It’s attractive and sits high on our current watchlist. You can read more about this BTZ here.
Switching gears from bond funds to stock funds, UTG is also very popular and very attractive for its long track record of big growing distributions. This fund is unique because it invests mainly in the Utilities sector (primarily through common stock, but also some preferred shares and even some bonds too).
For some perspective, the Utilities sector is known for its lower volatility than other sectors. Utilities stocks also generally pay higher dividends than other sectors, so this helps UTG keep its yield high with less leverage (or borrowed money) than some other funds (the funds leverage was recently just over 18%—equity funds are generally limited to 30% by regulation).
Also important to note, UTG is concentrated. Unlike other CEFs that can hold hundreds (or even over 1,000) of individual securities, UTG currently holds ~44 securities. This allows the fund to pursue strong performance by putting more weight into top ideas.
Further, UTG focuses on tax-advantaged income (qualified dividends, which can reduce your tax bill if you hold UTG in a taxable account). The distribution has steadily increased throughout history, but the total distribution history below looks bumpy because UTG also occasionally pays special dividends too. Said differently, UTG has never reduced its distribution (only increased it).
Also, UTG’s monthly distributions (which have steadily grown over time) generally consist of investment income and long-term gains (not short-term gains or return of capital). It’s good to avoid short-term gains (because they can be taxed at a higher rate) and to avoid ROC (return of capital) because it can reduce the cost basis on your investment so you get hit with a bigger capital gains tax when you do sell your shares.
If you are looking for big, steadily-growing, monthly income sourced from a steady sector of the market and currently trading at only a very small premium to NAV, UTG is attractive and worth considering. You can read more about UTG here.
If you are a contrarian income-focused investor, CEFs give you a lot to choose from, especially considering most stock and bond funds are down significantly this year. And while CEF strategies vary widely, you’ll likely want to consider some of the same metrics across strategies, such as leverage ratios, fees, discounts/premiums and more, all while staying true to your own individual investment goals.
If you appreciated the data in this report, you might also want to consider our expanded list in this report: 100 Big-Yield CEFs: Ranking Our Top 5. However, at the end of the day, you need to choose investments that are right for you, based on your individual situation. Disciplined, goal-focused, long-term investing is a winning strategy.
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Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.