Closed-end funds (CEFs) sometimes get lost in the never ending expanse of investment options. That certainly seems to be the case in recent months, as yield-starved investors continue to gobble up risky debt with coupons at all-time lows while ignoring safer plays in the fixed income CEF market.
As a refresher, CEFs are the subset of mutual funds that trade on an exchange, like stocks or ETFs. They often trade at discounts or premiums to their net asset value (NAV), as there are a finite number of shares for each fund. CEFs are issued via an IPO process at a premium to NAV, but often trade at a discount at some point after issuance.
The global stretch for yield has accelerated following the UK referendum vote in June, as investors have piled into safe haven assets and driven yields ever lower. But with over $13 trillion in negative-yielding sovereign debt and U.S. treasuries near all-time lows, investors are reaching outside of reason in their search for yield.
Take the recent $500 million Ultimate Fighting Championship loans, which were more than four times oversubscribed (in other words, there was enough demand to issue $2 billion worth of the loans if the UFC wanted to). The loans are rated seven levels below investment grade and yield 8.5%. Certainly this is indicative of just how far investors will go to find decent yields.
We believe investors can find much safer and more diversified sources of income among CEFs. One example is Eaton Vance’s Limited Duration Fund (NYES: EVV). EVV has a market capitalization of $1.6B and yields 7.6%, derived partly from the fact that it trades at a discount to NAV of 9.5% and uses low-cost leverage. The portfolio is 37% investment grade and 63% below investment grade, with an average credit quality of BB+ (the highest junk rating). With a leverage-adjusted duration of only three years, it also should hold up well with higher rates.
Other tailwinds across the CEF space should play well going forward. For example, in the last five years, we have seen a great migration from retail to institutional share ownership across CEFs. Institutional shareholders are typically much more demanding on fund managers than retail shareholders. As a result, we have seen increasing levels of activism, with new actions every few weeks. We see this as a sign that institutional investors think there is significant value in the space.
Some of the fixed income funds where we have seen recent activism include: Deutsche Multi-Market Income Trust (NYSE: KMM), Deutsche Strategic Income Trust (NYSE: KST), Franklin Limited Duration Income Trust of Beneficial Interest (NYSE: FTF) and MFS Charter Income Trust (NYSE: MCR). In the equity area, names include: Advent/Claymore Enhanced Growth & Income (NYSE: LCM), Virtus Total Return Fund (NYSE: DCA), The Zweig Total Return Fund, Inc. (NYSE: ZTR) and The Zweig Fund, Inc. (NYSE: ZF). In each of these cases a form 13D has been filled indicating that a shareholder wishes to exert influence over the fund. In many of these cases, the fund company board has taken action as a result of the activism.
Activism efforts are just icing on the cake for CEFs, as the underlying fundamentals are quite attractive, regardless of institutional shareholder actions.
At current levels, taxable fixed income CEFs are trading at a median discount of 7.1% (excluding municipals and preferreds), leaving plenty of room for further discount compression; however, not all fixed income CEFs are a smart buy at the moment. One sector that we are avoiding right now is municipal bond CEFs. The median municipal fund is trading near a 1% discount and is, in our view, overpriced at current levels, especially when compared to taxable funds.
We encourage investors to select diversified, discounted fixed income CEFs with a catalyst to narrow their discount in place of risky, concentrated bonds and loans.
Read more posts from Maury on Forbes.comRelative Value Partners merged with Kovitz Investment Group Partners, LLC as of August 2024. All Insights are opinions of the author as of the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete, and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.