These closed-end funds were unstoppable in early 2015; plus, did the first IPO of 2015 usher in a new era for CEF shareholders?
The Federal Reserve's quantitative-easing program was highly correlated with strong returns in the U.S. stock market in recent years. With a similar program under way in Japan, investors are heavily betting that the international sequel will be just as good as the original.
Japan stock was the best-performing closed-end fund Morningstar Category in the first quarter in both share price and net asset value. The two CEFs in the category take different approaches: Aberdeen Japan Equity JEQ focuses on larger-capitalization names while Japan Smaller Capitalization JOF focuses on small-cap stocks. Japanese equities of all sizes were boosted in the first quarter as the government continued its quantitative-easing efforts. Aberdeen Japan Equity gained 19% in share price and 15% in NAV in the first quarter, and Japan Smaller Capitalization gained just under 11% in both share price and NAV. The table below shows the top-performing categories for the first quarter ranked by share-price return.
One thing that benefited the Japan stock funds was a more stable yen. The depreciation of the yen has been one of the hallmarks of the quantitative easing in Japan. It has depreciated against the dollar by roughly 20% since the program was announced in late 2013 but was largely unchanged during the first quarter. How a fund manages its currency exposure can have a big impact on returns. Both Aberdeen Japan Equity and Japan Smaller Capitalization have some flexibility to hedge currencies, but neither had a significant hedge on as of their most recent portfolios, dated Feb. 28, 2015, and Nov. 30, 2014, respectively. Going forward, the attractiveness of both CEFs could hinge as much on currency movements as stock prices.
There's been a significant dispersion between local-currency-hedged Japanese equity funds and non-currency-hedged funds during the past few years. The exhibit below shows the difference in the growth of $10,000 between two exchange-traded funds: the unhedged iShares MSCI Japan EWJ and WisdomTree Japan Hedged Equity DXJ since 2013.
A New Era for CEF IPOs?
Calamos Dynamic Convertible and Income CCD raised $555 million in the first CEF initial public offering of the year on March 26. During the past year, many CEFs have been trading at wider discounts than usual. Municipal CEFs, for example, had an average discount of 5.76% at the end of the first quarter in 2015, considerably wider than their three-year average of 2.75%. The wider-than-usual discounts have made the IPO market dry up considerably. There were only 11 IPOs in 2014, after 24 in both 2013 and 2012.
Calamos' offering is unique, though. Instead of simply letting the market forces determine the share price relative to the fund's NAV, the fund implicitly stated that the advisor would step in if shares trade at a discount of more than 2% and purchase up to $20 million worth of shares to bring the price closer to NAV. It's essentially the first CEF warranty program.
To be sure, that condition only lasts for the first 245 days of trading, but a quick look at CEFs that have recently hit that time frame shows it's a long enough time period to make a difference. The table below shows how CEFs near or just past their 245-day mark were trading as of the end of the quarter.
As the exhibit shows, three of the five funds were trading at considerable discounts as of the end of the quarter, suggesting Calamos Dynamic Convertible and Income's advisor may need to step in to support its share price. We'll be keeping a close eye on the Calamos CEF's share price and trading volume to see how well the experiment works. It's possible just the threat of intervention could provide some stability to how well the fund's share price aligns with the NAV.
If the fund trades at a considerable discount after the warranty expires, there's another shareholder-protection feature that was built into the fund: After 15 years, the fund is triggered to liquidate and redeem shares at NAV unless shareholders vote to extend its life.
It's encouraging to see these kind of protections built into the fund to protect shareholders from persistent discounts. Wide discounts may make for attractive trading opportunities, but they aren't much help for long-term shareholders.
Best- and Worst-Performing CEF Categories
Equity precious metals continued to struggle in March. ASA Gold and Precious Metals ASA, one of two funds in the category, lost 12% of its share price during the month. It's a stark turnaround from January, when it was the best-performing CEF as it rode a surge in the price of gold to a 17% gain in share price. Gold, which gained 9% in January and gave it all back before quarter-end, wasn't the only commodity to struggle in March. Crude-oil continued its downward spiral during the month with a 7% drop in the price per barrel of WTI crude-oil. That weighed on several bottom-dwelling categories, like equity energy and energy limited partnership. Both categories were also among the worst performers of the quarter, with the average CEF in each category losing 1.04% and 4.87% in share price, respectively.
