CEF Market Update: 1.19.2017
Senior Portfolio Specialist Allen Webb talks with Portfolio Manager Steve O'Neill about the closed-end fund market for the last month.
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[BEGIN VIDEO TRANSCRIPT]
ALLEN: Steve doing a post-mortem on the 2016 closed-end fund market. It was a pretty good year. From a price return standpoint, all closed-end funds returned about 8 ½ percent. Most of the sub-asset classes also had positive returns, anywhere from munis up 50 basis points to taxable fix up over 16 percent, I believe. Then, from a discount standpoint, all closed-end funds had discounts narrow about 150 basis points on average, coming into the year at eight and ending the year about 6 ½. Any way you look at it, pretty good year for closed-end funds, even in light of capital market returns, broadly. Steve, turning to 2017, give us your thoughts on what we may see in the closed-end fund market.
STEVE: Sure. I think 2016 was such a win-win from both a NAV and discount-narrowing perspective that it would be hard to imagine replicating those kinds of returns. Frankly, I would be very surprised if you saw taxable bond funds up near 20 percent returns again, simply because spreads have narrowed so much as it is that you don't have that much juice left to squeeze. When I think about 2017 returns, you really have to break it down in two ways. You've got NAVs and discounts. Now, it's true that discounts tend to follow NAVs and so making any sort of forecasts, we kind of need to better frame the question. I would say if bonds clipped their coupons and equities deliver an earnings growth plus distributions type of return, then you have an environment where I think discounts continue to narrow.
You said they narrowed about 150 basis points last year. I think you could see another 150 basis points quite easily because investors buy assets when they're doing well. The typical investor is going to look at their closed-end fund portfolio and they're going to say, “Wow, the average fund was up 8 ½ and I've got a couple in my portfolio that were up 20 and the average distribution yield is still seven”. If those funds are also trading at a seven to 10 percent discount, I wouldn't be surprised to see those trading at five, because investors tend to put more capital to work when things are going well. I think bank loans are a perfect example of this, where last year when we had this conversation for December, bank loan closed-end funds were trading at 10 to 12 percent discounts. Now your average fund's trading close to par.
The reason for that is returns were solid. Investors put money into open-end mutual funds and ETFs so some of that trickled into closed-end funds and discounts narrowed. That was really just a case of demand pushing discounts narrow. That demand was based off investors extrapolating returns in the future. I think that that's fair to assume for closed-end funds as well. If you assume an environment where bonds are clipping coupons then investors will continue to put capital to work in closed-end funds because they are cheap and discounts have a lot of momentum.
On the equity side, discounts are still really cheap. You've got closed-end funds that own US large-cap stocks trading at 10 to 15 percent discounts. We've covered the reasons why that's the case, higher fees and active management. In an environment where taxable bond fund discounts are narrowing, which is my assumption, the rising tide will lift those as well, so your 15 percent discounts could easily be 10 to 12. I think that that also coincides. If positive sentiments towards equities persist it's just really hard to imagine discounts trading at the same level that they have been for the last few years. That's kind of my forecast for discounts. I think discounts continue to narrow.
Again, on the NAV side, valuations are high across the board. Equity valuations are high. We need earnings growth to deliver to really justify those high multiples. On the fixed-income side, most taxable closed-end funds have corporate credit exposure. A lot of that exposure is high-yield bonds, which is the reason why we talk about it so often. You've got spreads that are 50 basis points above their post-crisis lows. It's just mathematically impossible to deliver another 17 ½ percent return. When I think about the NAVs, it's a tough question to answer because, technically, I think discounts continue to narrow. Fundamentally, investors should be thinking about taking some chips off the table because asset-class returns have been so strong. I think it'll be another good year for closed-end funds but it's not going to be anything like 2016.
ALLEN: To that last point, Steve. I guess it's important to note that while you have an attractive structure in a closed-end fund from a valuation standpoint, the assets inside of that structure are obviously more fair value than they were at the beginning of 2016 when you saw some capital markets dislocation.
STEVE: Exactly. If we're talking about lower beta, lower asset-class returns, then it makes more sense than ever to own that asset class through a closed-end fund because the ability to generate a couple of hundred basis points of alpha is a large part of that expected total return, whereas last year, just going back to high-yield bonds, if the NAV was up 20 with a little bit of leverage and the market price was up 22, nobody really cared that much about that two percent of alpha.
I think a high-yield bond fund with a six, seven percent expected return, you add 200 basis points of alpha to that and it looks a lot juicier. When I think about asset classes and exposure levels, I think it's fair to say that investors should own, it's obvious from an evaluation perspective, own less-risky assets when valuations are high. When you own those asset classes, if you have an allocation to equities or spread fixed income, it makes a lot of sense, again, to own those at seven to 10 percent discounts.
ALLEN: Steve, you brought up a couple of interesting points that I want to circle back on, first being distributions. We have talked at length on some of these videos about the fact that the closed-end fund market is generally ultimately owned by retail investors. One of the reasons that retail investors are attracted to closed-end funds is yield. I personally find it interesting that the list of funds that cut their distributions in 2016 is pretty lengthy yet the closed-end fund market, as we referenced earlier in the video, had a great year. Can you help me sort of marry cutting distributions with the fact that discount narrowing and positive total returns was a theme for last year?
