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Commodities CEFs Tank in September

The Bond King's departure had a small impact on CEF performance compared with the onslaught in the commodities market.

Cara Esser, 10/16/2014

The unexpected departure of PIMCO founder and chief investment officer Bill Gross dominated the headlines at the end of September, but PIMCO investors were far from the most disappointed folks last month. Gold prices dropped 6% in September, continuing a months-long decline from its mid-March high of $1,391.77 per ounce. Since that high, gold prices have fallen more than 13% through the third quarter. The strengthening of the U.S. dollar and improving economy also put pressure on the prices of other precious metals and commodities like oil and gas. This price pressure landed the equity precious metals closed-end fund Morningstar Category at the top of the worst-performing funds list during September and affected other commodities-sensitive categories such as natural resources, Latin America stock, commodities precious metals, equity energy, and emerging markets stock.

Best- and Worst-Performing CEF Categories Commodities weren't the only disappointing sector last month; few categories performed well. And the two best-performing categories are small. There's only one market-neutral CEF--Eaton Vance Tax-Advantaged Bond & Option EXD--and two CEFs in the India equity category--India Fund Income IFN and MS India Investment IIF. India's stock market has been on a tear this year, with the S&P Bombay Stock Exchange SENSEX Index gaining more than 25% for the year to date through September. Interestingly, investors bid up the share prices of the India equity funds despite flat net asset value performance over the month. The table below highlights the best- and worst-performing categories for September.

Discount Trends CEF discounts continued to converge in September. For each of the broad categories, the average discount was about 8% at month-end versus 8% for equity CEFs, about 7% for taxable-bond and muni CEFs, and more than 9% for "other" CEFs at the start of the year. Historically, equity funds sell at wider discounts because of the lower distribution rates compared with bond funds. But the large and persistent disparity of high premiums of bond funds and wide discounts of equity funds following the crisis was unusual. That trend seems to be normalizing, though the average discount of bond funds is wider than it's historically been.

Source: Morningstar

As the bond market has slowed and the Federal Reserve inches closer to raising interest rates, taxable-bond CEFs look less attractive from a long-term investment standpoint than during the bull market of 2009 and 2010. For equities, after dipping to double-digit discounts in the aftermath of the 2008 financial crisis, those funds' discounts were slow to narrow, though continued economic improvement has helped.

Most Expensive and Inexpensive CEFs The middling performance of both bonds and stocks last month didn't create many attractive valuation opportunities. The four tables below list the five most inexpensive and expensive CEFs by broad category (taxable bond, equity, municipal, and other). The z-statistic measures how many standard deviations a fund's discount/premium is from its three-year average discount/premium. For instance, in these tables, a fund with a z-score of negative 2 would be two standard deviations below its three-year average discount/premium. Funds with the lowest z-scores are classified as Relatively Inexpensive, while those with the highest z-scores are Relatively Expensive. We consider funds with a z-score of negative 2 or lower to be "statistically undervalued" and those with a z-score of 2 or higher to be "statistically overvalued." That said, the z-statistic does have its flaws.

After a multiyear risk-lead rally in bonds, investors have become more wary of stretched valuations, keeping CEF discounts and premiums of taxable-bond funds in check.

A flattening yield curve, an improving economy, and the nearing end (but not reversal) of quantitative easing toppled a richly valued high-yield market in July. After a slight bounceback in August, junk bond funds performed poorly again in September. Most bond categories posted negative returns last month on both a share price and NAV basis, so it's not surprising that no taxable-bond CEFs appeared Relatively Expensive as of Oct. 7. Of the four funds that appeared Relatively Inexpensive, three invest primarily in bank loans. This is a bit surprising given that the end of quantitative easing in October begins the countdown for rate hikes, and bank loans are typically popular with investors anticipating higher interest rates.

The S&P 500 hit a new high of $2,011.36 on Sept. 18 but tanked the rest of the month: The index dropped nearly 1.5% in September but remained up 8% for the year to date.

While the Fed's march toward higher interest rates will have a negative impact on bond prices, it's likely better news for U.S. stocks. Internationally, however, investors are concerned over slowing growth in China and Europe, which has caused some volatility in globally invested funds. As of Oct. 7, six equity funds were Relatively Expensive based on three-year z-statistics, and seven were Relatively Inexpensive (only the top five appear in the table above).

Given the aftertax distribution boosts that investors get from municipal funds, it's surprising that some muni funds have traded at attractive valuations for much of 2014. A low supply and steady demand for tax-advantaged muni bonds boosted underlying NAV for many of those funds this year, but investors remain concerned about pension fund liabilities and the long-term prospects of some municipalities' shaky finances. In some cases, share prices haven't kept pace with these underlying portfolio gains. As of Oct. 7, no muni CEFs were Relatively Expensive and three were Relatively Inexpensive.

Two allocation funds have very high three-year z-statistics and look very expensive. Dividend and Income Fund DNI has seen its discount narrow significantly over the year, thanks in part to its decent returns and its nearly 10% distribution rate at NAV. Note that the fund categorized 80% of its September distribution as return of capital. Because this fund trades at a persistent discount, the return of capital is not destructive to long-term shareholder value, but it's worth noting that this "dividend and income" fund isn't living up to its name.

Cornerstone Progressive Return CFP is undervalued based on its three-year z-statistic, but we caution investors against loading up on "cheap" shares. This poorly managed fund distributes return of capital regularly and typically sells at a high premium. That said, the fund's premium collapsed to less than 1% from over 25% earlier this year, which is why it looks cheap at current valuations. For more on why we caution against this fund (and its sister funds) read this article.

