Hungry for income? CEFs may fit the bill, but there is often more than meets the eye.
As more investors enter retirement, the search for income is a top priority, especially in the current low-interest-rate environment. Closed-end funds have notoriously high distribution rates compared with open-end mutual fund and exchange-traded fund peers, piquing the interest of yield-hungry investors. But CEF distributions can be complex, and many investors don't fully understand them. This week, we continue our educational series and dive into CEF distributions.
First, the Rules
Like mutual funds and ETFs, most CEFs do not pay taxes. As regulated investment companies under the U.S. tax code, they simply pass tax consequences of their investments to investors. To maintain this tax-free status, a fund must distribute at least 90% of its net investment income (dividends and interest) and at least 98% of its net realized capital gains each year. For accounting and tax purposes, distributions must be linked to their original source, and funds make estimates throughout the year as to the sources of the distributions (CEFs generally make monthly or quarterly payments). Investors receive a Form 1099 each year with the final, taxable breakdown of the distributions paid during the previous calendar year. Prospective investors must rely on annual reports for historical breakdowns. Because funds estimate breakdowns throughout the year and generally make only a single announcement of the final breakdown, the analysis of distributions midyear can be difficult.
Next, We Break It Down
An astute reader will have noticed that I've not used the word "yield" or "dividend" to describe a CEF's distribution. These terms are generally used to describe bond payments (fixed-income yield) or equity dividend payments (dividend yield). For CEFs, there are three sources of distributions: income, realized capital gains, and return of capital.
Income includes both bond interest payments and dividends from stocks and is taxed at an investor's ordinary income tax rate. Some funds seek qualified dividends, which are taxed at reduced rates, at least through 2012. Because a fund is required to pay only 90% of its net investment income, it can hold some income each year in a rainy day fund. This account is called undistributed net investment income and can be a great tool for smoothing distribution payments. (Readers interested in a detailed discussion of UNII can read this article.)
While investment income can be paid throughout the year, a fund must receive an exemption from the Investment Company Act of 1940 to pay net realized capital gains more than once a year. In order to smooth distribution payments, many CEFs have received this exemption and pay capital gains throughout the year, as opposed to a lump sum at year end. Short-term capital gains are taxed at an investor's ordinary income rate, while long-term capital gains are taxed at 15%, at least until the end of 2012.
Overexposed, Yet Misunderstood: Return of Capital
So far this discussion has been relatively straightforward, but to this we add a CEF's ability to pay return of capital. Do not confuse this with return on capital. Return of capital is, at its core, paying shareholders with the fund's assets. Because of this, return of capital is tax-delaying--for investors, it lowers the cost basis of their investment.
Stepping back, some readers may be wondering why a fund would distribute return of capital, given the negative connotations attached to it. Well, investors tend to like steady and predictable distributions, and fund families are more than happy to oblige. A number of CEFs have "managed" or "level" distribution policies that fix the payment based on either a percentage of net assets (managed) or a specific dollar amount for each payment period (level). A fund's ability to distribute capital gains throughout the year allows it to maintain these predictable payments, but it may run into trouble. The 2008 market crash is a shining example. Funds made payments throughout the year based on income and capital gains actually earned, as well as assumptions about earnings the rest of the year. But, in the autumn of 2008, the market tanked. Unrealized gains were wiped out, and realized gains may have been erased by realized losses, leaving many funds in a lurch. Note that funds distribute net realized gains, a distinction that is especially important here. While a fund may have realized gains and paid distributions based on those realized gains, if, at year end, realized losses dwarfed the gains, the net amount would have been negative. This would leave the fund with two choices: pay return of capital or lower the distribution.
Because a fund's distribution is highly correlated with the premium or discount at which it sells, and changes are likely to affect the share price, the board of a fund may be loath to make adjustments, especially if the shortfall is estimated to be short-term in nature. In an effort to shield long-term shareholders from a disruption in share price, funds may distribute return of capital to make up shortfalls instead of lowering the distribution. Over time, however, if a fund continues to fall short due to market changes, we'd expect a cut to the distribution.
