Closed-End Fund Advisors: Fourth Quarter 2014 CEF/BDC Review and Outlook WEBINAR REPLAY Links
For those that were not able to attend our Quarterly Research Call on January 8, 2015, we have the replay link and slides in PDF format below. This quarter we covered The Closed-End Fund Universe, both traditional CEFs and BDCs.
We are excited to offer coverage of Business Development Company (BDC) CEFs alongside our coverage of Traditional CEFs. We produce 165 data points on traditional CEFs and 100 on BDCs in our weekly CEF Universe data.
GotoWebinar has a new feature that allows us to load the replay to their website, it can be accessed though the following link: https://attendee.gotowebinar.com/recording/8672554458466650370
Slides from the presentation can be downloaded in PDF format using the following link: http://www.cefadvisors.com/Download/2015-0108-CEFUpdate-Outlook.pdf
If you have any questions about the session or replay links please email Katerina@cefadvisors.com or call us (800) 356-3508.
Overview Traditional CEFs: According to our CEF Universe Service dated December 31, 2014, during the fourth quarter of 2014 the traditional closed-end fund universe ended with 571 funds totaling $262B in Total Net Assets, which reflects a net asset growth of about 4.2% during 2014. There were 225 total Equity funds and 346 total Bond funds. The average Discount to NAV is -7.5%, the average Market Price Yield is 7.3%; 8.2% for Equity funds, 7.9% for Taxable Bond funds, and 5.7% for Municipal Bond funds. In general, discounts have narrowed about -4.3% during this quarter and a 0.8% below the quarter’s average Discount per fund. US and Non-US Equity funds had generally widened, the narrowing was more prevalent in Municipal funds. This makes many CEF groupings (most Taxable Bond sectors, BDCs, MLP and global equity funds 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 December 31, 2014, during the fourth quarter of 2014 the BDC universe ended with 51 funds totaling $36.3B in total net assets growth since last quarter of +3.3%. The average BDC Discount to NAV is -12.8% and the average Market Price Yield is 10.4%. There were 9 Equity Focused BDC CEF funds with an average Discount of -28.86% and a Yield of 7.4% and 42 Debt Focused BDC CEF funds with an average Discount -9.32%, which is -6.4% wider than last quarter, and an average Yield of 10.7%. 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 -0.41% since their previously reported quarterly value with 15 BDCs having NAV losses of over -1% to -16% and 12 BDCs reporting a NAV growth of over 1% to +10%. 24 BDCs had mild NAV changes in the range of -1% to +1% showing little change during the previous quarter. It should be noted that BDC NAV TR for the quarter is for 3rd quarter as 4th quarter NAV TR will be released in February and March for most BDCs and will be covered in our 1stQ15 CEF/BDC research call.
Discounts and NAV vs. Market Price Total Returns: For Equity CEFs, 91% were trading at a discount to NAV at the end of the quarter, while 91% of Taxable Bond funds, 87% of Municipal Bond funds and 82% of BDCs traded below NAV at quarter’s end. 89% of all CEFs, or 554 funds, were at a discount. There were 406 or 60% of CEFs that had positive NAV Total Return performance during the quarter vs. 354 CEFs, or 57%, that had positive market price total returns. This is most evident in two areas; first, the municipal bond sector where 99% of funds had positive NAV TR and 94% had market price TR, and second, the BDC sector where there were no BDCs with negative NAV TR during the fourth quarter, but 33 (65%) of the funds had negative Market Price returns.
Traditional CEF Yield, Volume and Liquidity: At current Market Prices and distribution policies, 87% 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. Income-Only Yields for CEFs had generally been flat during fourth quarter. The sectors with increases to the income-only portion of their Yields are US Equity, Specialty Equity,Taxable Bond and BDCs . Trade volumes are up in fourth quarter vs. the third quarter by about 30%; the trend is most pronounced in Non-US Equity and Specialty Equity CEFs, which are up 50% and 49% respectively in trading volume. Liquidity for CEFs is trending higher for all groups, with highest trends for Specialty Equity & Non-US Equity (42% and 41% increase) funds and a milder increase for National Municipal Bond CEFs (3%). Currently about 69% of traditional CEFs trade over $500K a day in average Liquidity compared to 61% last quarter. 6.9% of traditional CEFs are currently trading over $5M a day in average Liquidity, compared to 2.4% last quarter.
