Closed-End Fund Advisors: First Quarter 2014 CEF Review and Outlook Summary and WEBINAR REPLAY Links
For those that were not able to attend our Quarterly Research Call on Wednesday April 9th at 4:30pm EST, in which we covered The Closed-End Fund Universe, we have included the slides and replay file with the following summary article, which roughly follows the slide order in the slide deck.
According to our CEF Universe Service dated March 31, 2014, during the first quarter of 2014 the closed-end fund universe ended with 595 funds totaling $259B in total net assets, which reflects an asset growth of about 3% year-to-date. There were 227 total Equity funds and 368 total Bond funds. The average discount to NAV is -6.7% and the average market price yield is7.1%. In general, discounts have been fairly stable during this quarter vs. their previous 9 months of general discount widening.
CEF Yield, Volume and Liquidity: At current market prices and distribution policies, 89% of all CEFs yield over 5% and 53.1% of all CEFs yield between 6.5% and 10%, which we feel is the core income universe for CEFs. Yields for CEFs peaked last summer and while they are still at very attractive, they are off the year-end tax-loss selling highs. The one major sector with an increase to the income-only portion of the yield is US Equity funds which have shown nice increases in March 2014. Trade volumes are down in March vs. the first quarter by about -4%; this trend is most pronounced in National Muni CEFs, which are trading down -8% and Non US CEFs, which are trading down -10% on average. Liquidity for CEFs is trending down from the abnormally high levels during the tax-loss selling season of the fourth quarter of 2013. Currently about 63.7% of closed-end funds trade over $500K a day in average liquidity, with less than 3% of CEFs trading over $5M a day in liquidity .
Equity CEFs: These funds had an average discount to NAV of -7.98% this quarter, which is .1% ahead of their average discount during the quarter. However the group did also have an average 1-year Z-Stat of -0.13. The average total market price yield is 7.8%, of which we estimate will be comprised, in 2014, of 44.9% income, 32.1% capital gains and 23% return of capital (RoC) on average. The average expense ratio is 1.71%. The average net assets figure is $537M. The average liquidity figure is $1.40M per day. Of the outstanding shares in this grouping, 21.9% of the shares are institutionally held and 8.19% of those shares are considered, by our firm, to be held by activists or activist followers.
Taxable Bond CEFs: These funds had an average discount to NAV of -5.68%, which is in line with their average discount during the quarter, but had an average 1-year Z-Stat of only -0.18. The average total market price yield is 7.4%, of which we estimate will be comprised, in 2014, of 93.2% income, 1.8% capital gains and 5% return of capital (RoC) on average. The average expense ratio is 1.65%. The average net assets figure is $454M. The average liquidity figure is $1.43M per day. Of the outstanding shares in this grouping, 20.67% of the shares are institutionally held and 6.40% of those shares are considered, by our firm, to be held by activists or activist followers.
National Municipal Bond CEFs: These fundshad an average discount to NAV of -5.8%, which is wider than their average discount during the quarter by -0.3%, and an average 1-year Z-Stat of -0.21. The average total market price yield is 6.3%, of which we estimate will be comprised, in 2014, of essentially 100% income on average. The average expense ratio is 1.46%. The average net assets figure is $436M. The average liquidity figure is $897K per day. Of the outstanding shares in this grouping, 10.03% of the shares are institutionally held and 2.57% of those shares are considered, by our firm, to be held by activists or activist followers.
Bond Fund Fundamentals: We have seen relative undistributed net investment income (UNII) levels rising for the average municipal bond CEF since November 2013 while levels have remained rather stable for the taxable bond CEFs since mid-December 2013. Earnings coverage for taxable bond and municipal bond CEFs has been trending up since mid-summer 2013; as this data point is based on both the dividend level and earnings, now that dividend cuts are occurring at lower levels for municipal funds, this metric is more bullish in our opinion for that sector. Looking forward, we hope to see the volume of dividend cuts reduced and earnings coverage improved for the taxable bond portion of the CEF universe.
