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2 Temptations That Trip Up CEF Investors

Proper comparisons can help you avoid missteps.

Mike Taggart, CFA, 03/15/2013

In last week's closed-end fund article, I discussed two ramifications of my perspective that CEFs are more akin to corporations than to mutual funds. First, just as you probably wouldn't compare an Internet company with an industrial company, we need to be aware of what CEFs' underlying portfolios--their businesses--contain. Second, after we group the CEFs by their underlying portfolio characteristics, we can make proper comparisons. We don't want to make large, absolute comparisons of one CEF against the CEF universe or compare a state municipal CEF with a large-cap growth equity CEF.

Let's see how this works in practice.

Income
Assume that you are a resident of Massachusetts and have decided that your portfolio would benefit from more exposure to Massachusetts municipal income. You've narrowed your fund selection process down to the six CEFs that offer Massachusetts municipals. But, now what?

In my experience, most investors would simply reach for the fund offering the highest distribution rate, or yield, at share price. In this case, that would lead to Eaton Vance MA Municipal Income MMV. But, let's step back. If you were investing in a blue-chip equity, would you simply purchase the company offering the highest dividend yield? Wouldn't you first want to know how that yield is generated and, as a close second question, how sustainable that yield is?

For CEFs, it is best to start with the distribution rate at net asset value. This gets us a little closer to how the distribution is generated. From the table above, we see that MA Health & Education MHE actually offers the highest distribution rate at 5.30%. Backing out the leverage effects of each fund, we can further see that the stripped-down NAV distribution rate of 3.84% is the same as that of Eaton Vance MA Municipal Income. So far, so good. But, there are four things to consider. First, MA Health & Education is trading at a 5.95% premium, reflecting the fact that other investors have jumped aboard the income train. Second, unlike the other five funds, this fund's latest portfolio holdings show only a very small allocation to credits rated AAA; a lot of this distribution comes from accepting more credit risk. Third, to capture yield, the managers are willing to buy underlying bonds at high premiums to par. So, in addition to fund investors paying a premium, the portfolio itself is at a premium. Fourth, four of the six funds have recently lowered their distribution rates, with MA Health & Education and Eaton Vance MA Municipal Income being the holdouts. Given the small size of the funds' investable universe, I wonder how long they can continue to hold out. It bears more digging.

Suddenly, Nuveen MA Premium Income Municipal NMT starts to come into the foreground, at least for me. True, it's only offering a distribution rate at NAV of 4.36%. Bear in mind, the distribution rates mentioned for municipal funds are not tax-equivalent rates. But here we have a fund trading at a 5.30% discount to NAV. The portfolio itself bears a 10% premium to par--nearly the lowest in the group. About one fifth of the total assets are in AAA rated securities and nearly two thirds are in AAA or AA rated bonds. And the fund just lowered its distribution rate. Given that Nuveen is considered a conservative fund sponsor and given its history with distributions, this offers some assurance that the distribution rate will not be reduced in the next few months.

We could delve further, looking at such metrics as call exposure, duration exposure,  leverage costs, etc. But I think the point is clear: Finding a suitable investment requires more than simply choosing the fund with the highest distribution rate. Note that there was no comparison with municipal CEFs in general or with the CEF universe. To me, the closest approximation in equities would be comparing a small group of regional banks to decide which one to invest in for yield. You wouldn't compare with all financials or with the global banks. You'd keep the peer group tight and focus on the underlying characteristics of the business model that allow the yields to be paid. 

Mike Taggart, CFA, is the director of closed-end fund research at Morningstar.
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