Closed-End Fund Advisors: Third Quarter 2014 CEF/BDC Review and Outlook Summary and WEBINAR REPLAY Links
For those that were not able to attend our Quarterly Research Call on October 9, 2014, we have the replay link and slides below. This quarter we covered The Closed-End Fund Universe, both traditional CEFs and BDCs.
We are excited to now offer coverage of Business Development Company (BDC) CEFs alongside our coverage of Traditional CEFs.
Link to Webinar replay slides:
Overview Traditional CEFs: According to our CEF Universe Service dated September 30, 2014, during the second quarter of 2014 the traditional closed-end fund universe ended with 581 funds totaling $266.5B in Total Net Assets, which reflects a net asset growth of about +5.9% year-to-date. There were 229 total Equity funds and 352 total Bond funds. The average Discount to NAV is -7.9%, the average Market Price Yield is 7.1%; 7.9% for Equity funds, 7.4% for Taxable Bond funds, and about 6% for Municipal Bond funds. In general, discounts have widened about -1 ¾% during this quarter and a -0.8% below the quarter’s average Discount per fund. US and Non-US Equity funds had generally flat discount trends, though the widening was more prevalent in the other CEF sectors. This makes many CEF groupings and individual funds very attractive for investors willing to take a slightly contrarian view of the current market environment.
Overview Business Development Company (BDC) CEFs: According to our CEF Universe Service dated September 30, 2014, during the third quarter of 2014 the BDC universe ended with 51 funds totaling $35.1B in total net assets growth since last quarter of +10.2%. The average BDC Discount to NAV is -7.2% and the average Market Price Yield is 9.1%. There were 9 Equity Focused BDC CEF funds with an average Discount of -27.16% and a Yield of 3.8% and 42 Debt Focused BDC CEF funds with an average Discount of -2.92%, which is down about -8% since last quarter, and an average Yield of 9.6%. As BDC CEFs are new to many investors, we want to note that they only produce a NAV or “Book Value” quarterly. This is because BDC CEFs typically own non-traded or public companies under $250M in market capitalization. BDCs had an average NAV loss of -0.2% since their previously reported quarterly value with 10 BDCs having NAV losses of over -1% to -12% and 13 BDCs reporting a NAV growth of over 1% to +5%. 28 BDCs had mild NAV changes in the range of -1% to +1% showing little change during the previous quarter.
Discounts and NAV vs. Market Price Total Returns: For Equity CEFs, 93% were trading at a discount to NAV at the end of the quarter, while 89% of Taxable Bond funds, 92% or Municipal Bond funds and 73% of BDCs traded below NAV at quarter’s end. 90% of all CEFs, or 570 funds, are at a discount. There were 351 or 56% of CEFs that had positive NAV Total Return performance during the quarter vs. only 191 CEFs, or 30%, that had positive market price total returns. This is most evident in two areas; first, the municipal bond sector where 100% of funds had positive NAV TR but only 61% had market price TR, and second, the BDC sector where there was only one BDC with negative NAV TR during the third quarter, but 45 (88%) of the funds had negative Market Price returns.
Traditional CEF Yield, Volume and Liquidity: At current Market Prices and distribution policies, 86% of all traditional CEFs yield over 5% and 45% of all traditional CEFs yield between 6.5% and 10%, which we feel is the core income universe for CEFs. Yields for CEFs generally peaked during the summer of 2012. The major sectors with increases to the income-only portion of their Yields are Taxable Bond and BDCs. Trade volumes are down in third quarter vs. the second quarter by about -1%; the trend is most pronounced in US Equity CEFs, which are down -7% in trading volume. With an average of +6%, Taxable Bond CEFs are the only grouping with positive volume trends. Liquidity for CEFs is trending higher for Taxable Bond (25% increase) funds and is at recent lows for National Municipal Bond CEFs (7% decrease in Liquidity compared to last quarter). Currently about 61% of traditional CEFs trade over $500K a day in average Liquidity which is similar to last quarter. Only 2.4% of traditional CEFs are currently trading over $5M a day in average Liquidity, compared to 2.6% last quarter.
