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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.

The Value Trap
The discount and premium phenomenon can get an uninformed investor into trouble for two simple reasons: CEFs almost always trade at a discount or premium (a fund with a share price equal to its NAV is rare, and the occurrence is likely coincidental), and these discounts and premiums tend to be persistent over time. A less informed investor may look at a fund selling at a 5% discount and think he's found a great deal. After all, he can buy $1 worth of assets for $0.95! But an absolute discount can close for many reasons, and only some will benefit him. The table below shows nine ways in which a discount can change. 


  - source: Morningstar Analysts
 

We will focus on the scenarios in which the discount narrows because we are assuming our ill-informed investor purchased a fund under the assumption that, at some point, the discount will close and he will realize $0.05 in profit. There the NAV remains the same and the share price rises. He will be able to realize a profit from the increase in share price, and the underlying portfolio value is unchanged. This is just one of many scenarios, however.

Another potentially positive, but worrying, outcome is if the fund's share price rises while the NAV falls. While our investor will realize some gains, he should be careful. The underlying portfolio is heading south, and the ultimate premium and discount rely, at least in part, on the portfolio's performance. He may rack up paper gains and feel self-righteous with a narrower discount in the short term, but the long-term impact may be unpleasant.

In the next two scenarios, the end result is a narrower discount, but our hapless investor won't benefit from this narrowing and may end up losing. First, the NAV falls and the share price remains stable. While the discount will narrow, our investor will not realize any profit. Second, both the NAV and share price fall, but the NAV drops faster, and our investor is in a heap of trouble. The underlying portfolio and his shares are losing value.

The best-case scenario for our investor is if the NAV rises and the share price rises even faster. Not only has he earned a profit by the discount narrowing, but the fund's underlying portfolio has also increased in value. This scenario is only one of nine options (including those scenarios that create a wider discount) and is really only one half of one of nine because in a "both up" scenario, the NAV could rise faster than the share price, widening the discount.

It's important to remember that discounts and premiums are simply names given to a relation between the share price and the NAV. As an investor, after you've bought shares, all you care about is the purchase price and subsequent total return. If you bought a fund for $10 per share when it was trading at a 5% discount, are you going to be upset if six months later the fund is trading at $12 per share at a 10% discount? 

Theory of Relativity
Using absolute discounts to find undervalued funds can lead to the CEF equivalent of investing in an equity value trap, hence, the importance of relative discounts and premiums.

Not only may our hapless CEF investor see his fund's discount narrow without benefiting him, he is also likely unaware that CEF discounts tend to be persistent. Academic studies have shown that current discounts and premiums converge to their average discounts and premiums much more regularly than they converge to their NAVs. If the fund, for example, has an average discount over the past three years of 10%, our investor (who bought at a 5% discount) may actually be buying at a high valuation, despite the appearance of a deal.

To measure relative discounts, we use a z-statistic calculated:

z= (current discount or premium – average discount or premium)/standard deviation of discount or premium 

A negative z-score indicates the current discount (premium) is wider (lower) than its average, and a positive z-score indicates the current discount (premium) is narrower (higher) than average. In our opinion, a z-score of less than -2 signals that a fund is relatively inexpensive, and a z-score greater than +2 signals that a fund is relatively expensive. We often reference the three-year z-score, but we also provide the six-month and one-year z-scores on all CEF quote pages on Morningstar.com.

The z-score tells us how to view a fund's current discount or premium in relation to its historical discount or premium. But it's also important to look at discounts and premiums relative to peers. For example, many municipal CEFs are currently selling at premiums and have either reached overvaluation or are approaching that level. Of course, an overvalued fund is overvalued even if its peers are also overvalued, but this comparison helps investors put current pricing in context of the overall market and investor sentiment. For instance, if a fund that typically carries a narrower discount relative to its peer group suddenly carries a wider discount, it could be signaling that now is the time to consider that fund; it's undervalued relative to where it usually ranks among its peers.

It's the Income, Stupid!
Many investors turn to CEFs for income generation, and it's easy to see why: The average CEF distribution rate is upward of 6%. It's important to point out that a discussion of distribution rates often refers to the distribution rate at NAV. But an investor pays the share price, and the discount or premium at which the fund is bought will affect the distribution rate that an investor earns.

