Closed-End Funds: Rising Rates and the Impact on Performance and Yield
Closed-end fund (CEF) investors have been asking our firm over the past year how we expect the various groups of funds to handle the eventual rise of interest rates. We generally hear the same two questions.
1. How likely are we to lose money on a total return basis?
2. How will my cash flow change during a rise in interest rates?
To help prepare for this environment, we have spent time researching the cost and terms of leverage for closed-end funds as we believe these data points will be an important part of fund selection during a rising rate environment. We recently wrote an article on how Business Development Company’s (BDCs), a sub-set of the closed-end fund universe, did from the period March 1, 2004 to September 28, 2007 vs. High Yield and Senior Loan Taxable Bond CEFs as 30 day Libor rose from 1.0973% to 5.4927% (a 4.40% increase) over a period of 43 months. You can read the full article on our blog (www.CEF-Blog.com). This is the most pronounced rise in rates in recent history, and one period of time that is potentially similar in nature to the increase in rates currently forecasted for 2015 or 2016.
This article is designed to give investors perspective on what they could expect to experience in terms of a total return perspective or for potential changes in their fund’s distribution yields. Of the 636 current closed-end funds (traditional and BDC), 381, or about 60% of the universe, existed on March 1, 2004 when Libor rates were at 1.0973%. Below is a summary on how the average fund performed both on a market price total return basis, as well as in terms of the average change to yield over the 43 month period. Libor rates peaked at 5.4927% on September 28, 2007.
We also want to show which groups had the highest number of significant dividend changes and where investors could have experienced negative market price total returns over the period. We show the total returns for the S&P 500 as well as a Barclays Taxable and Municipal Bond index for comparison.
The time period for the tables in this article is March 1, 2014 through September 28, 2017. Avg. Yield change is expressed in percentage terms. If the yield went from 8% to 7% the calculation would be -12.5%, not -1%. Also the column that shows the percentages of funds with dividend changes includes funds with increases, and is meant to help show which areas of the CEF universe are likely to have a higher number of funds that change their distribution policies.
Index Data from Thompson Reuters. CEF data from CEF Universe Data and Yahoo Finance.
* Over the 43 month period, US CEFs went from yields of 6.1% yields to 8.1% and Non-US CEFs went from yields of 4.9% to 6.1%. Many of the dividends came as semi-annual or annual dividends and were driven by pass through capital gains vs. income to maintain the tax-beneficial status for the fund itself.
In reviewing the sub-groupings of closed-end funds, we wanted to highlight the sub-groups where we thought investors would have the most interest in the changes in yield vs. total return. We focused on the Taxable and Municipal Bond groups plus three Equity sectors; Utilities, MLPs, REIT Funds and Preferred Equity. Only one group, US Government Bond Funds, had negative market price total return over the time period; the grouping had an average -1.99% cumulative loss on a total return basis. We were disappointed that there was only one MLP fund in March 2004 as we prefer to have more than one fund set the tone for an investor’s expectations of the sector.
*Of the 7 multi-sector bond funds, 3 cut on average -21.47% and 4 raised on average +81.31%. There were clear differences in dividend level changes, but, in our opinion, market price total return alone was not indicative of yield changes. We have tried to identify where the data is generally positive (green), Neutral (black) and Negative (red) for each table.
We also wanted to compare the top quartile (25%) vs. the bottom quartile of funds in the National Municipal Bond sector on both a market price total return basis and a yield change basis to see if any trends emerged. We decided to focus on Municipal Bond CEFs as they typically have the highest duration (currently about 10) in the CEF universe, and in our conversations, investors seem most concerned with this group of funds during a period of rising rates. With 89 funds, we looked at the top and bottom 22 funds in each area and took the average data for each. It should be noted that only 3 Municipal Bond CEFs increased their yield over the time period an average of +1.2%, so investors should expect yield reductions from most Municipal Bond CEFs over a period of prolonged rising rates, based on historical evidence. In general, the average Municipal Bond Fund reduced its yield by -19%, but still offered an average total return of +16% to +26%, depending on the sector, over the 43 month period.