BDC CEF Yield, Volume and Liquidity: At current prices and distribution policies, 94% of all BDCs yield over 5% and 75% yield over 8%, which we feel is the core income universe for BDCs. Trade Volumes are down 21% for BDCs this quarter vs. second quarter, which we believe was primarily due to their removal from the S&P and Russell indices earlier this year. The group is currently near historic discounts outside of the financial crisis lows vs NAVs. Liquidity for BDCs CEFs is typically much higher than their traditional CEF cousins with about 4X the average Trade Volume. Currently about 57% of BDC CEFs trade over $1MM a day in average Liquidity and 22% of BDC CEFs trade over $5M a day in Liquidity.
Traditional Equity CEFs: They ended with an Average Discount to NAV of -8.12% this quarter, which is -0.3% wider than their Average Discount during the quarter. The group has an Average 1-year Z-Stat of 0.0. The Average Total Market Price Yield is 7.9% (up from 7.4% last quarter), of which we estimate will be comprised, for 2014, of 39% income, 36% capital gains and 25% Return of Capital (RoC). The average Expense Ratio is 1.70% and the average Net Assets figure is $559M and the average Liquidity figure is $1.4M per day. For Equity CEFs, 22.14% of the shares are institutionally held and 12.59% of those shares are considered, by our firm, to be held by activists or activist followers.
Traditional Taxable Bond CEFs: They ended with an average discount to NAV of -7.04%, which is -1.1%% below their average Discount during the quarter, and had an average 1-year Z-Stat of -0.7%. The average Total Market Price Yield is 7.4%, of which we estimate will be comprised, in 2014, of 94.6% income, 0.4% capital gains and 5.0% Return of Capital (RoC) on average. The average Expense Ratio is 1.67%, of which 0.38% is leverage cost on average. The average Net Assets figure is $467M and the average Liquidity is $1.4M per day. For Bond CEFs, 13.89% of the shares are institutionally held and 9.84%% of those shares are considered, by our firm, to be held by activists or activist followers.
Traditional National Municipal Bond CEFs: They have an average Discount to NAV of -7.81%, which is lower than their quarter average by -0.98%, and an average 1-year Z-Stat of -0.99. The average Total Market Price Yield is 6.1%, of which we estimate will be comprised, in 2014, of essentially 100% income. The average Expense Ratio is 1.44%, of which 0.48% can be accounted for by leverage costs. The average Net Assets figure is $456M and the average Liquidity figure is $831K per day. For Muni CEFs, 10.31% of the shares are institutionally held and 5.86% (up from 4.67% 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 3Q14 from 16% to 15% for Muni Bond CEFs and from about 0% to -5% for Taxable Bond CEFs. Relative UNII had been stable over the past year, but now is trending down. This is why we think investors need to be diligent and tactical in picking and managing their CEF bond funds in order to help avoid dividend cuts. Earnings Coverage for Taxable Bond and Municipal Bond CEFs had been trending up since mid-summer 2013 but has flattened out in 2014 with Muni coverage recently drifting down to 98% from a recent level of almost 100%. We had expected to see the volume of dividend cuts reduced during third quarter, however, there were 75 cuts in the bond CEF grouping.
Return of Capital (RoC) Trends & Destructive RoC: Return of Capital (RoC), for traditional CEFs, has been trending down or flat for most funds but US Equity is showing more RoC used to cover dividends at the end of 3Q vs earlier this year. Specialty Equity, historically has the highest RoC, but in our opinion, is the group where RoC is the most common and least destructive for most funds. With the recent slowing and pull-back in NAVs it makes it easier for more Equity CEFs to use RoC to maintain dividend policies. Municipal Bond CEFs (National and State) are no longer showing RoC in the past 90 days which we find positive for the funds.
Destructive Return of Capital, as we calculate it, is currently showing in 62 CEFs (up from 11 last quarter) where it comprises about 22% 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 30 funds in this grouping averaging 13% of the RoC. This is up from 8 Taxable Bond funds last quarter, but the percentage of DRoC is down from 22%. 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 may be more forgiving of many Equity funds after positive NAV periods.
Business Development Company (BDC) Closed-End Funds: As of March 2014 our firm has initiated coverage of all BDC CEFs. They have been added to our weekly CEF Universe File under a separate tab and our Daily News and SEC Filings Alerts email. We added them to our Monthly Best Ideas List and launched a focused portfolio model covering them in September. 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 29th for subscribers to The Scott Letter. If you have not seen this interview you can find it posted to our website or sign-up to receive future issues. This summer we published an article on how BDCs should fair in a rising interest rate environment, as well as an article and video set called “Debt-Based BDC Boot Camp“ on our Blog to help introduce investors to BDC investing.
