Closed-End Fund Advisors: Second Quarter 2014 CEF Review and Outlook Summary and WEBINAR REPLAY Links
We are excited to know offer coverage in this call on Business Development Company (BDC) CEFs alongside our coverage of Traditional CEFs. We will post the replay summary article on this blog post over the weekend. The article will roughly follow the slide order in the slide deck.
Link to Webinar replay slides:
Overview Traditional CEFs: According to our CEF Universe Service dated June 30, 2014, during the second quarter of 2014 the traditional closed-end fund universe ended with 585 funds totaling $270B in Total Net Assets, which reflects an asset growth of about +7.4% year-to-date. There were 226 total Equity funds and 359 total Bond funds. The average Discount to NAV is -6.1% and the average Market Price Yield is 6.8%; 7.3% for Taxable Bond funds and about 6% for Municipal Bond funds. In general, discounts have been fairly stable during this quarter with about a +0.6% narrowing since last quarter-end and a +0.2% above the quarter’s average Discount per fund. We have not seen as tepid of discount movements in recent history since the 3rd quarter of 2012.
Overview Business Development Company (BDC) CEFs: According to our CEF Universe Service dated June 30, 2014, during the second quarter of 2014 the BDC closed-end fund universe ended with 50 funds totaling $32B in total net assets. The average Discount to NAV is -0.17% and the average Market Price Yield is 9.4%. There were 9 Equity Focused BDC CEF funds with an average Discount of -23.71% and a Yield of 4.6% and 41 Debt Focused BDC CEF funds with an average Premium of +5.13% and an average Yield of 9.9%. We want to note that as BDC CEFs are new to many investors, they only produce a NAV or “Book Value” quarterly as they typically own non-traded securities.
Traditional CEF Yield, Volume and Liquidity: At current Market Prices and distribution policies, 86% of all traditional CEFs yield over 5% and 42% of all traditional CEFs yield between 6.5% and 10%, which we feel is the core income universe for CEFs. Yields for CEFs peaked last summer and are back to levels we last saw in 2012, which is still higher than the Relative Yield lows of the first half of 2013. The major sectors with increases to the income-only portion of their Yields are the three equity groups: US Equity, Non US Equity and Specialty Equity funds. Trade volumes are down in June vs. the second quarter by about -4% (the same as last quarter); this trend is most pronounced in State Muni CEFs, which are trading down -12%. Specialty Equity CEFs are the only group positive with +2% volume trends. Liquidity for CEFs is trending higher for US Equity and Specialty Equity funds and is at recent lows for Taxable Bond and Municipal Bond CEFs. Currently about 61% of traditional CEFs trade over $500K a day in average Liquidity vs. 64% last quarter. 2.6% of traditional CEFs trade over $5M a day in average Liquidity, which is similar to last quarter.
BDC CEF Yield, Volume and Liquidity: At current market prices and distribution policies, 96% of all BDC CEFs yield over 5% and 60% of all BDC CEFs yield over 8%, which we feel is the core income universe for BDC CEFs. Trade Volumes are up 33% for BDC CEFs in June vs the quarter average which in our opinion is a reaction to the completion of the removal of BDC CEFs from the S&P and Russell Indexes. The group has just about completely recovered from the average loss of -5% to NAV during the quarter on the pull-back. Liquidity for BDCs CEFs is typically much higher than their traditional CEF cousins with about 6X the average Trade Volume. Currently about 78% of BDC CEFs trade over $1MM a day in average Liquidity and 32% of BDC CEFs trade over $5M a day in Liquidity.
Traditional Equity CEFs: These funds ended with an Average Discount to NAV of -7.76% this quarter, which is -0.1% behind their Average Discount during the quarter. The group has an Average 1-year Z-Stat of +0.29. The Average Total Market Price Yield is 7.4% (down from 7.8% last quarter), of which we estimate will be comprised, on average, in 2014, of 44.6% income, 28.4% capital gains and 27% Return of Capital (RoC). The average Expense Ratio is 1.70% and the average Net Assets figure is $576M. The average Liquidity figure is $1.52M per day. Of the outstanding shares in this grouping, 22.3% of the shares are institutionally held and 8.33% of those shares are considered, by our firm, to be held by activists or activist followers.
Traditional Taxable Bond CEFs: These funds had an average discount to NAV of -4.51%, which is 0.6% above their average Discount during the quarter, and had an average 1-year Z-Stat of +0.67. The average Total Market Price Yield is 7.1%, of which we estimate will be comprised, in 2014, of 95.8% income, 0.2% capital gains and 4% Return of Capital (RoC) on average. The average Expense Ratio is 1.68%. The average Net Assets figure is $461M. The average Liquidity figure is $1.30M per day. Of the outstanding shares in this grouping, 21.50% of the shares are institutionally held and 5.38% of those shares are considered, by our firm, to be held by activists or activist followers.