Return of Capital (RoC) Trends & Destructive RoC: Return of Capital (RoC) has been trending down since May 2013 for the average Equity fund, which is positive for the sector. We believe it was due to such strong NAV gains last year making gains easy to find for most Equity CEFs. Most Municipal Bond CEFs are no longer showing small amounts of RoC. There are three Municipal Bond funds showing some RoC on a 90 day basis, but the trend is flat or down vs. 12 month RoC for each fund. The only fund showing over 2% RoC is PCK, the PIMCO CA Muni fund, but the level is down from 11% to 7% in the past quarter.
Destructive Return of Capital, as we calculate it, is currently showing in 53 CEFs for which it comprises about 25% of the ROC for each of those funds. The sectors with the most red flags for Destructive Return of Capital include Specialty Equity (17 funds), which is a sector known for higher use of return of capital, and surprising to us, Taxable Bond CEFs (28 funds). We understand that as our formula for DRoC is based in NAV total return and NAV yield that after a rough year in the bond markets, the figure will be higher than normal.
Business Development Company (BDC) Closed-End Funds: As of March 2014 our firm has initiated coverage of all 47 BDC CEFs, totaling $30.4B in total assets, in our weekly CEF Universe File under a separate tab. We think of BDCs as yieldy “CEF cousins,” as they are 40 Act closed-ended investment management companies and fit into our definition of a CEF; our definition is 1. permanent capital, created at an IPO, 2. active management of portfolio holdings and 3. investor liquidity by listing on a stock market. We interviewed Prospect Capital (PSEC) in early March and released the interview March 29thfor subscribers to The Scott Letter. If you have not seen this interview you can sign-up for free on our website to receive the PSEC interview as well as future issues.
For the 47 BDCs that currently exist, market capitalization ranges from $22M to $5B with an average of $661M, and market price yield ranges from 1.2% to 22.8% with an average of 9.4%. On a one year market price total return basis, the 39 funds with a 12 month track record averaged 13.5% with a range of funds between -9.7% and +57.3%. Net asset value (NAV) is only produced quarterly for these funds. About 2/3 are externally managed; their fee structure often looks like 2% and 20%. BDCs are generally dividend driven investments, like most CEFs, but we have learned it is important to track the quality of the income and how the fund is holding or maintain net asset value over time under different market conditions. We think investors should look at BDCs as a way to diversify their income portfolio with minimal concern for principal losses due to a rising interest rate environment as long as you take a diversified approach. We suggest selecting 5-7 BDCs, depending on the amount of exposure you want in your portfolio, to allow for some diversification yet avoid simply indexing the sector. With the recent news of indexes removing BDCs, many funds are trading at price levels we find attractive. We do generally try to avoid paying more than a few percent above a fund’s last reported NAV, or book value as sometime referred to by the funds. The average fund trades about $7.2 M a day in liquidity so it is fairly easy to move into most funds for most portfolio sizes.
Municipal Bond Update: National and State Specific Municipal Bond CEFs currently account for $63 billion in net assets. Average earnings coverage for the sector is just below 100%; at 99.6% for the national funds and 98.8% for the state focused funds. Duration is averaging 11.48, if one includes leverage in the calculation, which is typically 30-40% for most of the Municipal Bond funds. The sector has 89% investment grade paper and an average discount of -6%; 54% of the funds in this sector show discounts wider than -7.5% and yields averaging 6.3%, with 62% of the funds yielding over 6.5%. These figures give us a fairly positive opinion of the National Municipal Bond sector.
