Investment opportunities, like objects in your car’s side-view mirror, may be larger, or smaller, than they appear. This is often true in the closed-end fund (CEF) market, where most funds strike daily net asset values (NAVs) as do open-ended mutual funds, but also have a second value: the market price. In periods of high uncertainty and volatility like we’ve seen this year, the difference between a CEF’s NAV and its market price can be wide and similarly volatile.
CEF shares trade on exchanges at market prices that are driven by supply and demand and can vary throughout the trading day. Premiums (market price > NAV) and discounts (market price < NAV) are common. Historically, discounts have averaged about 4.3 percent across the broad CEF market, but currently average just over 6 percent.
What is driving discounts?
Closed-end funds started their journey towards wider-than-average discounts during the “taper tantrum” that began in May 2013 as the market began to react to the Federal Reserve’s plan to taper its quantitative easing plan and eventually raise short-term borrowing rates. The anticipation of rising rates contributed to declining market prices for many CEFs because most (roughly 75 percent) use leverage1. Leverage involves borrowing (or issuing preferred shares) at short-term rates to garner additional capital to invest, with the goal of enhancing the fund’s return and income. If short-term rates increase, leverage costs typically increase as well, reducing—though likely not eliminating—the expected benefit of leveraging.
In addition, given that closed-end funds are mainly held by retail investors and the average fund’s market capitalization is approximately $470 million, it doesn’t take a very large change in either supply or demand to affect a fund’s market price.
Concerns about interest rates appear to have grown smaller in the mirror, however, as discounts on 24 of the 25 CEF market segments Nuveen tracks have narrowed over the three months ended March 11, 2016, by anywhere from 43 to 758 basis points (bps). In the municipal bond segment—the single largest asset class strategy in the CEF market—discounts improved an average of 390 bps across all national funds, and 492 bps across all state-specific funds, as their prices appreciated more than their NAVs. For the 12 months ended March 11, 2016, the municipal bond CEF segment had an average return at NAV of more than 6 percent. Several funds now trade at premiums.
Last fall, I wrote that in the midst of volatility, there may be opportunities for the steely and patient CEF investor. Many of those who stayed the course, or bought additional shares, appear to have been rewarded.
Are all the opportunities behind us?
Although discounts have narrowed for many funds, opportunities still exist. Discounts should not be the primary reason to invest in CEFs. CEFs are designed and managed for their income and distributions, which can often outpace those of traditional income investments. In the municipal bond sector, many unleveraged CEFs are yielding more than their related Morningstar mutual fund category. Even at a premium price, these funds’ yields may still represent attractive tax-exempt2 cash flow. And, leveraged municipal bond strategies continue to enjoy additional income from leverage, particularly because short-term rates in the municipal market have NOT increased since the Fed’s rate hike in December. Strong demand for short-term municipal investments, coupled with limited supply, has kept the cost of leveraging municipal CEFs relatively unchanged. In a “low and slow” rate hike scenario, leveraged municipal bond funds may continue to offer attractive yields.
In addition, some CEF market segments are still trading at wider discounts than they did a year ago, despite improvement over the past three months. Senior loan, U.S. large cap equity, global equity and real estate CEFs are trading at double-digit average discounts that are greater than their discount levels a year ago. Discounts on senior loan CEFs, which offer income from loans that is linked to changes in short-term rates, have tightened but still trade at an average discount of 10.52 percent. Since most senior loans are issued by below investment-grade-rated companies, this category is experiencing softness in concert with declines in broader high-yield credit markets, even though senior loans sit at the top of most issuers’ capital structures.
What should advisors do?
CEF returns can benefit from the funds’ distinct features: the ability to persistently use leverage and invest in less liquid but potentially higher-returning investment strategies, and fully invested portfolios that need not hold cash to meet investor redemptions. But successful CEF investing often requires a long-term focus and a willingness to zig while others zag. When evaluating CEFs, investors should consider:
- How CEFs may increase cash flow and diversification in an income portfolio, particularly for longer-term purposes like retirement income
- Targeting asset strategies based on expectations for a strategy’s performance potential
- Evaluating fund income and distributions relative to performance (NAV performance “fuels” a fund’s distributions)
- Seeking entry price points that represent value:
- When discounts are widening because a fund’s NAV is increasing faster than its price
- When a fund’s yield on market price is better than other suitable substitutes, whether those are competitive closed-end funds or other investment vehicles
Just like a smart driver focuses on the road ahead while scanning all the mirrors in the car, and occasionally looking over their shoulder, smart CEF investors and their advisors would do well to focus on long-term income and cash flow goals, while considering information from all available sources.
1 Leverage may increase a fund’s risk and volatility, and is not guaranteed to be successful.
2 Tax-exempt (municipal bond) fund income may be subject to state and local income taxes and the alternative minimum tax. Capital gains, if any, will be subject to capital gains tax.
Morningstar, as of 03/11/2016.
Closed-end fund shares are subject to investment risk, including the possible loss of the entire principal amount that you invest. Common shares frequently trade at a discount to their NAV. At any point in time, your common shares may be worth less than you paid, even after considering the reinvestment of fund distributions.
Senior loans and other below-investment-grade or unrated securities may fail to make dividend or interest payments when due, and may be subject to greater volatility and risk of default. Senior loan and municipal bond funds generally pay distributions composed entirely of net investment income, unless noted otherwise. In general, potential closed-end fund distribution sources include net investment income, realized gains and return of capital.
For detailed information, including full risk disclosure, for any Nuveen closed-end fund, please see that fund’s web page at www.nuveen.com/cef.
Anne Kritzmire is Managing Director of Closed-End Funds at Nuveen Investments.