STEVE: Sure. I think, more often than not, your average closed-end fund cut their distribution. A big part of that is just spreads coming down and so the asset side is earning less. On the liability side, the cost of short-term borrowing has increased and so distributions have been cut. Despite that, discounts narrowed on average. Asset class returns were positive, but that's not necessarily correlated to the movement from the discount.
When I think about distributions, it's important to remember that most closed-end fund sponsors kind of tweak distributions every month. If every other month the distribution gets lowered 1 ½ percent, that doesn't really bother a lot of investors because the distribution, from an absolute standpoint, is still pretty high.
The issue is when you've got sponsors that cut once a year and it comes out of the blue, or at least to the blue to investors that aren't doing their homework, the homework just being reviewing the distribution power of each closed-end fund. If you've got a closed-end fund that has an unsustainably high distribution rate and they cut it and they're already trading at a relatively rich premium or discount, then you always have that classic selloff, which most people expect when a closed-end fund cuts their distribution.
For the most part, bond funds stick pretty close to paying out what they earn. The rise in LIBOR and the declining yields in the asset side, it's been gradual and the distribution rates have been gradual as well. People don't have the same knee-jerk reaction as they might have in the past, and to be fair, a big part of that is that closed-end funds are still pretty cheap. If your closed-end fund's trading at a 10 percent discount that cuts the yield two percent, two percent distribution cut on a monthly basis, maybe it's only 25, 50 basis points annually. Nobody really cares about that.
ALLEN: Question number two... let's talk about activism for a second. In a couple of videos last year we talked about the rise in activism with some of the discount levels being somewhat wide. In addition, [there are] some new players from an activism standpoint. Is that something you think will continue in 2017, people from the outside trying to force discounts narrower in certain funds or have we kind of come through that cycle now with discounts narrowing a little bit?
STEVE: I'd say that now is probably the riskiest time to be a closed-end fund trading at a double-digit discount. There are more investors, in my view, with deeper pockets than ever trying to push closed-end funds to narrow the discount. That said, there are not a lot of funds trading wider than a 10 percent discount. I think the number of funds that are going to receive pressure will decline but any fund that's trading wider than 10 percent, I think, is highly susceptible to shareholder activism. That, frankly, is good for the space because closed-end fund discounts should never really get wider than 10 percent. When you're trading at 85 cents to the dollar, that's a failure of the fund company, it's a failure of the board and it, frankly, tells you the market doesn't want this investment vehicle. I think it's really important that there is that balance in the market. Institutional ownership has, in my view, kept discounts narrower than they otherwise would be. Again, to your point, do I think activism will continue? I think it's been successful enough that it will always be there, from an opportunistic standpoint. If our base case plays out and we say that discounts continue to narrow, then I suspect that there will be a number of liquidity events for 2017 because a lot of investors have already deployed the capital and they need to find an exit of their investment. Some of those will play out in 2017 but the number of new campaigns should certainly decline because the math isn't as attractive if you're starting at a seven or eight percent discount.
ALLEN: Steve, on that last note, if you think broadly about activism in 2016, without mentioning specific names or campaigns, was activism successful as a strategy in what was already a pretty good market for closed-end funds last year?
STEVE: Sure. Closed-end funds across the board narrowed and funds that had shareholder activism, whether a liquidity event was provided or not, the presence of new demand from institutional investors, or copycat investors, narrowed those discounts as well. I think everybody won in 2016. 2017, it's always tough to say, but from an institutional standpoint, I think there's a lot of opportunity still in a number of closed-end funds that are likely to have liquidity events. Again, the number of funds under attack should decline in 2017.
ALLEN: Last question, Steve. We talk frequently about, again, the fact that the closed-end fund market is generally a retail-owned market. When you look at the wide discounts early last year and then the subsequent performance of closed-end funds for the balance of the year, has that attracted any type of new player into the closed-end fund market, whether it be institutional or otherwise, or are we still sort of at that 90 percent retail-owned market that we have talked about at RiverNorth for a number of years?
STEVE: It's still a retail market. When closed-end funds IPO, they're predominantly owned by retail investors and so it certainly would take time for the investor to mix the change. What I think is really surprising, it's a consequence of discounts being wide for so long, is that many investors and many fund sponsors didn't think it was possible for institutional investors to accumulate 10, 15 percent of a fund in a very short period of time. It's happening. It's happening on dozens of closed-end funds. The reason for that is that, from a market price standpoint, when you think about distributions and the discount winding that occurred since 2013, you get a lot of funds whose market prices are well below where they were trading in 2012, 2013. Total returns are still pretty strong but, from a market price perspective, the market prices are lower.