Some folks unfamiliar with CEFs may consider returning any type of capital to investors a despicable practice. That's not our view. Consider what happens to a corporation when it cuts its dividend: the shares typically sell off quickly. This is what a short-term use of return of capital aims to avoid. A little return of capital for a short period of time can be viewed as a way to control or manage a fund's discount.
We often hear investors proclaim that they avoid any fund with a history of distributing return of capital and others that believe its use is so prevalent that they avoid CEFs altogether. This myth can be difficult to debunk, but the truth is that most funds do not distribute any return of capital. Only about 25% of all CEFs have distributed even $0.01 of return of capital (including what we call constructive return of capital) in the past five years. This myth has staying power because, of those funds that have used it, return of capital tends to make up a significant portion of the distribution (and its share has been increasing). Investors see a few funds returning lots of capital, and make assumptions about all funds. Don't let a few bad apples spoil the bunch. It's important to distinguish between the types of return of capital and the impact of each on the future of the fund.
The most innocuous, pass-through return of capital is simply an accounting convention, mostly applicable to CEFs investing in MLPs. We don't consider this type of return of capital "bad"; it is, in fact, a tax benefit of investing in MLPs.
Nondestructive return of capital is most likely a consequence of unrealized capital gains. Let's say a fund has only one investment (100 shares of ABC Co.) plus $250 on cash and 1,000 shares outstanding. The shares were purchased at $20 each for a total portfolio value of $2,250 (including the cash) or $2.25 per CEF share. At the end of the calendar year, ABC Co. has appreciated to $25 per share, for a total portfolio value of $ 2,750 (including the cash), or $2.75 per CEF share. The fund is set to pay a distribution to shareholders of $0.25 per share. The manager has two options. First, he can sell 10 shares of ABC Co. to raise $250 for the distribution. The fund's post-distribution net asset value, or NAV, will be $2,500, or $2.50 per share. The distribution will be treated for tax purposes as capital gains. This is not a bad option, but what if the manager believes ABC Co. shares will continue to appreciate?
As for the second option, instead of selling shares to meet the payment, the manager may choose to hold the shares and use cash on hand to meet the distribution. In this scenario, the fund's post-distribution NAV is the same ($2,500, or $2.50 per share), but if ABC Co. shares continues to appreciate, the eventual portfolio value will be higher in the second scenario because the fund holds more shares. Also, the distribution will be classified as return of capital for tax purposes, which will have the effect of lowering the investors' cost basis in the fund (pay no taxes now, but delay them until the fundholder sells the shares).
A quick way to assess whether return of capital is destructive or nondestructive is to look at the fund's NAV at the start and end of a fiscal or calendar year. If, after distributions have been accounted for, the NAV grew, return of capital is considered nondestructive. If not, we consider it destructive return of capital. Nondestructive and destructive are simply adjectives to describe the distribution's effect on the CEF's beginning NAV value, which can also be viewed as the fund's future earnings power.
Going back to our example, if ABC Co. shares dropped to $15, and the fund still paid a $0.25 per share distribution, the distribution of return of capital would be considered destructive. Over the course of the year, the fund's per share NAV fell to $1.75 (including cash on hand) from $2.25 per share due to the unrealized capital loss. Subtracting the $0.25 per share distribution leaves the post-distribution NAV at $1.50.
As the example shows, destructive return of capital, over time, will erode a fund's net assets and diminish its future earnings power, which is never good for long-term shareholders. A consistent use of destructive return of capital to maintain a too-high distribution is, in our opinion, simply an attempt to woo foolish investors into purchasing the fund. And a high distribution rate goes hand in hand with a high premium, so an investor who simply purchases a fund for its high payouts is likely to pay a premium for its shares.
Analysis of Distributions
Armed with this basic understanding of distribution mechanics, investors can now begin to analyze them. Because a CEF has a NAV and a share price, distribution rates are displayed as a percentage of both. On Morningstar.com, distribution rates are calculated by annualizing the latest distribution amount and dividing by either the share price (distribution rate at share price) or NAV (distribution rate at NAV).
As an investor, the distribution rate that will actually be received (assuming the distribution dollar amount isn't changed) is the one based on the share price. 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.