Most Expensive and Inexpensive CEFs
The next four tables list the most expensive and inexpensive CEFs based on three-year z-statistic as of April 7, 2015. 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."
Federated Enhanced Treasury Income FTT is the only taxable-bond CEF that looks overvalued on a three-year statistical basis, but the fund has a new distribution policy so the historical discounts might not be as relevant. The fund initiated a managed-payout program effective March 1 that requires it to make monthly distributions of approximately 2.50% of the fund's NAV. For comparison, the open-end short-government fund category sported an SEC yield of 0.59% as of March 31, raising the risk that the fund's new distribution policy could begin to erode its NAV. The fund's share price rallied 4% following the policy change, which pushed its discount to less than 4%, well below its three-year average discount of more than 10%.
Herzfeld Caribbean Basin CUBA continues to look overvalued. The fund, which focuses its holdings on firms expected to benefit from economic and political developments in the countries in the Caribbean Basin, saw its share price skyrocket in January after the United States announced it would restore full relations with Cuba. The fund's shares went from a 12% discount to a 70% premium in the days following the announcement. Even though the premium has come down considerably, at 21% it's still a hefty price to pay for CEF with a topical ticker.
On the other end of the spectrum, Cushing MLP Total Return SRV looks cheap, but the fund has traded at a significant premium (three-year average of 18%) because of strong performance in 2009 and 2010. Those sunny days are looking pretty far away now, though. The fund's NAV has underperformed the energy limited partnership category every year since 2011. With falling oil prices weighing on master limited partnerships, it seems like investors aren't willing to stick around to see if management can recapture its old magic. The fund's share price fell 30% in the first quarter.
There aren't any bargains to be had in the municipal CEF categories. Despite a number of significant discounts, none of the CEFs look undervalued on a three-year statistical basis. Municipal CEF NAVs have held up quite well this year, with the muni-national long and muni-national intermediate-term categories both outpacing the S&P 500's 1.00% return in the first quarter, with returns of 2.98% and 2.17%, respectively.
Calamos Convertible and High Income CHY is the only fund in the rest of the CEF universe that looks overvalued on a three-year basis. Its shares traded at a steady discount from 2011 through mid-2014, which makes the current premium of 5.72% look rich. The premium has been fairly steady during the past year, so on a one-year basis, shares look fairly valued with a 1.18 z-statistic.
News You Can Use
Fund Liquidations and Mergers
BlackRock announced that shareholders of BlackRock MuniHoldings New Jersey Quality MUJ have approved the merger of BlackRock MuniYield New Jersey Quality into the fund. It also announced that shareholders of BlackRock MuniYield Pennsylvania Quality
Fund Manager and Name Changes
Invesco announced it was moving to a single-team structure for all of its muni-bond CEFs effective March 6. William Black, Thomas Byron, Mark Paris, James Phillips, Robert Stryker, Julius Williams, and Robert Wimmel will now share the lead on each of Invesco's 10 offerings.
Neuberger Berman High Yield Strategies
The board of directors of Virtus Global Multi-Sector Income
Nuveen Texas Quality Income Municipal
NexPoint Credit Strategies
The table below lists significant distribution changes during March.
Discounts and Premiums
The average discounts for all four CEF asset classes narrowed in the first quarter.
Municipal-bond CEFs saw the largest narrowing, with the average discount at 5.76% by the end of the quarter, down from 7.01% at the start of the year. Taxable-bond CEFs saw the smallest narrowing. The average discount was still a sizable 7.32%, but that's lower than the 7.88% average discount at the start of the year. The fear of rising interest rates and the subsequent bond portfolio losses are still keeping bond CEF discounts wider than their historical average. The three-year average discount for muni CEFs is 2.75% and for taxable-bond CEFs it's 2.94%.