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Midyear Review for Fixed-Income CEFs

We take a look at 2012's CEF performance, distributions changes, and IPOs.

Steven Pikelny, 07/13/2012

We've reached the midpoint of 2012, and, overall, the closed-end fund, or CEF, universe has performed well. In the past, we've highlighted the entire universe of funds in our midyear review. Based on user feedback, this year, we've decided to discuss fixed-income and equity funds separately. Although equity funds steal the spotlight in terms of best and worst performers for the year to date, fixed-income funds comprise the lion's share of the CEF universe. This week, we focus on fixed-income CEFs, and next week, we will dive into equity, hybrid, and real estate CEFs.

For the first half of 2012, fixed-income CEFs logged good aggregate performance, but not for the reasons one would expect. Typically billed as income generators, many of these CEFs cut distribution payments and experienced large gains from capital appreciation. In all, only one fixed-income CEF posted negative net asset value gains for the year to date (Federated Enhanced Treasury Income FTT), and its 0.4% loss is small. Also impressive, 394 of the 403 fixed-income CEFs posted positive share price gains in the first half of the year. Even the IPO market, which typically presents a tremendous problem for new CEFs, has, so far, fared pretty well.

Let's take a look at overall performance.

Year-to-Date Top-Performing Fixed-Income CEFs
The table below shows the top and bottom five performers from a NAV perspective between Jan. 2, 2012, and June 29, 2012.

A glance at the top-performing CEFs over the past six months shows that PIMCO led the pack from a NAV perspective. In fact, the fund family runs 12 of the top 20 performing funds, as well as the top four listed here. But investors should note that many PIMCO funds utilize higher-than-average amounts of leverage, which will magnify returns in good times as well as bad. While the average fixed-income CEF had a leverage ratio (total assets/net assets) of 1.42 at the midyear, the ratio for PIMCO's CEFs ranged from 1.51 to 2.00. PIMCO High Income PHK is an exception, with a leverage ratio of 1.38. Interestingly, the only non-PIMCO fund in the top five, Western Asset Mortgage Defined Opportunity DMO, does not use any leverage, making the mortgage-bond fund's performance all the more impressive.

While cheap leverage helped some of the highly leveraged funds, the worst performers typically utilized lower-than-average or no leverage. Babson Capital Participation MPV, NexPoint Credit Strategies HCF, and Babson Capital Corporate MCI had leverage ratios of 1.12, 1.38, and 1.12 at the midpoint, while Federated Enhanced Treasury FTT and Templeton Emerging Markets Income TEI used no leverage.

Although many investors typically attribute the high performance of CEFs to the use of leverage, this criticism is not necessarily relevant for the overwhelming positive performance of fixed-income CEFs in the first half of the year. This impressive, albeit short, track record across the fixed-income CEF would hold true in spite of any leverage.

Year-to-Date Fixed-Income Sector Performance
Although no sector dominated the top- or bottom-performer lists, there was still some healthy variation among categories. On average, government and limited-duration categories were the lowest NAV performers. The groups were still in the black with 3.4% and 5.4% average returns, respectively, but other, slightly riskier groups posted stronger gains. The multisector and high-yield categories, for example, returned 9.4% and 8.3%, respectively. The table below shows performance results by sector.

One-Year Top-Performing Fixed-Income CEFs
Of course, investors should take caution before giving too much weight to such a short time period. Taking the past full year into account tells a much different story. The next table expands the performance to a one-year view (which is still too short to make judgments about medium- to long-term performance).

Over the past year, municipals clearly dominated the top performers. In fact, the table does not capture the magnitude of this dominance: Muni CEFs made up the top 142 performing fixed-income CEFs based on NAV over the trailing 12 months. Pretty good, considering there are 251 funds in the category. Even the worst-performing municipal CEF (unleveraged Nuveen Select Maturity NIM) returned a respectable 7.3% on NAV, clocking in at number 318 out of 403 fixed-income CEFs.

The strong performance can be explained, in part, by the global macroeconomic environment over the second half of 2011. As Europe perpetually appeared to be on the brink of financial collapse, the fiscal outlook of many municipalities continued to improve. Munis were seen as a safe haven by investors, which led to rampant capital appreciation. Similarly, 10 of the bottom 20 fixed-income performers focused on either emerging-markets or global debt, the credit quality of which is more susceptible to the outcome of the eurozone debacle. Munis did see a small sell-off in mid-March, but this was not significant enough to hamper one-year performance.


The above table shows changes in the distribution rates for fixed-income CEFs for the year to date. In general, investors have seen few increases to distributions so far in 2012. While 49 funds raised distributions in absolute terms, 135 cut distributions. Taking into account capital appreciation, distribution rates with respect to NAV fell an average 5.4% (37 basis points) to 6.5% from 6.9% for the year to date. Because the average premium also increased, distribution rates with respect to share price fell an average of 6.5% (45 basis points).

Tax-free income from municipal CEFs are particularly popular, so let's look at the same table including only municipal funds.

For munis, the average distribution rate at NAV fell 6.7% (42 basis points) to 5.7% from 6.1% for the year to date. Accounting for the increase in premiums, investors are now realizing 7.3% less income (45 fewer basis points) than at the beginning of the year. This can partially be attributed to three main factors. First, and most obvious, is the capital appreciation of municipal bonds. Because coupon payments are fixed, an increase in the price of the bonds translates to lower yields. Second, the already low interest rates have led many municipalities to exercise the call options (when available) on their bonds. This means that many funds with high exposure to callable bonds have faced reinvestment risk, which has weighed on income. Third, many municipal funds have redeemed their auction-rate preferred shares in favor of alternative financings. This has weighed on the profitability of leverage, as these alternatives are typically more expensive than ARPS.

Initial Public Offerings
The first six months of the year also saw five fixed-income CEF IPOs, matching the total number of fixed-income CEF IPOs in all of 2011. Multisector-bond funds were the most popular, with three IPOs: DoubleLine Opportunistic Credit DBL, PIMCO Dynamic Income PDI, and Virtus Global Multi-Sector Income VGI. Legg Mason BW Global Income Opportunity BWG focuses specifically on global debt, and Prudential Short Duration High Yield ISD focuses on the high-yield market. DBL and PDI were perhaps the most notable IPOs of the year so far, as they each defied the common wisdom of CEF IPOs.

CEFs typically have difficulty completing IPOs because their underwriting fees automatically cause shares to trade at approximately a 5% premium. This means that shares typically drop to NAV, and sometimes to a discount, within a few months of the IPO. Because many seasoned CEF investors expect this, it can be a hard sell. Although DBL's premium briefly dropped to a post-IPO low of 4.2%, shares have consistently remained at a premium. As of July 12, 2012, the premium was 9.5%. The fund has performed well; its NAV returned 10.1% since inception. But this is below the 12.3% average for multisector CEFs over the same time period. On share price, the fund has returned 19.7%, compared with the peer group, which gained an average of 16.0%.

PDI is notable for its size. Considering the difficulty in bringing a new CEF to market, it is a remarkable feat that PDI was able to raise more than $1 billion in capital. We believe that PIMCO, the fund's parent company, played a large part in ensuring adequate secondary market support. Of the 18 PIMCO CEFs, all are trading at substantial premiums (22.5% on average). This makes PDI's current 4.6% premium appear small by comparison.

In all, the fixed-income portion of the CEF universe has performed well, both in terms of NAV performance and rising share prices. Although CEF investors might have mixed reactions over their now-lower distribution rates, they can take solace in their overall total returns.

Steven Pikelny is a closed-end fund analyst at Morningstar.
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