Traditional National Municipal Bond CEFs: These fundshad an average Discount to NAV of -5.34%, which is slightly higher than their quarter average by 0.2%, and an average 1-year Z-Stat of +0.35. The average Total Market Price Yield is 6.1%, of which we estimate will be comprised, in 2014, of essentially 100% income on average. The average Expense Ratio is 1.44%. The average Net Assets figure is $452M. The average Liquidity figure is $925K per day. Of the outstanding shares in this grouping, 9.99% of the shares are institutionally held and 4.67% (up from 2.57% last quarter) of those shares are considered, by our firm, to be held by activists or activist followers.
Traditional Bond Fund Fundamentals: We have seen Relative Undistributed Net Investment Income (UNII) levels trending down during 2Q14 from a peak of 17% to just above 15%. This is still above levels seen at the end of 1Q14 and is not of major concern for our firm. Traditional Taxable Bond Relative UNII has been pretty stable over the past year, but levels are off a similar -2% from levels seen at the beginning of the year. Earnings Coverage for Taxable Bond and Municipal Bond CEFs has been trending up since mid-summer 2013 but has flattened out mildly during the quarter. We expect to see the volume of dividend cuts reduced and Earnings Coverage improved for the Taxable Bond CEFs.
Return of Capital (RoC) Trends & Destructive RoC: Return of Capital (RoC), for traditional CEFs, has been trending down since May 2013 for all sectors but Specialty Equity, which is positive. Specialty Equity, in our opinion, is the group where RoC is the most common and least destructive for most funds. With continued strong NAV gains it makes it easy for most Equity CEFs to pass gains on to investors. Most Municipal Bond CEFs are no longer showing RoC. There are two Municipal Bond funds showing some RoC on a 90 day basis, and four on a twelve month basis. The only fund showing over 2.5% RoC annually is PCK, a PIMCO CA Muni fund, but the level is down from 6% annually to 0% in the past quarter.
Destructive Return of Capital, as we calculate it, is currently showing in 11 CEFs (down from 53 last quarter) for which it comprises about 32% of the ROC for each of those funds. The sector with the most red flags for Destructive Return of Capital is the Taxable Bond sector; there are 8 Funds averaging 21% of the RoC. This is down from 28 Taxable Bond funds last quarter. 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 and also more forgiving of many Equity funds.
Business Development Company (BDC) Closed-End Funds: As of March 2014 our firm has initiated coverage of all BDC CEFs, in our weekly CEF Universe File under a separate tab, added them to our Daily New and SEC Filings alerts and expect to add them to Our Monthly Best Ideas List in September and launch a focused portfolio model covering them this fall. We think of BDC CEFs as yieldy “traditional 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 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. We recently published an article on how BDC CEFs should fair in a rising interest rate environment on our Blog (www.CEF-Blog.com).
We think investors should look at BDC CEFs 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. 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.
Traditional Municipal Bond Update: National and State Specific Municipal Bond CEFs currently account for $66 billion in net assets. Average Earnings Coverage for the sector is just below 100%; at 98.9% for the national funds and 98.8% for the state focused funds. Duration is averaging 10.36, down from 11.48 last quarter. The sector has 89% investment grade paper and an average Discount of -5.35; 47% of the funds in this sector show Discounts wider than -7.5% and Yields averaging 5.8%, with 47% of the funds yielding over 6.5% and about 1/3 having trade Liquidity over $1MM per day. These figures give us a fairly positive opinion of the National Municipal Bond sector. Duration has been trending down, which we expect to continue this year.
Investors new to Muni CEFs need to be aware that they currently have an average NAV Volatility of 4.3, down from 6.2 last quarter, but a noticeably higher average Market Price Volatility of 11.3, also down from 13.3 last quarter. Liquidity can be an issue for this sector; 59% of funds in this sector have daily average trading Liquidity under $500K. We think along with many investors experiencing higher tax bills in 2013 and with net issuance of Muni debt down this year, the muni market will experience positive fundamentals going forward. When comparing recent Yields of a common Municipal Bond ETF, MUB of 2.8% a couple with $1M+ in household W-2 income gets a federal Tax Equivalent Yield (TEY) of about 4.9%, while the same investors in the average traditional Muni Bond CEF would receive an average Yield of about 6.1% for a TEY of 10.7%. 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 12-13% TEY, based on our CEFU data.