News You Can Use September was a busy month for many CEF firms. PIMCO's month ended with the surprise departure of Bill Gross and a need to fill the lead portfolio manager role on five CEFs. The firm also announced a redemption program for outstanding Auction Rate Preferred Shares issued by two of its funds, an unexpected move given the firm's inaction on this issue since the ARPS market froze in 2008. Meanwhile, Nuveen Asset Management continued to consolidate its lineup, merging a number of "me-too" funds.

Manager Changes The sudden departure of PIMCO founder and CIO Bill Gross meant the five CEFs he managed were in need of new leadership. PIMCO named Alfred Murata and Mohit Mittal as lead portfolio managers of the following funds:
• PIMCO Corporate & Income Opportunities PTY • PIMCO Corporate & Income Strategy PCN • PIMCO High Income Fund PHK • PIMCO Income Strategy PFL • PIMCO Income Strategy II PFN
Murata remains comanager of:
• PIMCO Income PIMIX • PIMCO Dynamic Income PDI • PIMCO Dynamic Credit Income PCI • PIMCO Income Opportunity PKO

Murata joined PIMCO in 2001 and is a member of the mortgage-credit team. He was named Morningstar Fixed-Income Manager of the Year in 2013 for his performance on PIMCO Income with comanager Daniel Ivascyn, who succeeds Gross as PIMCO's group chief investment officer. Mittal is a member of the corporate credit team and manager of a number of investment-grade credit, total return, and unconstrained bond accounts for the firm. We've downgraded PIMCO Corporate & Income Opportunities' Analyst Rating to Neutral from Bronze to reflect the uncertainty of new management on the fund's process and performance going forward.

Ashton Goodfield replaced Philip Condon as co-lead portfolio manager of Deutsche Municipal Income KTF. Co-lead manager Michael Generazo remains on the fund, and Rebecca Flinn joined the team as a portfolio manager.

Eaton Vance announced that Lew Piantedosi and Yana Barton joined the portfolio management team of Eaton Vance Enhanced Equity Income II EOS and announced that Edward Perkin and John Crowley joined the portfolio management team of Eaton Vance Tax Advantaged Dividend Income EVT.

Fund Mergers and Launches In early September, Nuveen finalized the reorganization of four American Strategic Income funds into the newly created Diversified Real Asset Income DRA. The new fund will implement Nuveen's real asset income strategy, a significant change for shareholders of the funds that previously fell into the intermediate bond Morningstar Category. Nuveen's real asset team took over management of the fund.

The firm also finalized the reorganization of First American Minnesota Muni Income II and Minnesota Muni Income into the newly created Nuveen Minnesota Muni Income NMS.

Nuveen renamed the American Income Fund to Nuveen Multi-Market Income Fund and changed the ticker to JMM, though the investment strategy and portfolio managers remain the same.

Finally, shareholders of American Muni Income approved a proposal to merge the fund into Nuveen Investment Quality Muni NQM. The merger was effective in early October.

Tender Offers and Rights Offerings PIMCO announced a voluntary tender offer for up to 100% of two of its funds' outstanding ARPS. While many firms in the industry redeemed outstanding ARPS after that market froze in 2008 (it remains frozen today), PIMCO is one of the last large fund companies that still uses these securities to create leverage. Although the reluctance to redeem the ARPS created ill will among preferred shareholders, it has benefited common shareholders as other types of leverage have tended to be more expensive. PIMCO notes that it conducted a leverage cost-benefit analysis for each of its CEFs, and, for now, only two funds are offering redemptions to preferred shareholders: PIMCO Income Strategy and PIMCO Income Strategy II. The firm will pay 90% of the liquidation price for any tendered ARPS. The tender offer period began on Sept. 19 and lasts for one year.

Herzfeld Caribbean Basin CUBA announced a nontransferable rights offering. Shareholders as of Oct. 9, 2014, will receive one right for every share owned, and three rights will be required to purchase one additional share. The offer will begin on Oct. 16 and end Nov. 6.

A table summarizing significant distribution changes and special nonrecurring distributions made during September is below.

Initial Public Offerings The CEF IPO market has been abnormally quiet this year (see below for a comparison of calendar-year net proceeds from IPOs dating back to 2000). For the year to date through September, there have been six CEFs launched, which raised a total of $3.5 billion in net proceeds. Those statistics do not include the reorganization of four American Strategic Income funds and the reorganization of the two Minnesota muni funds mentioned above. In contrast, during the first three quarters of 2013, 21 funds launched and raised more than $12.7 billion in net proceeds.

Source: Morningstar

The pace of bond-fund IPOs has slowed considerably, though high-distributing and energy-focused master limited partnership funds remain a popular choice. Four of the six funds launched this year focus on MLPs, bringing the total number of CEFs in the energy limited partnership category to 31, 3 times the number that existed five years ago.

September has long been a disappointing month for stocks. Since 1950, the Dow Jones Industrial Average and the S&P 500 Index have declined, on average, close to 1% during the month of September. This year the bond market didn't fare much better as we neared the end of quantitative easing and Bill Gross' unexpected departure sent some into frenzy. Volatility has picked up, and, after several years of complacency that pushed investors into riskier fare, it's time to pay the piper. For example, the high-yield market experienced a significant sell-off in July and saw a dip in sentiment again this month. Investors that piled money into risky asset classes while volatility remained low need to consider whether they are willing to handle the market swings inherent in these asset classes. Now is the time to reassess portfolio decisions, because volatility is unlikely to slow as we remain in a period of uncertainty surrounding global economic growth and the Fed's plans to raise interest rates.

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

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