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 and do some fundamental research of the manager and portfolio. 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 generally try to avoid paying more than a few percent above a fund’s last reported NAV (a premium), or “Book Value” as it is sometimes referred to by the funds. Looking to buy good quality BDCs post a secondary offering may allow a great entry point into these funds. With discounts currently wider than normal we think investors new to the structure will be rewarded over time.
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 at 97.8%, down slightly from 98.9%. Duration is averaging 9.67 vs 10.36 last quarter and 11.48 at the end of 2nd quarter. This is a great trend to see for investors worried about rising interest rates and their muni CEF portfolios. The sector has 89% investment grade paper and an average Discount of -8.17%, down from -5.35% last quarter. 66% of the funds in this sector show Discounts wider than -7.5% and Yields averaging 5.85%, with 52% of the funds yielding over 6.0% and about 17% having trade Liquidity over $1MM per day. These figures give us a fairly positive opinion of the National Municipal Bond sector. As noted above, duration has been trending down, which we expect to continue over the next few quarters.
Investors new to Muni CEFs need to be aware that they currently have an average NAV Volatility of 3.4, down from 4.3 mid-year and 6.2 at the end of 2nd quarter. Muni CEFs have noticeably higher average Market Price Volatility of 9.4, down from 11.3 mid-year and 13.3 at the end of 2nd quarter. Liquidity can be an issue for this sector; 58% 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 6.0% for a TEY of 10.5%. 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 1800 press releases during the third quarter of 2014. About two-thirds 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; there were only 80 notices of cuts and 55 notices of increases. Overall, we saw far less changes this quarter than we saw in the past year. We break out distribution changes in two buckets: small changes (Under 5%) and large changes (over 5%). The average small change resulted in an average increase of +2.2% or an average decrease of -2.7%. The average large change resulted in an average increase of +12% or an average decrease of -10%. In looking over the past quarter, the gains were spread across the US Equity, Specially Equity, Taxable Bond and State Specific Municipal Bond groupings of the CEF universe. Taxable bond funds had over 35 cuts, and only 10 increases while National Muni Bond CEFs had 14 cuts with no increase and State Muni CEFs had 25 cuts, but 4 increases. Debt-based BDCs had 2 dividend cuts and 4 increases while there were no changes to Equity-based BDCs.
There were 9 press releases for Rights Offerings this quarter, which is up from 6 during 3Q13 and the average of 8 per quarter since 1Q13. Tender Offers announcements were elevated at 28 vs. an average of 16 per quarter. There was one Secondary Offerings for traditional CEF vs. 25 for BDCs. There were 2 distribution policy changes and there were 18 leverage amount or leverage type changes this quarter as many CEF position themselves for the expected period of rising rates.
NAV vs. Market Price Total Return: During the second quarter, Equity CEFs averaged NAV returns of -2.3% vs. a Market Price TR of -2.8%%. Taxable Bond CEFs averaged -1.4% NAV returns vs. a Market Price TR of -3.5%. Municipal Bond CEFs averaged NAV returns of +3.1% vs. a Market Price TR of +0.4%. This is not surprising due to a strong continued recovery in the Muni Bond market. We believe that Taxable Bond CEF and BDCs Discounts will widen for tax-loss season and then recover by year-end. Debt Focused BDC CEFs posted a +2.4% NAV total return and -6.2% Market Price TR as investors sold down most yieldy assets in September. We think many investors are overlooking that most BDCs, from our research, will perform well through rising rates in both market price total return and yield increases on average. Equity focused BDC CEFs posted a -0.1% NAV TR and a -6.2% Market Price TR. Year-to-date on Market Prices, the major CEF groupings are up: +8.8% for Equity Traditional CEFs, +9.6% Bond Traditional CEFs and -2.2% for BDCs.
Activist / Corporate Action Update: Activist investors were a little more active during the third quarter vs. the second quarter. Karpus disclosed a 13G filing with an increase to 22% of Fed Enhanced Treasury Income Fund’s (FTT) shares. City of London announced a 13D increased stake in Taiwan Fund (TWN) to 30.6%. Bulldog filed and 13D for Nuveen Dividend Currency Opp (JGT) to 6.9% and an increase to 6.1% for Deutsche High Income Opp (DHG) In the past quarter there have been 57 activist/activist follower increases vs. 59 decreases in share ownership filings.