Press Releases During the Quarter: We reviewed about 2800 press releases during the second quarter of 2014. About half of these press releases typically involve the Distribution Level for upcoming dividends; as usual, 92% of those notices were that the level would be maintained, with 72 notices of cuts and 48 notices of increases, but overall, we saw far less changes this quarter than we saw in the first quarter. 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 +1.7% or an average decrease of -2.6%. The average large change results in an average increase of +8% or an average decrease of -12%. In looking over the past quarter, the gains were spread across the US Equity, Specially Equity, Taxable Bond and Municipal Bond groupings of the CEF universe. Taxable bond funds had over 50 cuts, as we anticipated in last quarter’s research call, and only 16 increases.
There were 16 press releases covering Rights Offerings this quarter, which is up from 11 during 2Q13 and the average of 9 per quarter since Jan 1 2013. Tender Offers announcements were at a normal level of 11. There were three Secondary Offerings and 12 distribution policy changes and there were 0 Director or Fund Manager Changes for the quarter.
NAV vs. Market Price Total Return: During the second quarter, Equity CEFs averaged NAV returns of +6.0% vs. a Market Price Total Return of +6.5%. Taxable Bond CEFs averaged +3.1% NAV returns vs. a Market Price TR of +4.4%. Municipal Bond CEFs averaged NAV returns of +4.9% vs. a Market Price TR of +5.6%. This is not surprising due to a strong continued recovery in the Bond CEF market. We do believe that Bond CEF Discounts will continue to narrow slightly during the rest of 2014. Debt Focused BDC CEFs posted a +2% NAV total return and +4% Market Price TR. Equity focused BDC CEFs posted a -0.4% NAV TR and a +0.3% Market Price TR. Year-to-date on Market Prices, the major CEF groupings are up: +11.3% for Equity Trad CEFs, +11.3% Bond Trad CEFs and +2.5% for BDC CEFs.
Activist / Corporate Action Update: There was little activity in this area during the second quarter. Karpus disclosed a 13G filing with an increase to 38% of Asia Pacific Fund’s (APB) shares. Bulldog announced a 7.25% stake in Nuveen Global Income Opportunities Funds (JGG) and a 6% stake in Madison Strategic Sector Premium Fund (DDF). In the past month there have been 202 activist/activist follower increases vs. 75 decreases in share ownership.
Recent Traditional CEF Initial Public Offerings (IPOs): There were only 2 Traditional CEF IPOs in 2Q 2014. One IPO was a MLP focused fund, DSE. The second IPO was spun off another; GGZ spun off from GDV. Year-to-date there have been 4 traditional CEF IPOS, only raising $1.3B in new assets. These IPOs were smaller than normal ($320M vs. the 2013 average of $580M and 10-year average of $431M). Both occurred in late June. This is understandable after the tax loss pain of the fourth quarter of 2013. We think we will see about 8-10 traditional CEF IPOs this year (4-6 more). A recent N-2 filing by Tekla has us expecting a third healthcare fund by that firm in the 3Q; their other two funds, HQH, and HQL had significant success in 2013 with 52%+ Market Price Total Returns for each fund. 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.
Recent Business Development Company CEF IPOs Initial Public Offerings (IPOs): There were 2 new BDC CEF IPOs this quarter. ABDC IPOed on May 8th and TPVG IPOed on June 6th. We think that we will see 2-3 BDC CEF IPOs a quarter for the next few quarters as they are peaking the interest of a lot of new investors. BDC IPOs are typically smaller as they have the expectation of raising more capital later in their life as well as invest in typically smaller companies than traditional CEFs. $225M was raised in the two IPOs.
Two funds that IPOed in the past 3 calendar quarters are trading at a premium, a traditional CEF, StoneCastle Financial Corp (BANX), and A BDC CEF, TPG Specialty Lending Inc, (TSLX). The average discount for a recent traditional CEF IPO is
-5.05% and the average Price Per IPO price is 94.7%, up from 86.98% last quarter. The average discount for a recent BDC CEF IPO is -0.07% and the average Price Per IPO price is 99.4%.
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 decrease during 3Q 2014, with less than 10 mergers in the second half of 2014, and then believe it will settle back into a normal range of 5-10 per year going forward.
CEF Deaths: We only lost 11 funds in the past 30 months; this includes about 4-5 non-merger deaths per year. This is below normal vs. the long-term average of 8.5 per year. We do not see any reasons for this to change in the near term.