Investors new to Muni CEFs need to be aware that they currently have an average NAV volatility of 6.2 but a noticeably higher average market price volatility of 13.3. However, the average market price volatility is down from the 15-16 range in recent months. Liquidity can be an issue for this sector; 69% of funds in this sector have daily average trading liquidity under $500K. We think that with many investors having just paid, or about to pay their generally higher tax bills for 2013, that they will be thinking about how to get better after tax results for their taxable investments that they desire to have in the bond allocation. When comparing the yield on a common municipal ETF, MUB of 3.29% a couple with $1M+ in household W-2 income gets a federal tax equivalent yield (TEY) of about 5.7% while the same investors in the average CEF would receive an average yield of about 6.28% for a TEY of 10.91%. If investors live in New York City or California and can blend to about 65% exposure to their own state’s paper the figure could possibly rise to 12% to 13% TEY, based on our CEFU data.
Press Releases During the Quarter: We reviewed about 2300 press releases during the first quarter. Half of these press releases typically involve the distribution level for upcoming dividends; as usual, 90% of those notices were that the level would be maintained, with 153 notices of cuts and 145 notices of increases. We break out distribution changes in two buckets: small changes (Under 5%) and large changes (over 5%). The average small change results in an average increase of +1.9% or an average decrease of -2.5%. The average large change results in an average increase of +20% or an average decrease of -17.6%. In looking over the past 6 months, many of the gains were in the Equity sector of the CEF universe. Municipal bond funds we roughly split with 20 cuts and 18 increases. Taxable bond funds had over 85 cuts and only 35 increases.
NAV vs. Market Price Total Return: During the first quarter, Equity CEFs averaged NAV returns of +3.6% vs. market price returns of +4.2%. Taxable Bond CEFs averaged +3.2% NAV returns vs. market price returns of +4.0%. The best performing sector was Municipal Bond CEFs with NAV returns of +6.7% vs. market price returns of +7.7%. This is not surprising due to both a recovery in the bond market and discounts narrowing by about 3% during the quarter. We do believe that bond CEFs will continue to narrow during the rest of 2014.
Activist / Corporate Action Update: There was little activity in this area during the first quarter, though it picked up somewhat from the fourth quarter 2013. The proposal for ACG to open-end was not approved by shareholders. While many of our contacts thought it would go through, we sold our position soon after the announcement, as we suspected it would have trouble passing based on the shareholder base even though the fund shows activist ownership of about 10% and total institutional ownership of 28%. The other items of note included Karpus adding to Invesco Bond Fund (VBF), building to a 5.3% position (13G filing), and a new 5.2% position in Asia Pacific Fund (13G filing). Bulldog took a new position in Virtus Total Return Fund (DCA), building to a 5.2% level (13G filing). In the past month there have been 206 activist/activist follower increases vs. 76 decreases in share ownership.
Recent CEF Initial Public Offerings (IPOs): There were only 2 IPOs in 1Q 2014; both were MLP focused funds (JMLP and FPL) and raised an additional $700M in assets. These IPOs were smaller than normal ($348M vs. the 2013 average of $580M) and they were both in March. There were no IPOs in January and February of 2014. This is understandable after the tax loss pain of the fourth quarter of 2013. We think we will see about 8-12 IPOS this year. A recent N-2 filing by Tekla has us expecting a third healthcare fund by that firm this year; their other two funds, HQH, and HQL had significant success in 2013 with 52%+ market price total returns for each fund and this year the market price has been just above or below NAV in most cases. The ten year average for IPOs in the CEF Universe is 26 funds per year, averaging $430M each or about $12B in Net New Assets.
The only CEF IPO currently trading above IPO price is RGT, which was not born traditionally, but spun off RVT in the fourth quarter of 2013, greatly reducing the cost of the offering. None of the funds IPOed in the past 3 quarters are trading at a premium except StoneCastle Financial Corp (BANX), a $108M fund which we initially missed and just caught in the past month. However, we are not alone, for some reason both Morningstar and Thomson/Lipper have not added this fund to their databases as of yet. The average discount for a recent IPOed fund is -9.29% and the average price per IPO price is 86.98%.
