Instead of blindly chasing yield, only focus on what's relevant.
One oft-cited benefit of buying closed-end funds, or CEFs, is that they pay shareholders smooth streams of income. Exchange-traded funds and open-end funds merely distribute the entirety of net investment income earned in a given period, and this leads to variability. CEFs differ in that the board of directors set a distribution payment (say, $0.050 per share per month or 5% of net asset value per year). The underlying portfolio might underearn or overearn the stated distribution in some periods, but investors receive a stable payout in each period. For many income investors, such as retirees living off of stock dividends and bond coupon payments, this is an understandably attractive quality. But would investors be better off ignoring distribution payments altogether?
To income-focused, hands-off investors, this might sound like crazy talk. After all, buying a fund and leaving it alone allows them to focus on more important things, like golf or gardening. Meanwhile, many CEF investors prefer to take an active hand in managing their portfolios, with income stability taking a backseat to total returns. For the latter class there is more to the story than letting a fund "work its magic." After considering the necessary risk/reward characteristics, factors such as return of capital, undistributed net investment income, and distribution trends typically play key roles in determining whether distributions are stable. Nevertheless, distribution analysis is often overcomplicated. Consider simplifying the process to the following rule:
Ignore distributions, and focus on earnings.
While we have discussed return of capital at length (see parts I, II, and III in our CEF Solutions Center), return of UNII is also an issue worth considering. In both cases, a CEF's portfolio earns less than it is paying out in distributions, and the fund erodes its net asset value to make up the difference. The difference arises in how the erosion is classified for tax purposes. Return of UNII is taxed as ordinary income, while return of capital lowers the investment's cost basis (taxes are delayed until shares of the fund are sold). In short, it doesn't really matter how a fund makes up for the shortfall. At the end of the day, shareholders may technically receive a stable level of "income," but total returns will still suffer. For every penny a fund underearns, the NAV ultimately takes a penny-sized hit.
CEFs that overearn their distributions actually have a small (aftertax) total return advantage. Consider a CEF portfolio that consistently earns $0.05 in NII per share per month and also pays a monthly distribution of $0.05 per share ($0.60 per year). Investors receive the distribution at the end of each month, which is ultimately taxed as income. On an aftertax basis, investors in the highest income bracket would be left with about $0.03 per share each month, or, more precisely, $0.3624 per share at year-end.
Alternatively, consider a fund that makes the bare minimum distribution requirement (taxable CEFs are required to distribute at least 98% of NII). This means the fund would distribute $0.588 per year, which translates to $0.3552 per share after taxes. While shareholders miss out on $0.0072 per share of income, the NAV would be $0.012 per share higher than if the fund distributed 100% of NII. This effectively amounts to a tax-free reinvestment. (Note that this does not apply to municipal CEFs or CEFs in tax-sheltered accounts.)
This means that shareholders will likely receive most of the NII earned in excess of distributions at year-end. Any NII the fund holds on to creates a slight benefit to shareholders on an aftertax basis. This difference on a per-share basis is small, but it can add up for larger positions. While the difference would obviously be larger if the fund didn't make any distributions, the monetary and legal ramifications would not offset the tax benefits received by shareholders.
Distributions, Discounts, and Premiums
Many CEF investors disagree with this viewpoint. After all, if so many other CEF investors are income-focused (rather than total-return-focused), this sentiment should be reflected in share prices. This outlook implies that UNII balances have an intrinsic value because it allows the fund to hide an unsustainable distribution and subsequently maintain its current pricing. For investors looking to speculate on the market sentiment for a CEF, this outlook is not necessarily wrong. Large UNII balances are often good indicators of whether an underearning fund will maintain its distribution, and high distributions often lead to high premiums. With this in mind, investors are unaffected by a fund that erodes its NAV to maintain its distribution, provided that the share price stays constant.
But for longer-term investors, that strategy does not make much sense. For share prices to remain constant in the face of an eroding NAV, the fund would either have to see a narrowing discount or a growing premium. Unless one can justify that underearning a distribution somehow has a positive effect on fundamental values, such share price behavior would not be sustainable.
A more prudent decision might be to simply focus on a fund's earning rate and ignore the distribution rate altogether. From an income standpoint, it gives a better indication of the actual return (underearning a distribution means lower effective income, while overearning a distribution might lead to a year-end special distribution). From a share-price standpoint, a CEF that is earning enough NII does not need to cut its distribution (which is a risk to share prices). With this approach, UNII balance has less relevance. Any shareholder worried that an underearning CEF's UNII balance will run out has already waited too long.