BDC CEF Yield, Volume and Liquidity: At current prices and distribution policies, 98% of all BDCs yield over 5% and 77% yield over 8%, which we feel is the core income universe for BDCs. Trade Volumes are down 6% for BDCs this quarter vs. third quarter, which we believe was primarily due to their removal from the S&P and Russell indices earlier this year. There was also yield compression for BDCs and they generally added lower risk and lower yielding loans and had trouble adding as much equity to fuel new loan issuance. This was followed by energy fears, which is way overdone for BDCs as they only have 8% average energy allocations and many are 1st Lien loans that investors should not be as nervous about. The end of the year BDCs we impact by tax-loss selling. The group is currently near historic discounts (according to Wells Fargo a 3.3% standard deviation on a 10 year basis, only deeper during the finical crisis. 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 29% of BDC CEFs trade over $5M a day in Liquidity.
Traditional Equity CEFs: They ended with an Average Discount to NAV of -8.07% this quarter, which is 0.1% wider than their Average Discount during the quarter. The group has an Average 1-year Z-Stat of -0.1. The Average Total Market Price Yield is 8.2% (up from 7.9% last quarter), of which we estimate will be comprised, for 2014, of 45% income, 30% capital gains and 25% Return of Capital (RoC). The average Expense Ratio is 1.71% and the average Net Assets figure is $555M and the average Liquidity figure is $2.3M per day. For Equity CEFs, 23.32% of the shares are institutionally held and 12.71% 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 -7.29%, which is 0.23% wider than their average Discount during the quarter, and had an average 1-year Z-Stat of -0.7%. The average Total Market Price Yield is 7.9%, of which we estimate will be comprised, in 2014, of 90.9% income, 4.0% capital gains and 5.1% Return of Capital (RoC) on average. The average Expense Ratio is 1.67%, of which 0.35% is leverage cost on average. The average Net Assets figure is $454M and the average Liquidity is $2.4M per day. For Taxable Bond CEFs, 23.48% of the shares are institutionally held and 15.19% 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 -6.67%, which is narrower than their quarter average by 0.5%, and an average 1-year Z-Stat of -0.20. The average Total Market Price Yield is 5.9%, of which we estimate will be comprised, in 2014, of essentially 100% income. The average Expense Ratio is 1.41%, of which 0.43% can be accounted for by leverage costs. The average Net Assets figure is $467M and the average Liquidity figure is $961K per day. For Muni CEFs, 10.62% of the shares are institutionally held and 5.80% (compared to 5.86% 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 staying flat during 4Q14 at15% for Muni Bond CEFs and trending up from about -5% to -0.1% 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 fourth quarter, however, there were 34 cuts during the quarter in the bond CEF grouping.
Return of Capital (RoC) Trends & Destructive RoC: Return of Capital (RoC), for traditional CEFs, has been trending up 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 97 CEFs (up from 62 last quarter) where it comprises about 17% 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 45 funds in this grouping averaging 29% of the RoC. This is up from 30 Taxable Bond funds last quarter, percentage of DRoC being up from 13%. 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 (www.CEF-Blog.com) 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 $67 billion in net assets. Average Earnings Coverage for the sector is at 97.5%, down slightly from 97.8%. Duration is averaging 9.02 vs 9.67 last quarter and 10.36 at the end of 2nd quarter. This is a great trend to see for investors worried about rising interest rates and their municipal CEF portfolios. The sector has 90% investment grade paper and an average Discount of -7.04%, from -8.17% last quarter. 57% of the funds in this sector show Discounts wider than -7.5% and Yields averaging 5.69%, with 38% of the funds yielding over 6.0% and about 27% 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 3.2, down from 3.4 third quarter and 4.3 at the end of 2nd quarter. Muni CEFs have noticeably higher average Market Price Volatility of 8.4, down from 9.4 third quarter and 11.3 at the end of 2nd quarter. Liquidity can be an issue for this sector; 49% 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 2.3% a couple with $1M+ in household W-2 income gets a federal Tax Equivalent Yield (TEY) of about 4%, while the same investors in the average traditional Muni Bond CEF would receive an average Yield of about 5.9% for a TEY of 10.3%. 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 2560 press releases during the fourth quarter of 2014. About two-thirds 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 (slightly higher than normal); there were only 45 notices of cuts and 70 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 +2.3% or an average decrease of -2.7%. The average large change resulted in an average increase of +9.9% or an average decrease of -7.6%. In looking over the past quarter, the gains were spread across all groupings of the CEF universe. Taxable bond funds had 26 cuts, and only 17 increases while National Muni Bond CEFs had 5 cuts and 6 increases , State Muni CEFs had 3 cuts, but 8 increases. Debt-based BDCs had 1 dividend cut and 4 increases while there were no changes to Equity-based BDCs.