CEF Mergers: We have seen a large increase in merges since 2012, averaging almost 50 per year in 2012 and 2013. We expect this to wind down this year; we expect less than 20 mergers in 2014 and that it will then settle back into a normal range of 5-10 per year going forward.
CEF Deaths: We have only lost 11 funds in the past 27 months (about 5 per year), which is below normal vs. the long-term average of 8.5 per year. We do not see any reasons for this to change this year.
Closed-End Fund NAV / Market Price Correlation: Currently the average equity fund has a correlation over the previous 90 days to its NAV of 79.8%. Taxable Bond CEFs are showing an average correlation to NAV of 58.3% and Municipal Bond CEFs are showing an average correlation of 83.3%. The funds with more volatile 30 day correlation figures are on average -19% less correlated to their NAV during March than during the entire quarter. We find this is positive when there is both NAV and market price positive performance during the same time period. Historically the major groups of CEFs have averaged correlations as low at 20% and as high as 95% to NAV over various time periods since we started collecting the data in June 2012.
Market Price Volatility vs. NAV Volatility: Bond CEFs are currently showing NAV 1-year standard deviations of 5 to 6 while Equity CEFs have NAV volatilities of 12 to 16. For a CEF’s market price the difference is less pronounced between Equity and Bond CEFs. Bond CEFs are showing market price volatility of 12-13 and equity CEFs are showing market price volatilities of about 16-18. Bond funds are starting to lower in volatility as both the Bond markets and Bond CEF investors act in more rational manors with their investment decisions.
New CEF Universe Data: During the first quarter we added 19 items to our weekly data service. We added a separate tab for BDC CEFs as well as started a log of CEF Deaths, notes on what occurred when a CEF merged, liquidated or open-ended. We included the 6 month and 12 month discount volatility, and summarized the % of the bonds that are investment grade vs. non-investment grade, to make some of our data screening easier. We then added data that gave us more transparency in the types of leverage being used by CEF, and whether it is portfolio leverage or structural leverage. In addition, we included the average cost to net assets of the leverage as well as the percent of the expense ratio that is leverage cost and implied cost of leverage. For Municipal Bond funds we added the percent of the bond callable in forward looking one-year periods, as well as, average price per bond and average coupon to try and avoid muni CEFs with above normal amounts of zero coupon bonds. We wanted to use this data in addition to duration to try and help improve the results for our fund selections. The last small project completed was adding the board’s distribution policy type (managed/level etc.) to help understand the risk of dividend changes for a broader point of view.
CEFA’s 2Q 2014 Outlook: For the quarter we are looking to add exposure to BDC CEFs especially as prices are lower due to the removal of BDCs from various indices; we expect to grow and add many data points this quarter for this sub-sector of funds. We do not see significant overall risk in the near term for Taxable Bond or Muni Bond CEFs, especially in the Senior Loan fund grouping which has had strong NAV performance relative to other Taxable Bonds, but increased discount widening. We expect dividend cuts to slow down across most CEF sectors during the quarter. We expect IPO activity to increase to 3-5 funds launched during the quarter with activist activity picking up a little vs. normal. We think that for Equity funds, investors should understand that if NAV performs well, even if a -15% discount does not change, they have exposure to a dollar worth of assets but only had to pay $0.85 of real money. We are pleased when a discount narrows after we buy it, but that is not the only way to make money in CEFs.
Even though there are better overall fundamentals in Bond CEFs, we expect there to be funds with problems and cuts or poor NAV performance. We suggest investors be selective and not be afraid to make changes to allocations of holdings based on the market or fund specific movements. We think sustainable dividend levels will continue to be an important theme for the year.
The views and opinions herein are as of the date of publication and are subject to change at any time based upon market or other conditions. None of the information contained herein should be constructed as an offer to buy or sell securities or as recommendations. Performance results shown should, under no circumstances, be construed as an indication of future performance. Data, while obtained from sources we believe to be reliable, cannot be guaranteed. Data unless otherwise noted come from our CEF Universe data form March 31, 2014.