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.
Also, be on the lookout for funds that supplement their distributions with return of capital or realized capital gains. While this is not always detrimental to the fund, it can give a false impression of how much income it is generating.
5) Call Exposure
NII is backward-looking. It is not always possible to determine whether a fund can sustain its current level of income, but looking at call exposure can give some indication in today's low-rate environment. Many bonds can be redeemed, or "called," by the issuer. If you're a municipality or corporation with a 7% bond outstanding, it probably makes sense in today's market to issue another bond at today's lower rates and use the proceeds to repay the 7% bond. This creates an especially pressing issue for municipal and high-yield funds: Because these markets are not very liquid, many funds might be hard-pressed to find assets that pay a similar coupon to one that has been called, creating reinvestment risk.
This may be self-evident, but a fund that charges lower fees is better than a fund that charges higher fees, all else being equal. What is less self-evident is comparing the costs of leverage. For the time being, the best way to compare leveraged funds is to use adjusted-expense ratios, which strip out leverage costs, and then comparing reported leverage costs separately. Many funds have refinanced to more expensive forms of leverage over the past few years (having redeemed their auction-rate preferred shares), but they have done so at different times. Until these funds each have a full fiscal year with their new leverage, comparing total expense ratios might not be completely accurate.
As we explained earlier this week, evaluating performance is not as simple as looking at total return numbers. It is also important to look at performance compared against the benchmark asset class, peers, and sister funds. Moreover, if the fund blew up in 2007 and 2008, it is important to determine whether the fund has made any substantial changes to its process and portfolio composition. Even a different management team might not be enough of a change to compensate for the same risky strategy.
Is the fund run by experienced, shareholding managers, or by investment newbies who are afraid to eat their own cooking? Is the parent company well-regarded in the industry, or is it a fly-by-night management shop?
Annual reports typically include a blurb about management experience and compensation. When looking at parent-company quality, either consult Morningstar's Stewardship Grades or visit the firm's website. As a rule of thumb, a fund company's transparency and willingness to divulge information on its website is typically a good indication of whether it has investors' best interests in mind.
9) Board of Directors
For CEFs, the board of directors is not insignificant. If a distribution is unsustainable, the directors can vote to keep it stable or lower it. If shares are trading at a discount, the board can vote to implement a tender offer. If shares are trading at a premium, the board can vote to implement a rights offering. What's more, they should ensure that these actions would be accretive to common shareholders. We typically like boards that are not staggered and are voted in by majority, as these measures counteract director entrenchment. As with managers, we prefer board members who align their interests with those of the common shareholders by owning substantial shares themselves.
10) Share Price
Only after the first nine steps are completed, evaluate whether the fund deserves to trade at its current discount or premium. Keep in mind that discounts and premiums are somewhat cyclical and typically move along with the rest of a fund's sector. The current low-rate environment, for example, has boosted demand for leveraged fixed-income funds, causing the sector to largely trade at a premium. Also, remember to check the fund's historical discount or premium. A 10% discount that has persisted for the past five years, for example, may not dissipate anytime soon. In fact, this might be an indicator that something else in the fund is wrong.
We recommend against buying a fund at a double-digit premium, even if it is in line with its category or has persisted for a long period of time. As this week has shown, premiums can collapse suddenly and without warning. Even if such a collapse is unjustified given the positive qualities of the fund, they do happen occasionally. More directly, high premiums diminish the distribution realized by shareholders.
It bears repeating that this list is not fully inclusive of everything worth researching about a fund. Because investors have different priorities, some will want to focus on certain factors more than others. Meanwhile, many will want to write their own checklists. But this list should give you a start.
Click here for data and commentary on individual closed-end funds.