If a fund is selling at a discount, the distribution rate at share price will be higher than at NAV. This "yield enhancement" adds to the appeal of purchasing funds at a discount. At a premium, the distribution rate at share price is lower than at NAV. In this case, the "yield impairment" is important to consider. The higher the premium, the lower the actual distribution rate received. As an extreme example, the previously mentioned PHK is selling at a 70% premium. Its distribution rate at NAV is nearly 18%, but at share price it's 10.5%. To be sure, the share price distribution rate is still very high, but investors are so keen to tap into this income stream that they are willing to take a 40% haircut to what the portfolio is actually paying out (and also willing to overlook the risks of both the fund's portfolio and its premium).

Another important consideration is reinvesting distributions, and the discount and premium at which a fund is currently selling plays a role. For funds trading at a discount, most will automatically reinvest distributions at the share price. Shares trading at a premium will automatically reinvest distributions at the greater of NAV or a percentage of the share price (usually 95% or 98%). Investors can benefit greatly by reinvesting distributions, especially if shares are trading at a discount, but many investors do not take full advantage of this feature

We are just scratching the surface here in regard to distributions and will discuss the topic in greater detail in a future article.

The IPO Premium 
Because CEFs trade on an exchange, similar to a stock, there is an initial public offering of shares. All CEFs trade at a premium at the IPO because of accounting conventions and simple math. The launch of a CEF entails costs related to marketing and underwriting the IPO and other expenses, such as filing and legal fees. These expenses are paid from the fund, specifically from the capital raised during the IPO. Thus, immediately after the IPO, the fund's underlying net asset value is less than the share price, creating a premium. Generally, IPO premiums persist in the short run only. Underwriters can support the share price for a few months at most after the launch, but at some point, the premium typically dissipates.

Although some investors may believe so, this phenomenon is not a reason to avoid investing in all CEF IPOs and certainly no reason to avoid CEFs altogether. First, most CEFs have made money for investors since their launch. Last fall, we highlighted since-inception performance for IPOs between Jan. 1, 2011, and Oct. 31, 2011. The two-part article (read part 1 here and part 2 here) debunks the "CEF IPOs always lose money" myth. Of the 372 IPOs during this period, nearly three fourths posted subsequent positive share price total returns (measured from the CEF's IPO through Oct. 31, 2011, or until the CEF was acquired, merged, liquidated, or otherwise ceased to exist).

Municipal-bond funds make up a large portion of the CEF universe and likely skewed these results as these funds performed well over the past few years. During the studied period, 112 municipal CEFs launched, and 111 of them produced positive total returns for shareholders. Removing these funds from the group left 260 non-muni IPOs, and 163 (62.7%) of them had positive since-inception share price total returns.

While our study attempts to debunk the CEF IPO myth, it is not the final word. We only looked at a single time period and only the performance of funds from the launch. Investors purchasing shares after the launch (and after the IPO premium dissipated) likely had even better returns. We also assumed distributions were reinvested, but we know that, in practice, many investors do not reinvest distributions. Finally, we did not consider the relative performance of funds against peer groups or benchmarks. The simple study was meant to examine the often promoted idea that all CEFs are money-losing investments because of premium pricing at the IPO.

Rules of Thumb 
CEF discounts and premiums are a complex topic, and it's difficult to distill the information into bullet points, but investors often look to rules of thumb to quickly narrow an investable universe.

We generally have three rules of thumb for discounts and premiums. First, always use relative discounts and premiums to evaluate a fund (relative to both its own historical discount/premium and to its peers' discounts/premiums). Second, avoid funds trading at double-digit premiums; the risk of capital loss is just too great. Finally, never buy a fund simply for its negative z-score. There may be a plausible, fundamental reason for the fund trading at a new, lower valuation. Returning to CFP, the fund's three-year z-stat is -3.4, indicating that it's extremely undervalued. But any price is too high, in our opinion, for a fund that is essentially an economic (and apparently perfectly legal) Ponzi scheme.

Investors may be scared away from CEFs for their perceived complexity, but a little education and research can allay many of the fears. CEFs are a unique investment vehicle, too often ignored, that can play a prominent role in an income-generating portfolio. Learning how to properly take advantage of a fund's discount and premium movements can provide a boost to your portfolio's total return.

Click here for data and commentary on individual closed-end funds.

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