There were 4 press releases for Rights Offerings this quarter, which is down from 8 during 4Q13 and the average of 7 per quarter since 1Q13. Tender Offers announcements were elevated at 10 vs. an average of 16 per quarter. There were 8 Secondary Offerings for traditional CEF vs. 7 for BDCs. There were 6 distribution policy changes and there were 20 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 third quarter, Equity CEFs averaged NAV returns of -0.4% vs. a Market Price TR of -0.3%. Taxable Bond CEFs averaged -1.2% NAV returns vs. a Market Price TR of -1.5%. Municipal Bond CEFs averaged NAV returns of +2.3% vs. a Market Price TR of +3.5%. This is not surprising due to a strong continued recovery in the Muni Bond market. We believe that Taxable Bond CEF and BDCs Discounts widened for tax-loss season and then should recover in early 2015 . Debt Focused BDC CEFs posted a +2.5% NAV total return and -4.8% Market Price TR. 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 +3.0% NAV TR and a +3.4% Market Price TR. Full Year 2014 on Market Prices, the major CEF groupings are up: 7.9%% for Equity Traditional CEFs, +11.2% Bond Traditional CEFs and -5.0% for BDCs.
Activist / Corporate Action Update: Activist investors were a little more active during the fourth quarter vs. the third quarter. Karpus disclosed a 13D filing with an increase to 12% of Invsc Bnd Fd(VBF) shares. Lazard announced a 13D increased stake in Abd Emrg Mkt Sml Co Opp Fd (ETF) to 21.2%. Bulldog filed and 13D for Nuveen Dividend Currency Opp (JGT) to 8.0% and SIT Investment disclosed a 13G filing with an increase to 26.9% for BR Enh Govt Fd (EGF).In the past quarter there have been 45 activist/activist follower increases vs. 60 decreases in share ownership filings. We expect 2015 to be a very, very busy year for Activists and CEF shareholder will benefit from their work in narrowing discounts.
Recent Traditional CEF Initial Public Offerings (IPOs): There were 3 Traditional CEF IPOs in 4Q 2014. First IPO was made by Eagle Point , a Loan Participation Fund. It raised $103M on October 14 and trades under the ticker symbol (ECC). The second IPO a BlackRock fund. It is a technology Covered Call focused fund and raised $420M in assets on October 29 and trades under the ticker symbol BST. Third fund that IPOed this quarter is Miller/Howard Hi Incm Eq Fd, trading under the symbol HIE. It raised $245M on November 25. What is of note for HIE is that it will return shareholders NAV at the end of 10 years. This may be a new feature in future equity IPOs to help bring them to market and address the concerns about discounts.
During 2014, there have been 9 traditional CEF IPOs, only raising $4.2B in new assets and averaging $469M per IPO vs. the ten year average of $431M per fund and $11B per year.
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. $3.5B was raised in BDCs during 2014 with an average size of $575M when historically they raised on average $166M but have historically grown net assets about $700M 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.
Two funds that IPOed in the past 3 calendar quarters are trading at a premium: TPG Specialty Lending Inc (TSLX) and TP Vntr Gwth BDC Corp (TPVG), both BDCs. The average discount for a recent IPO is -8.71% and the average price per IPO price is 86.3%, which is down from 97.5% last quarter.
CEF Mergers: We have seen a large increase in mergers since 2012, averaging over 40 per year and 36 in 2014. The trend decreased in the last part of the year, with less 5 mergers in fourth quarter 2014. We believe it will settle back into a normal range of 10 per year for 2015 and the near to medium term.