From a discount perspective, there are a lot of investors that are selling out the closed-end funds at 10 percent discounts. They're able to accumulate very large size without moving the discount the way you might have thought so in the past. I think that's a symptom of two bear markets in closed-end funds. You had the taper tantrum and then you had another bear market in 2015. When investors lose that kind of money twice, despite everybody else making so much money in other asset classes and other investment vehicles, that just sows the seeds for unhappiness and discontent. A lot of investors sell closed-end funds or look to get out. These institutional investors are really coming out of nowhere to pick up that liquidity.
What historically kept the market primarily retail was the lack of trading liquidity. It was really hard to accumulate a 10 percent position. Now, a lot of investors are like, “Look, I'm going to get out of these closed-end funds and so I'm happy to sell to this strong buyer” and so—
ALLEN: So - sorry to interrupt - the strong buyer providing liquidity for the others to exit the trade.
STEVE: Exactly. It's kind of like the pig and the python. There are a lot of shareholders that want out of closed-end funds. The liquidity provider recently has been institutional investors that are pressuring for change. Again, I think, with returns being so strong and a lot of the selling already taking place, that volume of selling should subside. That's a big reason why discounts narrow, right? Discounts are only narrowing when there's an imbalance to the buy side, so if all of a sudden all the sellers, from a retail perspective, just say, “Hey, look. I don't really dislike this closed-end fund anymore. Hey, look. It was a great return in 2016. Maybe I want to own it. Maybe I want to buy it”, then all of a sudden discounts narrow and the market where discounts are seven percent to zero, that's going to be a retail market. In an environment where discount are seven to 12, that will be an institutional market.
The last three years have really been an anomaly. It has actually increased the institutional ownership in the space. I think that that is cyclical. As discounts narrow it will go back to more of a retail market.
ALLEN: Steve, thanks as always for your comments. I look forward to seeing how the year unfolds.
STEVE: Thanks, Allen.
[END VIDEO TRANSCRIPT]
Video recorded 1.19.2017.
Produced by RiverNorth Capital Management, LLC ("RiverNorth" "we" or "us").
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This information is provided for informational purposes only and should not be considered tax, legal, or investment advice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Opinions referenced are as of the day recorded and are subject to change due to changes in the market, economic conditions, or changes in the legal and/or regulatory environment and may not necessarily come to pass.
Past performance is not a guarantee of future results. Diversification does not ensure a profit or guarantee against loss.
Investing involves risk. Principal loss is possible.
The price at which a closed-end fund trades often varies from its NAV. Some funds have market prices below their net asset values - referred to as a discount. Conversely, some funds have market prices above their net asset values - referred to as a premium.
Definitions
The S&P 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy based on the changing aggregate market value of these 500 stocks. The Barclays Capital U.S. Aggregate Bond Index is an unmanaged index of investment-grade fixed-rate debt issues with maturities of at least one year. The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. The indices cannot be invested in directly and do not reflect fees and expenses.
Muni is short for municipal bonds.
Basis Points (BPS): A common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. Widening credit spreads indicate growing concern about the ability of corporate (and other private) borrowers to service their debt. Narrowing credit spreads indicate improving private creditworthiness.
Coupon is the annual interest rate paid on a bond/loan.
Total distribution yield is calculated by taking the last declared distribution (including all elements: Income, capital gains and return of capital) then annualizing the amount (i.e., multiplying by 4 for a quarterly paying fund; by 12 for a monthly paying fund). The total distribution amount is then divided by the current share price and multiplied by 100 to arrive at a percentage figure. Year-end “special” distributions are excluded – i.e. the yields are based on recurring distributions only.
Par is a term that refers to a financial instrument that is trading at its face value.
Market Capitalization (Market Cap) is the total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying a company's shares outstanding by the current market price of one share.
The financial crisis of 2007–08, also known as the global financial crisis and the 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.
Beta reflects the sensitivity of a fund’s return to fluctuations in the market index. A beta of 0.5 reflects half of the market’s volatility as represented by the Fund’s primary benchmark, while a beta of 2.0 reflects twice the volatility.
Alpha is a measure of performance on a risk-adjusted basis. The excess return of a fund relative to the return of the benchmark index is a fund's alpha.
Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value.
LIBOR is the world’s most widely-used benchmark for short-term interest rates. It serves as the primary indicator for the average rate at which banks that contribute to the determination of LIBOR may obtain short-term loans in the London interbank market.
Shareholder activism is a way in which shareholders can influence a corporation's behavior by exercising their rights as owners. Although shareholders don't run a company, there are ways for them to influence the board of directors and management. These can range from dialogue with management to voice their concerns about a particular issue to formal proposals that are voted on by all shareholders at a company's annual meetings.
A bear market is a condition in which securities prices fall and widespread pessimism causes the stock market's downward spiral to be self-sustaining.
An Initial Public Offering (IPO) is the first sale of stock by a private company to the public.
Fed Taper Talk: Federal Reserve Chairman Ben Bernanke announced that the central bank would begin paring back its $85-billion-a-month bond-buying program should the economic data continue to improve. This caused an aggressive stock market sell off and an increase in interest rates.
Source: RiverNorth, Morningstar, Inc.
