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  1. Rising-Rate Fears Create CEF Bargains

    As investors ditched certain income-producing assets on worries of rising rates, an abundance of fixed-income CEFs moved into undervalued territory, according to Morningstar's Cara Esser.

  2. Second Quarter in Bonds : A Damage Check

    Many managers are of the mind that rates have gone about as far as they're going to go for a while, so investors probably don't want to exit the bond market while their funds are down, reports Morningstar's Eric Jacobson. Plus, get an update on fund category performance in the second quarter as well as updates on fund leaders and laggards, including PIMCO Total Return.

  3. Special Report: Investing in a Volatile World

    Morningstar's top strategists discuss their tips for investing in a rising-rate environment, where equity values lie, and some of their favorite investment ideas right now in this special midyear roundtable.

  4. What Will Higher Rates Mean for Levered Closed-End Funds ?

    With short-term rates remaining low, we don't anticipate an immediate impact on the cost of leverage financing for most CEFs .

Bargains Abound as Investors Flee Closed-End Funds

Check out these positively rated, undervalued funds. 

Cara Esser, 07/02/2013

Some avid closed-end fund investors and Morningstar discussion board commentators have bemoaned an overvalued and frothy market, particularly regarding fixed-income funds. But after the market fallout over the past month or so, previously sidelined investors are diving in. Over the last month, the average CEF lost 7% on a net asset value basis and 9% on a share price basis. Fixed-income funds suffered the most; the average taxable fund was down 5% on NAV and 10% on share price, while the average municipal fund lost 10% on NAV and 11.5% on share price. Equity CEFs fared a bit better, but still lost, on average, 6% of NAV and 8% of share price. Share prices have, in general, been falling faster than underlying portfolio NAVs, causing many premiums to shrink and discounts to widen, creating some strong buying opportunities.

As some investors continue to run for the exits, astute investors can pick up some great funds at good prices. An added bonus is that the funds themselves can also take advantage of cheap asset prices, picking up deals for the portfolio and increasing the long-term growth potential of the underlying portfolio. As of June 25, there are 211 funds (out of nearly 600) with one-year z-statistics less than negative 2.0 (the threshold we use to denote undervalued funds) and 201 funds with six-month z-statistics less than negative 2.0. As the market has tanked over the last month, we've highlighted numerous undervalued funds in previous articles. This week we pay special attention to the most undervalued funds on a relatively short-term basis with positive Morningstar Analyst Ratings (an article in mid-May discussed a similar topic, but that list was much smaller as the market had yet to fall off in such a large way). The table below lists 25 funds meeting this criteria.

Only three of the 25 funds on the list employ equity strategies: Nuveen Equity Premium Opportunity JSN, BlackRock Enhanced Capital and Income CII, and Tortoise MLP NTG. Nuveen Equity Premium Opportunity and BlackRock Enhanced Capital and Income invest in equities and write call options on indexes and on individual securities, respectively. The Tortoise fund is one of our favorite master limited partnership funds, which have garnered a lot of interest over the past few years. The fund's share price actually dipped below its NAV on June 25, closing the day at a slight discount, something that had not happened since the start of 2013. Even then, the discount lasted two short days, reaching a more than 5% premium a month later.

John Hancock Premium Dividend Fund PDT and John Hancock Tax-Advantaged Dividend Income HTD are allocation funds, holding mostly preferred shares and common stock. These funds have strong long-term track records and a stable and capable management team.

The remaining funds on the list invest in bonds, many focusing on high-yield (aka junk rated) bonds. Investors flocked to junk-bond portfolios for their high distribution rates, but with the uptick in long-term rates, these portfolios lost some ground in their underlying portfolios as prices fell (bond prices and interest rates move in opposite directions). What's more, investors reacted to the news by fleeing these funds, causing share prices to drop faster and farther than the underlying NAVs. Managers of these funds believe the fundamentals in many high-yield firms are unchanged from a few months ago: default rates remain and are expected to remain quite low in an improving economy. Like-minded investors can snap up some bargains in the junk-bond CEF space, particularly some offerings from the usually high-priced PIMCO.

Speaking of PIMCO, their income funds (PIMCO Income Strategy PFL and PIMCO Income Strategy II PFN) are an interesting case study. These funds invest in a multisector strategy, holding corporates of investment-grade and junk quality, bank loans, and common stock, as well as asset- and mortgage-backed securities. Last year, managers took efforts to derisk the portfolio by bringing down leverage, lowering duration, and improving credit risk from the portfolio. The funds' leverage ratios shrunk to less than 1.30 each from 1.56 (PIMCO Income Strategy) and 1.40 (PIMCO Income Strategy II) as of July 31, 2012. Leverage-adjusted durations also shrank to eight years for Income Strategy and six years for Income Strategy II from 20-plus years for both funds just nine months ago. The significant derisking in the portfolio paid off during the start of the market fallout in May, but Income Strategy's NAV lost 8% over the last month and Income Strategy II lost 6.5%, compared with the average loss of 4.5% for its leveraged peer group. Despite lowering the duration, the funds' still had relatively long duration portfolios (the peer average is closer to three years), and the leverage ratios, though lower on a historical basis, remain slightly higher than peers'. The funds did, however, experience a much more significant drop in share price (13% for Income Strategy and 12% for Income Strategy II versus the peer average loss of 10%) causing the funds' usually small premium to reach small discounts.

CEF investors need to use market dislocations to pick up funds they like at deeply discounted prices. The recent fall-off in the market has been described as an overreaction by many pundits and fund managers. Investors who keep their cool and think about their long-term portfolios can profit by adding good funds at great prices.

Click here for data and commentary on individual closed-end funds.


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

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