Continuing with last week's return-of-capital discussion.
Last week, we tackled the issue of return of capital in closed-end funds. The ideas and calculations presented were appropriate for evaluating most CEFs but, importantly, not master limited partnerships.
Master Limited Partnerships
MLPs are partnerships, not corporations. Buying a share of a corporation (that is, a stock) means the investor owns a portion of that firm’s equity. Buying a share of a partnership means the investor owns a unit of the partnership's business interests. Unlike a firm, partnership units are not taxed at the business level but at the investor (or partner) level. Thus, taxable income from a stock's dividends and MLP cash distributions are not the same. Under accounting rules, an MLP's pipelines (most MLPs own and operate energy pipelines) are depreciated as an expense. Because of the accounting treatment of depreciation expense, taxable income for MLPs is typically less than their actual cash flow generation. Conversely, the amount of cash available for distribution is usually higher than taxable income recorded.
That presents partnership unitholders with two distinct issues. First, partners have to report their proportion of the partnership's net income on their individual tax return, even if the partnership distributes none of that income and the partner does not sell any units. Second, any distributions received from the partnership are declared for tax purposes but are tax-advantaged relative to a dividend from a company. These distributions are often considered a "return of capital," and taxes on these distributions are deferred. We'll revisit that taxation issue below.
Covered-call funds are not special cases in the same way that MLP funds are, but they're worth mentioning separately.
Covered-call funds hold underlying equities and write call options on indexes or individual equities in an effort to generate additional income for distributions. Investors may notice that a covered-call fund tends to distribute more return of capital than an equity fund using a similar strategy without the call overlay.
When a fund writes a call option, it earns a premium. This premium is not "earned" by the fund until the option contract has expired or is closed. Once this happens, the fund will either book a gain or loss on the option contract (although it is also possible that a fund would break even) based on the price of the underlying security relative to the strike price and the premium received. Any option premiums distributed to investors are categorized as a combination of short-term and long-term capital gains for tax purposes. Because of netting of capital gains and losses, these funds may end up returning capital.
Let’s look at two oversimplified scenarios. They assume a fund is writing call options on an index and holding securities that mimic the index. At the start of the year, the fund’s net asset value is $10 per share. Assume that no trades are made throughout the year and that the fund does not earn income from dividends of underlying holdings.
First, take a declining market scenario in which the fund's underlying holdings fall 10% during the year (at a steady pace throughout the year, which means none of the fund’s options are exercised). The NAV at year-end is $9 per share. During the year, the fund sold call options and recorded a $1 per-share capital gain from those premiums. The fund pays an annual distribution of $1 per share. Thanks to the option premiums, this distribution is categorized as a combination of short-term and long-term capital gains. But the fund's total return (which includes distributions) is zero: The $1 per-share distribution perfectly offsets the $1 per-share decline in NAV. The table below illustrates this scenario.
In the reverse scenario during which the market steadily increases by 10% to $11 per share, the fund still sells call options. Because the market is rising, the options are exercised, so the fund does not book any gains from the option premiums. Instead, assume a break-even scenario in which the premium earned by selling the call option exactly offsets the cost to the fund incurred by the counterparty exercising the option. At the end of the year, the fund pays the $1 per-share distribution. But the fund has not made any trades and, therefore, has not realized any capital gains and has no option premiums to distribute. In order to make the distribution, the fund could sell some of the underlying holdings that have appreciated and then distribute the realized gains. But, if managers believe the market will go higher, they may not choose to sell shares simply to meet the distribution. In this case, the fund’s total return is zero--the $1 increase in NAV is offset by a $1 distribution from return of capital, which lowers the NAV. The table below illustrates this scenario.
It is important to note here that the tools described in part 1 of this discussion are still applicable for covered-call funds. Looking at the change in NAV relative to the amount of return of capital helps to quickly assess whether the use of return of capital is "good" or "bad." And the fund’s discount or premium matters. In fact, these covered-call equity funds have historically sold at discounts, so these funds may be more attractive for certain investors, despite heavy use of return of capital.
A key tax advantage of owning a fund that returns capital is the ability to defer long-term capital gains until the shares are sold. For a non-MLP CEF that distributes return of capital, investors pay no tax on that portion of the distribution. Instead, this lowers the cost basis of the investment. When the shares are sold, the investor pays taxes on the difference between the cost basis (including any reductions due to return of capital distributions) and the price at which the shares were sold, assuming that number is positive.
Circling back to MLPs, owning individual MLPs can be an administrative nightmare at tax time. Investors must keep track of cost-basis adjustments for all MLPs owned. In addition, if an MLP has pipelines in 20 states, the investor may need to prepare 20 out-of-state tax filings. Putting a CEF wrapper around a portfolio of MLPs makes a lot of sense. Investors in the fund get nearly all of the benefits of direct MLP investing without the tax-administration headaches, though CEF investors must pay management fees.
Return-of-capital distributions are also the reason that most MLP CEFs trade at large premiums to reported NAV. When the CEF receives a return-of-capital distribution from an MLP in its underlying portfolio, it, too, must write down its cost basis for that MLP. Deferred taxes come into play, and often MLP CEFs have very large deferred tax liabilities. Such liabilities, by definition, lower the reported NAV, even though some of those deferred liabilities may never actually be recognized. Astute investors realize all of this and are willing to pay more than reported NAV for the fund. Investors interested in these tax benefits should consult a tax professional to fully understand the impact these complex tax scenarios may have on an investment portfolio.
Return of capital is a complex topic that takes time to fully understand. There are many moving parts that make it difficult to determine whether it is constructive or destructive to long-term shareholder value. But informed investors have many tools at their disposal to make decisions regarding the appropriateness of a fund’s use of return of capital for their own investment needs. And it’s important to remember that it's not what you make, it’s what you keep. Total return trumps "yield" every day.