CEF Deaths : We only lost 16 funds in the past 36 months and 7 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 84%, compared to 80% during third quarter. Taxable Bond CEFs are showing an average Correlation to NAV of 74%, down from 77%. Municipal Bond CEFs are showing an average Correlation of 25%, down from 38%. State Muni funds are at the lowest levels at only a 14% correlation. CEFs as a whole are about -1% 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 3.2 to 4.9 while Equity CEFs have NAV volatilities of 12.7 for Specialty Equity and 14 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 7.9 to 9.1, down from 9-10 last quarter and traditional Equity CEFs are showing Market Price Volatility of 15.4 to 17.1. 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 28.1, while Debt-Based BDC CEFs have lower Volatility at 19.6. Both are essentially lower than last quarter.
New CEF Universe Data: During the fourth quarter we added 21 items to our weekly data service for BDCs bring the data covered to 100 data points. Notable items include, 3 year Z-stats, % owned by institutions, dividend increase and decrease %, last dividend change date, 1 year and 3 year dividend growth rates, SBA debentures %, more portfolio allocation breakdowns, % variable and fixed portfolio loan %, non-leverage expense ratios, YTD and 1 year price return (excluding dividends), Non-accrual investment %, average maturity of loans, number of loans, # of portfolio companies (loan and equity), ex-dividend date, 52 week discount low and high and finally % of portfolio Energy, Oil, Gas or related services. We expect to add about 15-20 data points for BDCs and 10-15 for traditional CEFs during 1Q15 and bring the total up to about 115 total data points by year-end for BDCs and 185 for traditional CEFs.
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 activism trends. We were asked about what we thought the impact of volatility on a diversified portfolio would be. People asked about the ratio of retail vs. institutional ownership of CEFs. Several people asked about examples of our current best ideas for CEFs. We were also asked by a number of people about our outlook for IPOs in the coming quarter. We were not surprised to be asked about the effect of interest rate increases on Muni Bond CEFs. We were also asked if it is too early to consider investing in high-yield Bond/Loan CEFs, especially if they have energy exposure. As usual many people asked about discounts now compared to historical levels (1,3,5,10 years) and what we saw for discount trends going forward. We were asked about how well CEFs perform when they’re at wide discounts. We also got a few questions about BDCs. Several people wanted to know about the changes we expect for the BDC sector in 2015 and whether or not the incentive fees are worth it. Specifically people wanted to know our opinions on PSEC, FSIC, and MCC. People wanted to know about our dividend outlook for traditional CEFs and BDCs.
CEFA’s 1Q 2015 Outlook: We are still planning on maintaining BDC exposure for all but our Municipal Bond model at a 4% to 20% level. NAV stability/growth, dividend coverage and yield are important data points for evaluating BDCs in the coming quarter. Compared to historical levels, BDCs are very, very cheap right now. We expect the number of dividend cuts for Bond CEFs to increase this quarter. If NAV performance slows, we will have some concern that RoC will become more prevalent in US Equity funds. Though some are at pervasive discounts, in general, CEFs have benefited from their fixed capital structure.
Energy exposure to MLPs funds and BDCs was overdone in our opinion. We think BDC discounts have priced in that the energy exposure for most BDCs goes down by a loss of over -50% which is a very low probability event. We will get BDC data updated in February and March and that is when we think BDCs will start to trade at higher levels to book or NAV levels. We are overweight MLPs, Sr. Loan and emerging market bond funds and underweight high yield bond exposure
Muni Bond CEFs are a little cheap; though Earnings Coverage is positive, the UNII trend for the sector is concerning. It is important to be selective when choosing amongst these funds and to watch Destructive RoC and UNII trends and check to make sure that the data is not stale. When comparing the cost and terms of leverage and their impact in 2015, factor in whether your goal is to is to buy and hold or to capture alpha. We expect 20% to 40% of municipal bond funds to reduce dividend levels as UNII trends are running low and replaced bond from maturities and calls are still at very low levels vs. most dividend policies.
When swapping between funds, look for those that have NAV performance above the peer “Anchor Point” average. We think investors should stay diversified, look at their asset allocation objectives and then continue to monitor CEFs for NAV performance, dividend risk and pricing levels vs NAV on a historical and peer-group level.
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 December 312014.