Closed-End Fund Advisors started tracking two new data points we thought would help us select and compare dividend risk for a closed-end fund. They are: Undistributed Net Investment Income Trend (UNII) and Earnings Trend. By taking the slope of the last three UNII and earnings figures for a fund, a trend is determined as “up”, “flat” or “down”.
When CEF collects dividend and bond income and pays a regular dividend to shareholders, it reports UNII as a line item on its balance sheet. If a CEF increases its UNII balance, it has more reserves on hand to possibly distribute as a dividend. Increases in earnings also gives the potential that a fund could be increasing its dividend level in the near future. When these figures are in line with each other (i.e. both earnings and UNII trends are positive or both negative), it makes a stronger case that either the fund is increasing or reducing its future income production. This, in our experience, makes it more likely that the Board may alter their dividend policy accordingly.
At Closed End Fund Advisors (CEFA) we also believe Earnings the Coverage Ratio (ECR) may be a predictor of dividend changes. This data point is defined as the current average earnings per share (EPS) divided by the appropriate dividend per share. Earnings above the dividend policy can result in increased UNII. Increased UNII can increase the fund’s ability to navigate poor markets or poor investment decisions by the portfolio manager.
Since we believe these three data points (UNII trend, earnings trend and earnings coverage ratio) all are relevant to dividend changes, we sought to find a combination of the three that gave us the highest confidence levels to predict a dividend change for a municipal tax-free bond CEF. We picked this CEF group as there are over 100 funds in which to identify a trend. This allowed us to review and identify a correlation between our data and the board of director’s distribution changes.
Our research began by examining each major category of CEF’s (equity, taxable bond and tax-free municipal-bond), attempting to find the category that most correlated with these metrics. What we found was a high correspondence between dividend cuts and downward UNII trend. This makes sense as reduced UNII means the fund has less of a cushion to distribute to its shareholders, possibly warranting a cut. The next step was finding a combination of these metrics that gave us the highest confidence levels for predicting a distribution cuts. Below is a graph showing the Relative UNII for all National Muni Bond Funds in 2012.
In addition to UNII trend, we saw a relationship between dividend changes and earnings coverage ratio. As a reminder, the earnings coverage ratio is defined as current EPS over dividend per share. A ratio greater than 100% means the fund can cover its distribution with its reported earnings level. Any figures below 100% mean the fund may not be able to distribute solely from its earnings, but possibility from capital gains, return of capital, or from its UNII balance.
As seen in table above, there is a trend between the funds that cut, maintained or increased dividends and their respective ECR’s. It should be noted that during this time span, there was an overwhelming amount of dividend cuts compared to increases, the majority occurring in December. Because the sample size for increases was so small, we again narrowed our focus to dividend cuts. Increases also all occurred in the 4 Build America Bond funds. We only looked at funds that report UNII monthly which equals around 62% of the total number of funds in the category. We felt this was the best way to look at funds on an equal basis though various market fluctuations.
Given the significant relationships between dividend changes with both ECR and UNII, a combination of the two must yield a significant figure in predicting dividend cuts. In funds that cut their dividend in the last four months AND have an ECR of less than 100%, 91% of the funds had a downward UNII trend.
Given these results, we now know looking for a Muni CEF with ECRs of less than 100% and a downward UNII trend can be a useful first step in predicting a dividend cut, and should generally be avoided by income oriented investors.
One concern we noted with these findings is the fact that some funds with negative UNII trends and ECRs under 100% did not cut their dividend. This is puzzling, as a fund that is unable to cover its dividend with its earnings AND is using up its UNII does not feel the need to reduce its distribution. A possibility to consider would be short and long term gains for the funds that would help cover the dividend. One way to quickly check for this is to look at the composition of distributions for each fund, for short-term/long-term capital gains or return of capital for the fund.
In every fund that met our criteria, none had any distributions reported as anything besides income. We will continue to closely monitor a CEF’s data and dividend announcements for CEFs in 2013, hoping that we can improve our dividend increase/decrease predictability.
Note: This project and article was conducted and written by Andrew Pavloff, a senior at The College of William and Mary who has been “externing” with Closed-End Fund Advisors for the 2012-2013 academic year under the direct supervision of John Cole Scott.