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Size Matters When It Comes to CEF Premiums

Thirsty investors are pushing some CEF share prices into the stratosphere. 

Cara Esser, 09/15/2016

While mainstream investors tend to be less familiar with closed-end funds, or CEFs, the prolonged period of low interest rates and the never-ending search for yield have pushed investors outside their comfort zones and into these quirky investments. Driven by sky-high distribution rates, a number of CEFs have soared to unbelievable premiums in recent months. All told, as of Sept. 2, 125 funds sold at a premium, and 26 of those premiums were in the double digits. Compare this to 57 at the start of the year, with 15 of those in the double digits. 

The fund with the largest absolute premium in early September was PIMCO Global StocksPLUS & Income PGP. This fund is no stranger to large premiums, but the recent runup in price is mind-boggling--as of Sept. 9, the fund's share price was more than double its underlying net asset value, giving the fund a 110% premium. Think about that for a bit--investors are willing to pay more than double the fund's liquidation value. Why? For starters, the fund's distribution rate at NAV is a staggering 22%. Factoring in the gigantic premium, however, and the actual distribution rate received by an investor buying shares in early September is just under 11%, though still an enviable payout in the current low-yield environment. 

Investors need to look beyond that payout because the volatility of this fund's premium has been extreme. During the past two years--though the premium has been quite volatile since the 2008 market crash--PGP's premium ranged between 18% and 111%. Investors who bought shares at that "rock-bottom" 18% premium (mid-September 2015) would have seen a tremendous increase in share price as the premium widened almost 90 percentage points between then and early September 2016. Over the trailing 12 months through Sept. 9, the fund gained 43% on share price and just 4% on NAV. But timing the market is nearly impossible, and most investors aren't that lucky. While the current share-price returns look great, investors should be concerned about the fallout. A 100%-plus premium is unsustainable and will collapse at any sign of trouble, real or perceived--and that collapse can happen fast. Just one week before the fund's premium bottomed out at 18%, it was at 43%. PGP is not alone in its super-high premium pricing. The exhibit below shows notable funds selling at large premiums along with various z-statistics.

  - source: Morningstar Analysts

It is important to note that the z-statistic, a commonly used valuation tool, can lead investors astray when funds are selling at consistently large premiums. As background, the z-statistic measures how many standard deviations a fund's discount/premium is from its average discount/premium over the stated time period. For instance, a fund with a three-year z-statistic of positive 2 would be two standard deviations above its three-year average discount/premium. Funds with the lowest z-statistics are classified as relatively inexpensive, while those with the highest z-statistics are relatively expensive. We consider funds with a z-statistic of negative 2 or lower to be "statistically undervalued" and those with a z-statistic of 2 or higher to be "statistically overvalued."

Many of the funds in above exhibit look fairly valued based on z-statistics over varying time periods (z-statistics between negative 2 and positive 2). PGP's premium only appears "overvalued" when looking at the fund's five-year trading history. Over the past three and 10 years, it falls in the "fair value" range. A previous article titled "The Z-Statistic Is No Silver Bullet" explores the relationship between consistently large premiums and z-statistics in more detail. 

CEF Discount Trends
After months of tightening, the average muni CEF's discount actually widened in August to 47 basis points from a premium of 77 basis points at the end of July. For equity CEFs, the average discount narrowed by 32 basis points to 7.6%, and for taxable-bond funds, the average discount narrowed by 17 basis points to 3.2%. Each category has seen a significant narrowing in average discount in 2016: Equity CEFs started the year at an average discount of 9.4%, taxable bonds at 8.3%, and munis at 4.8%. The exhibit below shows the three-year average discount for taxable-bond, equity, and muni CEFs. 


  - source: Morningstar Analysts

Best- and Worst-Performing CEF Categories 
Investors trying to anticipate interest-rate movements continued to drive the top- and bottom-performing CEF categories in August, a familiar pattern for much of the year. Financials, one of the top-performing categories in July, was the top-performing category for August. The category's average share-price gain easily outpaced its NAV return, a sign of growing investor optimism for financials. During the month, the front-end of the yield curve steadily rose, with the two-year Treasury yield rising to 0.80% by the month's end, up from 0.67% at the start of the month. Banks and other financial companies would benefit from higher short-term interest rates because the gap between what they charge borrowers and pay for deposits would widen. 

On the flip side, equity precious metals, real estate, and utilities were among the categories that saw the biggest sell-offs during the month. Each of these categories has enjoyed tremendous returns this year as interest rates failed to nudge higher until recently. The exhibit below lists the best- and worst-performing CEF categories in August.


  - source: Morningstar Analysts

Conclusion
Ultimately, investing involves risk. Any investment can lose money. It is easy to be wooed by distribution rates that exceed 10% each year, but buying a fund solely for its stated payout is misguided. While we generally avoid blanket investment rules, we are firm in our belief that investors have no business purchasing a fund selling at a double-digit premium--the risk of capital loss is just too great. Understanding the risks of CEFs and avoiding the trap of chasing performance or distributions is essential to reaping the rewards of this quirky, yet potentially profitable, investment vehicle.

 

Cara Esser is a closed-end fund analyst at Morningstar.

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