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The Discount Double-Check

Investors seeking out CEFs for their discounts should heed these rules of thumb. 

Cara Esser, 09/21/2012

Two weeks ago, we kicked off a seven-part educational series highlighting the unique features of closed-end funds, or CEFs. This week we tackle the often misunderstood discount and premium phenomenon of CEFs, an occurrence that either attracts or repels investors to CEFs. Some investors like the opportunities that discounts can present when used properly, and others hate that the share price doesn't equal their CEF's net asset value.

But we're getting ahead of ourselves. Let's step back and start with how discounts and premiums arise.

The Basics
Like a mutual fund, a CEF has an underlying basket of securities from which a net asset value can be derived. A fund's NAV is the sum of the market value of the portfolio's holdings (its assets) minus its liabilities (leverage is generally the bulk of a CEF's liabilities). The fund's NAV is then divided by the number of shares outstanding to obtain NAV per share. The per-share calculation is important because CEFs trade intraday on an exchange, like a stock or an exchange-traded fund, so every CEF has a corresponding share price that can be compared with its NAV. While a fund's NAV is determined by its underlying holdings (it is theoretically the liquidation value of the portfolio), share prices are determined by market sentiment. And yes, the value of every portfolio security is also dictated by investor sentiment.

The difference in share price and NAV gives rise to a premium or discount. Investors pay the share price, not the NAV, so we are concerned with how much an investor pays for a fund compared with its underlying NAV. If the share price is above the NAV, it's said to trade at a premium; if the share price is below the NAV, the fund is trading at a discount. To find the amount of the discount, you simply divide the share price by the NAV and subtract 1. If this number is negative, shares are selling at a discount; if it's positive, shares are selling at a premium. We denote a discount with a minus ("-") sign and a premium with a plus ("+") sign.

A fund's share price and NAV are rarely, if ever, the same. This has plagued efficient markets gurus because the actual value of the fund is known--it's the NAV. If markets were truly efficient, the share price should equal the NAV. But, as with many economic and financial theories, reality is much murkier.

Greater Fools
Before we get to the nitty-gritty details of discounts and premiums, it's important to discuss why they arise. We are often asked why a certain fund is trading at a persistent double-digit premium or another is always trading at a wide discount. Studies have shown that a fund's distribution rate at NAV plays a big role in a fund's pricing. Generally, a higher distribution rate at NAV leads to a higher premium and a lower distribution rate at NAV leads to a larger discount. The result of these discounts and premiums, vis-a-vis distribution rates, is that they push the distribution rates at share price closer to an average. In this respect, then, the market is acting efficiently; in other words, if all the market cares about is a CEF’s distribution rate, then the premiums and discounts are usually very rational.

Other factors causing discounts and premiums include market sentiment, volatility, fund family and portfolio manager reputation, changes to the distribution policy, and unrealized capital gains in an equity fund. A great example that incorporates many of these factors is PIMCO High Income PHK. This fund currently sells at about a 70% premium, and its three-year average premium is more than 50%. PHK is run by powerhouse investment firm, PIMCO; its manager, Bill Gross, is a household name; and, importantly, its distribution rate is a whopping 18% at NAV. Investors have been willing to pay up for this fund, but there are risks that the market seemingly overlooks.

We generally avoid blanket investment rules (investing is nuanced and decisions are rarely black and white), but 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. A shining example of this is Cornerstone Progressive Return Fund CFP. We've discussed our negative opinion of this fund often in the past (mostly for its poor distribution policy), but the impressive collapse of its premium should be a warning for all investors. This fund traded at a double-digit premium for much of its life: It reached a high of more than 80% in 2009 only to fall to its current premium of less than 13%. This premium collapse has been caused largely by the share price drop from a May 6, 2009, peak of $11.71 to $5.67 at yesterday's close (the fund's NAV has fallen, too). Investors ignoring the high premium and chasing this fund's extremely high distribution rate saw the share price plummet by more than 50%. And this during a market upturn! To be sure, it paid $5.30 in distributions over that time (mostly from destructive return of capital), but the total distributions haven't made up for the $6-plus per share loss in share price. Do not buy into overhyped CEFs trading at double-digit premiums, as there is real risk of premium collapse and capital loss over the ensuing years.

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