The table above, in our opinion, shows why investors should not think of all Municipal Bond CEFs as essentially the same investment vehicle. Yield changes were not uniform across the grouping, the funds with the best total return also generally have the least dividend changes. The funds with the least dividend changes also were generally those that performed better for investors. In our opinion, this data refutes the idea that dividend changes are not important, that just the NAV performance of a closed-end fund is significant. All factors need to be considered.
Hypothetical Balanced Portfolio 60% Equity and 40% Bonds:
Based on previously stated data from the time period in question, we wanted to show how a portfolio that was 60% US Equity did when combined with 20% Municipal Bond CEFs and 20% Taxable Bond CEFs exposure. The blended performance during the 43 month period is +29.91% or +7.39% annualized. This compares to a 60% S&P 500 and 20 % Barclays Taxable and 20% Barclays Municipal Bond Index with returns of +31.44% or +7.77% annualized. This was during a period where many investors might have been concerned with discounts widening to hurt performance in a negative fashion. Performance was essentially the same and the CEF portfolio would be expected to blend 6.5% to 8% per year in distributions, the actual amount depending on the underlying funds selected.
According to our research, the sectors you may want to avoid during rising rates are Preferred Equity Funds, Investment Grade Bond Funds, US Govt. Bond Funds and Mortgage Bond Funds. We cannot expect the next rise in rates to have the same path or necessarily the same winners or losers. We continue to recommend investors take a few steps to handle their portfolio with a good chance for positive results. First, is to diversify across US and Non US Equity as well as some of the sector funds that are typically aligned the blended growth and income needs for retired investors. Second, we suggest a mix of Taxable Bond Funds; focusing on High Yield Funds, Loan Funds, Emerging Mkt. and Global Income Funds. Try to diversify across the regions of the world while simultaneously looking for ways to get some exposure to some of the top managers in the space. Most well regarded managers have at least one CEF option. For Municipal Bond exposure there are over 100 funds to choose from so it is ok to be picky and make strategic changes to your holdings over time.
Don’t forget basic “CEF Rules of Thumb”
Discounts: Know what a fund’s discount/premium to net asset value is, what direction it seems to be headed, and what it has done over the past few years.
Manager NAV Total Return: Compares the fund manager’s actual results vs. just the fund’s market price movements to assess how successful the manager has been in his environment. You should include a tracking index as well. Look at the fund’s marketing materials, they typically have index data for you to review and analyze.
Distribution Level Analysis: Does it look repeatable based on the fund’s portfolio holdings? When was the last change? For Bond CEFs we look heavily into Relative Undistributed Net Investment Income (UNII) and the fund’s earnings coverage. We also use the trend of this data vs. peer funds to help assess when the fund is actually stressed and may have to reduce the yield. The final important point for UNII and Earnings data is to make sure it is not stale. We can get data under 120 days old for most Bond funds. After 5-9 months the data is almost useless, in our opinion, in making an investment selection.
Want more perspective on these topics? Look for our articles, “The CEF Trifecta” and “Beyond the Trifecta,” posted to our blog (www.CEF-Blog.com).
Conclusion: The average National Muni CEF Ended the period with a 4.8% annualized total return over the 43 months. We estimate that about 5% of principal was lost in the period of rising rates, based on 6.1% current yields. We think investors need to work to build out their asset allocation levels now and fill each group with 1-2 CEFs. We suggest buying funds with good NAV TR vs. peer funds that are priced somewhat cheap to themselves and their peers, and have a distribution level that is sustainable. One of the best times to get into a CEF you are attracted to, is after you get a 5%-15% cut in the distribution. This will often push investors out of the funds and allow for generally favorable entry points.
Swapping CEFs: Find funds similar to each other and when they get rich or cheap sell across the trade to seek some CEF alpha. As an example, this year we have been doing this actively in the MLP sector. If a discount narrows 3%+ and a peer fund’s discount widens -1% then you have the potential for a 4% relative values swap.
We hope knowing what could happen will help you make better research and portfolio decisions as we get closer to a market that, based on general consensus, will experience some sort of prolonged rise in interest rates.
Disclosure: The views and opinions herein are as of the date of publication and are subject to change at any time based upon market movements 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 stated comes from the August 1, 2014 issue of our CEF Universe service with historical fund prices and distributions on Yahoo Finance.