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Are Either of These Freshly Minted CEFs Worth Buying?

We look at two recent CEF launches.

Steven Pikelny, 05/03/2013

Following our publication of two articles on closed-end fund, or CEF, IPOs last month, the topic has made the rounds among fund-oriented blogs and new outlets. Some may view this all as sensationalist drivel, but the subject is definitely noteworthy: Over the past 12 months, we have seen 28 IPOs, five of them raising more than $1 billion. In the past week alone, DoubleLine Income Solutions DSL and Dreyfus Municipal Bond Infrastructure DMB raised about $2.2 billion and $250 million in assets, respectively.

This might sound like small fries compared with the open-end fund and exchange-traded fund universes, but it is much more difficult to bring new CEFs to market, making DSL's $2.2 billion IPO quite impressive. Even more impressive, DSL was the second $2 billion-plus IPO of 2013 (PIMCO Dynamic Credit PCI), a threshold CEF IPOs have not crossed since 2007.

For those unfamiliar with the CEF IPO process, the key point to remember is that fund families pay an underwriting fee (typically about 5% of assets raised) to mint a new fund. This fee comes directly out of the fund's net asset value, meaning that the fund will begin trading at a premium on Day 1. Restrictions on short-selling IPOs and temporary secondary market support by the underwriters typically help the premium persist for a short time before dissipating.

The adage "CEF IPOs are sold, not bought" makes sense here. After all, why pay a 5% premium for a fund with no operating history, especially if the premium is going to soon disappear? With this in mind, the recent spate of IPOs is somewhat perplexing. If IPOs are such a bad deal, how can a fund raise several billion dollars in assets? One school of thought goes so far as to proclaim that CEF IPOs are such a bad deal that investors should avoid them at all costs. While this may have some truth to it, the viewpoint is a bit extreme. Sometimes an IPO is worth buying, though it depends on the environment of alternatives. For example, PIMCO Dynamic Credit Income's ability to raise more than $3 billion is less surprising considering the premium pricing of several of its sister funds: A 5% premium is a bargain compared with a 50% premium.[1]

While PIMCO might be an extreme example, record-low interest rates have boosted investor demand for high-income products across the spectrum. Even so, it can be unclear when an IPO presents the opportunity for a relative deal and when it presents the opportunity for a rip-off. With this in mind, let's take a look at last week's two IPOs.

Dreyfus Municipal Bond Infrastructure DMB
"Gimmick" might be a strong word to define this fund, but it certainly comes to mind. Like many supergranular (and now defunct) ETFs, this fund intends to focus on a narrow slice of the municipal market--namely, bonds backed by the revenue from infrastructural projects. For investors looking specifically for exposure to these types of securities, this may be the vehicle to do so. Dreyfus Municipal Bond Infrastructure's closed structure and small size allow it to invest in less-liquid issuances, while it also has the ability to use leverage. Otherwise, investors looking for municipal exposure in general would do better to buy a more diversified fund.

In any case, the average leveraged national municipal fund is currently trading at a 1.8% discount, making Dreyfus Municipal Bond Infrastructure's 4.5% premium the sixth highest in the category. Considering that the three other leveraged Dreyfus national municipal CEFs are trading at 3.7%, 3.0%, and 1.4% premiums (and have each logged decent performance, donning 4-star Morningstar Ratings), Dreyfus Municipal Bond Infrastructure is not terribly more expensive. Nevertheless, it is a hefty price to pay for an unknown portfolio and distribution rate. It is a compelling candidate for conforming to the "IPO slump," in our opinion. Interested investors might want to put it on their watchlists.

DoubleLine Income Solutions DSL
While last year's launch of DoubleLine Opportunistic Credit DBL raised about $300 million, DoubleLine Income Solutions raised about 7 times as much. The main difference between the two funds is that DoubleLine Income Solutions reserves the right to leverage its portfolio as much as 1.5 times (and will likely do so). In addition, DoubleLine Income Solutions plans to be more aggressive with its portfolio, investing nearly all of its assets in below-investment-grade fixed-income securities. For a bit of context, DoubleLine Opportunistic Credit used its flexible investment mandate to load up on nonagency residential mortgage-backed securities. The strategy has proved successful so far, despite its credit risk. It might go without saying, but DoubleLine Income Solutions is not suitable as a core fixed-income holding. Considering the leeway that head manager Jeffrey Gundlach is reserving for this fund, investors should be prepared to put their faith in DoubleLine's management team.

Even though DoubleLine Opportunistic Credit's IPO might be considered lackluster in absolute terms, it is noteworthy in that it managed to maintain its persistent premium pricing, which fell to a low of about 4.5% last November. The fund is currently trading at a 7.4% premium, which is below its six-month average of 8.0%. For investors willing to buy into an unknown portfolio with a wide-open strategy, DoubleLine Income Solutions' 5% premium does not appear particularly expensive relative to its sister fund. However, an IPO slump is still not entirely out of the picture. After raising $2.2 billion, one has to wonder whether there are enough marginal buyers left to prop up the premium.


[1] It is worth noting, however, the combined difference between each PIMCO CEF's respective net assets and market capitalizations is about $1.4 billion, less than half the amount raised by PCI.

 


SPECIAL EVENT
Hear Morningstar CEF Expert at Upcoming Forum
Join Morningstar on Wednesday, May 22, 2013, at The Advisor Summit on Closed-End Funds in New York City. The Closed-End Fund Association is sponsoring the event. Mike Taggart, head of U.S. closed-end fund research, will be presenting a panel on "How to analyze CEFs." Click here for the agenda and registration.

Steven Pikelny is a closed-end fund analyst at Morningstar.
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