Recent Traditional CEF Initial Public Offerings (IPOs): There were only 2 Traditional CEF IPOs in 3Q 2014. One IPO was a third fund for Tekla Capital Management (Our Last Scott Letter interview), a Healthcare Opportunities Fund about 1/3 focused on income generation for the portfolio. It raised $770M on July 28 and trades under the ticker symbol (THQ). The second IPO was Goldman Sachs’s second fund since the Great Depression. It is focused on MLP investing and raised $1.4B in assets on September 26 and trades under the ticker symbol GER. Year-to-date there have been 6 traditional CEF IPOs, only raising $3.5B in new assets and averaging $575M per IPO vs. the ten year average of $480M per fund and $12B per year. Based on previous N-2 filings and market conditions, we think we will see about 2 more traditional CEF IPOs during the fourth quarter of 2014.
Recent Business Development Company CEF IPOs Initial Public Offerings (IPOs): There were no new BDC CEF IPOs this quarter. We think that we will continue to see 1-2 BDC CEF IPOs a quarter once average discounts return to average premiums for Debt-based BDCs. However with a lack of BDC IPOs, current BDC discounts have upside from secondary market support. This is helpful for supporting market prices for current BDCs and we think it will be a few months before new BDCs are likely to be launched. BDC IPOs are typically smaller as they have the expectation of raising more capital later in their life and they typically invest in smaller companies than traditional CEFs. $3.3B was raised in BDCs during 2014 with an average size of $543M when historically they raised on average $138M but have historically grown net assets about $500M over IPO assets. The average IPO size in 2014 is higher than normal, as one BDC, FSIC’s IPO, was actually the public listing of a non-traded BDC that had already existed for years prior to listing. If we exclude that fund, the average is near the average at $130M for 2014.
Four funds that IPOed in the past 3 calendar quarters are trading at a premium: a traditional CEF, StoneCastle Financial Corp (BANX), though BANX recently filed to change registration, and three BDCs, including TPG Specialty Lending Inc. (TSLX), FS Investment Corp (FSIC) and TP Venture Growth BDC Corp (TPVG). The average discount for a recent IPO is
-2.73% and the average price per IPO price is 97.5%, which is up from 94.7% last quarter.
CEF Mergers: We have seen a large increase in mergers since 2012, averaging over 40 per year and 31 so far in 2014. We expect this trend to decrease for the rest of the year, with less than 5 mergers in fourth quarter 2014. We believe it will settle back into a normal range of 5-10 per year for 2015 and the near to medium term.
CEF Deaths: We only lost 11 funds in the past 33 months and 2 for 2014; recently this has averaged about 4-5 non-merger deaths per year. Recent trends are below normal vs. the long-term average of 8 per year. We do not see any reasons for this to change in the near term. Periodic deaths are healthy for the CEF Universe in order to get rid of funds that are too small and can’t be merged into a peer CEF or funds with a history of disfavor by investors.
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%, essentially the same as during the second quarter. Taxable Bond CEFs are showing an average Correlation to NAV of 77%, up from 53%. Municipal Bond CEFs are showing an average Correlation of 24%, down from 80%. State Muni funds are at the lowest levels at only a 10% correlation. CEFs as a whole are about
-12% less correlated on average to NAV during the past quarter. We find this data most positive for muni CEFs as discounts are at very wide levels and it is not because of a poor performing muni bond market. 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 3.5 to 4.5 while Equity CEFs have NAV volatilities of 13 for Specialty Equity and 15 for Non-US and US equity funds. 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 9-10, down from 10-11 last quarter and traditional Equity CEFs are showing Market Price Volatility of 13-16. Bond funds are continuing to show lower volatility than in 2013 as both the Bond markets and Bond CEF investors generally act in a 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 18.2. Both are essentially the same as last quarter.