Traditional Closed-End Fund NAV / Market Price Correlation: Currently the average Equity fund has a Correlation over the previous 90 days to its NAV of 80.4%. Taxable Bond CEFs are showing an average Correlation to NAV of 52.7% and Municipal Bond CEFs are showing an average Correlation of 83.3%. The funds with more volatile 30 day Correlation figures are on average -22% less correlated to their NAV during June 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: Traditional Bond CEFs are currently showing NAV 1-year Standard Deviations of 4 to 5 while Equity CEFs have NAV volatilities of 10 to 15. For a CEF’s Market Price the difference between traditional Equity and Bond CEFs is less pronounced. Traditional Bond CEFs are showing Market Price Volatility of 10-11 and traditional Equity CEFs are showing Market Price Volatility of about 13-17. 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. Equity focused BDC CEFs are showing an expectedly high standard deviation of 30.0, while Debt-Based BDC CEFs have lower Volatility at 18.4.
New CEF Universe Data: During the second quarter we added 9 items to our weekly data service for traditional CEFs. Notable items include, Insider Share Ownership, a Top Sheet of Traditional CEF Data and 46 new data columns covering extended portfolio allocations. This can help us find and group funds with similar allocations as well as go after regional and country exposure in a more precise manor. For BDC CEFs we added 21 more data points, bringing the total up to 45 data points for BDC CEFs. We added many data points on the dividend including its makeup and on the Leverage being used by the funds. We expect to add about 20 data points for BDC CEFs during 3Q14 and bring the total up to about 75 total data points by year-end.
Summary of What Registrants Asked Us to Cover: As usual we asked each registrant what one topic we should cover on the call. This is the summary of anything asked by more than one person. Thirteen people asked for commentary and perspective on the Marco trends for 3Q14 – both for Equity and Bonds funds with an eye on rising rates. We were asked to comment on IPOs and new issuance by eight registrants. On the topic of how to build a portfolio of CEFs, questions like how to start a portfolio and how to diversify that portfolio were asked by eight registrants. Four people asked about how to fund data and info on CEFs as well as how to select a fund in a grouping. MLPs commentary was requested by two registrants and BDC CEFs got seven requests. Three people asked about the different types of Leverage and the pros and cons of a leveraged fund. Six people asked about discount trends and the trend for distributions for CEFs. Four people asked specifically about current vs. historical discounts. Three people asked about Return of Capital and when it is considered destructive. Three people asked for an update on activist and corporate actions. Two asked about what to do in a Rights Offering. Three wanted to hear about traditional Muni CEFs and two about traditional Covered Call CEFs. We thought it may be helpful to see what issues other CEF investors are looking for answers on.
CEFA’s 3Q 2014 Outlook: For the quarter we are maintaining BDC CEF exposure for all but our Municipal Bond Model at a 4% to 12% level for clients. We do not see significant overall NAV risk in the near term for Taxable Bond or Muni Bond CEFs, especially in the Senior Loan fund grouping which continues to have strong NAV performance relative to other Taxable Bonds, but many funds have experienced discount widening. We expect dividend cuts to slow down across most CEF sectors during the quarter. Dividend cuts were above normal for Taxable Bond CEFs during 2Q14, but 3Q14 should be less painful for investors. We expect IPO activity to increase, in the traditional CEF universe, to 6-8 funds launched during the second half of 2014 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.
We don’t think the recent (post quarter-end) muni movement was due to Puerto Rico, simply a discount shift caused by some investors’ expectations that rates might rise sooner than previously believed. This is an added reason to be a little proactive and make relative value trades, seeking discount alpha to help with the eventually headwinds of duration risk.
We recently wrote two articles that could benefit attendees of our quarterly webinar. The first was an article talking about what to look for past our traditional CEF Trifecta analysis. It discussed our thoughts on allocations size and some common mistakes we see from our ongoing conversations with investors. The second article covers how Debt-Based BDC CEFs handled the 4%+ rise in interest rates from 2004 to 2007. By our calculation BDC CEFs ended up doing better than both High Yield and Loan traditional CEFs with both higher Relative Total Return and Yield levels. Both articles can be found on our Blog: http://www.CEF-Blog.com.
We think there will be continued demand for most CEFs sectors with more new investors seeking exposure to the closed-end fund structure. With current life expectancies, it is possible that those retiring at 55-60 will be retired longer than they worked. Even though there are good overall fundamentals for traditional 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 owning funds with sustainable dividend levels will continue to be an important theme for the year. We typically make the call to use NAV TR and Discount data to make decisions when fundamental data has gotten stale – gone 4 months without being updated. One additional thing to keep in mind during 2014 is the time period covered by any data you review. Fourth quarter 2013 was deeper discounts on many funds that we should see for many years to come.
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 June 30, 2014.