In analyzing a distribution rate, it's important to compare a fund's distribution rate to its peers and to its own historical rates as distribution rates in absolute terms may not provide enough useful information. The table below lists the high-yield leveraged CEF peer group, sorted by highest premium, along with discounts and distribution rates as of Oct. 1.
Distribution rates and discounts go hand in hand, and often funds with the highest distribution rates at NAV in a peer group sell at the highest premiums. Looking at the table, though it's not exact, we see that funds trading at the highest premiums do generally have higher distribution rates at NAV. And we can see "yield impairment" first-hand. Because the average premium for the group is 9.5%, the average distribution rate at NAV is almost a full percentage point higher than the average distribution rate at share price.
While CEFs themselves may be considered inefficient due to the discount and premium phenomenon, investors in CEFs, as a whole, are rational and make the market efficient by bidding up (or down) share prices and pushing down (or up) distribution rates. Therefore, while distribution rates at NAV may be wide-ranging, the distribution rates at share price across peers are generally pretty similar. To illustrate this, we can measure the range of distribution rates at both NAV and share price for the high-yield group. The highest distribution rate at NAV is 17.6%, from
PIMCO High Income
The key takeaway is that a higher-than-average distribution rate at share price is more intriguing than a higher-than-average distribution rate at NAV. A more sophisticated analysis is still needed, however, to determine sustainability.
Is My Distribution Safe?
Past performance is not representative of future performance, and investors need to determine the sustainability of a distribution. In general, an income-only distribution rate is seen as the safest, as income earned from bonds and dividends are relatively predictable and more stable than capital gains. However, an income-only distribution rate may not be sustainable due to changing market conditions. For example, a number of municipal CEFs hold callable bonds. Should the bonds be called away (which is likely in this low-interest-rate environment), these funds would face significant reinvestment risk, jeopardizing their ability to sustain distribution payments unless there is a substantial UNII balance to make up the difference. UNII and a fund's earnings are disclosed monthly, quarterly, or semiannually, depending on the fund. While these numbers can and do change, they do provide a glimpse into whether a fund is over- or underearning its distribution and how long the UNII balance (if any) can fill the gap.
Capital gains, as mentioned previously, are difficult to predict and are generally only paid in equity funds. (In addition to the long- and short-term gains from investment appreciation, this category also includes income earned from writing options.) An investor's take on the market will inform his analysis of whether an equity fund's distribution rate is sustainable. However, as discussed previously, if a fund pays distributions at the start of the year and estimates they will be categorized as capital gains and the market turns south at the end of the year, there is no guarantee those distributions will remain categorized in that manner. In fact, they may be categorized as return of capital, as occurred in 2008.
Obviously, destructive return of capital is the least sustainable, but investors should not dismiss a fund outright for its use. The percentage and frequency of destructive return of capital matter. If its use is generally small and/or infrequent, we may give the fund a pass if we believe its distribution rate is reasonable for the current market outlook and the fund's strategy. For example, in 2008, many funds used destructive return of capital, and it proved an anomaly for most. Cutting a distribution can have a negative impact on a fund's share price. It may be better for long-term shareholders to maintain the distribution if the managers believe the shortfall to be an abnormality and the fund will be able to earn the distribution going forward. What's more, investors can benefit by reinvesting return of capital distributions if shares are trading at a deep discount.
Finally, even though changing distributions can affect share prices, funds often do raise and lower them, and it's important to understand the reasons for those changes. Some firms provide comments around distribution changes to help investors better understand their thought processes. At a minimum, it is typically discussed in the annual report, so investors can get a sense for the reasoning behind previous changes. Share prices often react immediately, but long-term investors should not make sudden moves based solely on this news. The most important question to ask is whether the new rate (higher or lower) is sustainable. If not, it may be time to sell.
Income-hungry investors are often wooed by the high distribution rates offered by CEFs while turning a blind eye to the mechanics behind them. Because distributions play a significant role in a CEF's total returns, understanding and assessing their sustainability is of the utmost importance. Investors should look at the sources of the distribution, the fund's earnings coverage, and UNII balances and make comparisons with similarly invested peers. Putting in the extra work up front can pay off for a long time. Many CEFs have made stable and steady payments over the long term, providing a predictable stream of income for their investors.
Click here for data and commentary on individual closed-end funds.