10 points that income-hungry investors should address before making their decisions.
With roughly 400 fixed-income closed-end funds, or CEFs, in existence, it's easy to get confused between them. After drilling down into a specific sector, it can become difficult to tell the difference between two funds. Especially within a single fund family, it is not uncommon to come across several funds with nearly identical investment mandates and strategies. (Are the differences between Nuveen Premium Income Muni 2 NPM and Nuveen Premium Income Muni 4 NPT truly significant?) Barring this, some CEF investors simplify the research process down to two questions: Is the fund trading at a premium or discount? And what is the fund's distribution rate compared with its peers?
Looking a bit closer, it becomes apparent that many funds have small differentiating factors. Nevertheless, keeping track of all the moving parts, such as leverage structure, distribution coverage, and call exposure, can be daunting. With this in mind, it may help to use the following checklist as a guideline for making sure you have covered all your bases. While this is by no means fully inclusive, it is a good starting point for income-hungry investors.
1) Portfolio Composition
Take a look at the fund's latest available portfolio and look for red flags. Although certain metrics such as weighted average credit quality can give some indication as to a fund's credit risk, it does not always identify red flags. Watch out for funds with high exposure to unrated debt, concentrated sector bets, and large positions in illiquid assets. For global and municipal-bond funds, geographic and sector concentration can also be important. A Puerto Rico general-obligation bond, for instance, may not be equivalent to a Virginia general-obligation bond.
An even more important point is to check the fund's derivative positions. While it is not uncommon to see international-bond funds hedge their currency exposure through forward contracts, others take obvious speculative bets on currency movements. If you cannot understand the logic of the portfolio's derivative positions with a simple spreadsheet, move on to the next fund.
One of the most well-known advantages of investing in CEFs is that they provide easy exposure to leverage. But investors should not blindly rush into a fund because of this benefit. Make sure to compare the leverage ratio (total assets/net assets) with other funds in the category and determine whether the type of leverage being used is suitable for the fund. More important, do a gut check. Keeping in mind CEF leverage requirements and the risk of deleveraging, ask yourself whether you are comfortable with the magnitude of the fund's leverage. (For more of the specifics on analyzing leverage, click here).
To draw a more accurate comparison between funds' distribution rates, one hard and fast comparison is to divide the distribution rate by the leverage ratio to derive the "core" distribution rate. This gives an approximation of the portfolio's ability to generate income if no leverage were used.
Duration is a rough measure of the percentage change in a fund's net asset value given a 100-basis-point change in interest rates. Although the metric is highly imperfect (fund families calculate the number differently, it does not account for portfolio convexity, and it assumes that interest rates uniformly increase across the yield curve), it gives a general idea of a portfolio's interest-rate risk. With short- and long-term rates at all-time lows, an increase in interest rates would likely lead to capital depreciation. Leverage-adjusted effective duration is an even more useful metric, as it accounts for embedded call options in the portfolio and any amplification due to the fund's leverage.
4) Distribution Coverage
What good is a high distribution if it is not sustainable? For most fixed-income funds, looking at how net investment income, or NII (that is, investment income earned by the portfolio holdings net of expenses), stacks up against total distributions payouts is a fairly reliable measure. For example, a fund that earned $1.00 per share over a given period but only paid out $0.80 in distributions could sustain a 20% drop in income before having to make a cut. Funds that have accumulated excess NII over time (undistributed net investment income, or UNII) can dip into this balance instead of lowering the distribution. However, it is important to remember that this is just an accounting convention: Taking money out of the UNII balance still lowers a fund's NAV.