New CEF Universe Data: During the second quarter we added 9 items to our weekly data service for traditional CEFs. Notable items include, Short Interest, Percentage of Muni Bond Exposure to Zero Bonds, the Number of Bonds per Bond Fund and a data point we call “Discount Vs. Avg. Price” for Muni CEFs, to help see if a muni funds discount offsets the average premium (if there is one) for the bond holdings. The goal is to help address the risk of maturing and callable bond positions and the impact to the investment you have made in the fund. For BDCs we added 42 more data points (double the 21 added last quarter), bringing the total up to 87 data points for BDCs. We added many data points on the leverage cost and level for the BDCs. We broke out equity vs. debt exposure, added the NII coverage ratio, short interest, activist and institutional ownership, NAV Growth, estimated NAV announcement dates and comparable data for BDCs to help see trends inside the sector on a relative basis. We expect to add about 20-30 data points for BDC CEFs during 4Q14 and bring the total up to about 100 total data points by year-end.
Summary of What Registrants Asked Us to Cover: We find it very helpful to get a sense of investor’s questions each quarter to make sure our presentation covers their interest. During this quarters’ registration, you asked us to cover long-term bonds vs. short-term bond and how this would impact duration in a rising rate environment. We were asked about what CEF sectors should do well in that environment and be impacted the most from both a leverage basis and assets basis. Attendees wanted to know about our thoughts on what period is appropriate for measuring discounts and Z-stats and what trends we have seen and expect to see for CEFs. We were asked how many funds per investment objective are appropriate and what allocation ranges for funds make sense for investors. We also were asked about the ETNs CEFL and BDCL that have 2X leverage exposures to CEFs/BDCs. People asked about the safest BDC and why the sector is down so much recently, as well as a similar question about why prices for CEFs are down when investors need the yield. As usual people asked about our outlook for the next quarter, for all CEFs, but BDCs and Muni’s in particular. Questions about future dividend changes and funds using Return of Capital are always common. We were not surprised to be asked about Bill Gross leaving PIMCO. Registrants asked about year-to-date IPOs and IPO trends. We were asked about the impact to CEFs/BDCs with more institutional interest and ownership as well as what we see for tax loss selling this year. The answers to these questions are recorded in the replay about 80 minutes into the session, when you see slide #42.
CEFA’s 4Q 2014 Outlook: For the quarter we are maintaining BDC exposure for all but our Municipal Bond Model at a 3% to 20% level for clients’ investment models. We have added to our research approach looking at a BDC’s NAV growth and stability as well as comparable 1 year NAV total return vs. peer-funds. We are paying particular attention to net investment income coverage ratios for BDCs in order the help us seek high quality BDCs. We think this part of the CEF universe is very cheap. It may get cheaper before recovering, but this is where we appreciate the benefit that BDC management teams have, just like traditional CEF managers, the use of permanent capital to avoid having to make redemption decisions on their portfolio. We also expect to see news that many BDCs buy in shares during the fourth quarter – which, when at a discount, is accretive to all investor’s NAV.
Though many funds have experienced continued discount widening, we don’t see significant 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. We expect dividend cuts to slow down across most CEF sectors during the next quarter with the highest risk being in Taxable Bond CEFs. Dividend cuts were above normal for Taxable Bond and Municipal CEFs during 3Q14. We expect IPO activity keep coming at 1-2 funds per month, in the traditional CEF universe. We think that for Equity funds, investors should understand that if NAV performs well, even if a -10% to -15% discount does not change, they have exposure to a $1 worth of assets but only paid $0.90 – $0.85 of real money. This also applies to Muni Bond funds where you can presently control a $1 of professionally managed tax-free bonds with 90% average investment grade for $0.92. We are pleased when a discount narrows after we buy it, but that is not the only way to profit in CEFs. The significant benefit for those that are diligent CEF investors is the ability to maintain a portfolio that serves your personal investment objectives and uses the inefficiency and volatility of CEFs to help you add alpha to your returns over time. We hope our articles and this research call helps give perspective on this matter.
We recently recorded two videos; “Secondary Market Support for Fund Sponsors” and a “BDC Boot Camp: An Introduction to BDCs”. We wrote an article, “Balancing CEF Data vs. Portfolio Data when Selecting a Closed-End Fund” and released an article that covered how all CEF sectors did in the last rise of interest rates. The worst performing group was Preferred Equity, so we scheduled the next Scott Letter on that sector, in order to learn more from an experienced portfolio manager on what we can expect for shareholders in the next move in rates. Both the videos and articles can be found on our blog.
We think there will be continued demand for most CEFs sectors with more 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 that cut their dividends and/or experience 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.
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 September 30, 2014.