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Should More CEFs Use Discount-Control Mechanisms?

Yes, and here's why.

Steven Pikelny, 07/05/2013

Closed-end funds are often closed for good reason. Many CEFs invest in illiquid assets, utilize leverage, and engage in other investment strategies that are negatively impacted by inflows and outflows. But despite these advantages, the resulting premiums and discounts can often harm shareholders. The most obvious detriment is the added volatility of share price movements on top of changes in net asset value. But even long-term, buy-and-hold income investors who don't place much emphasis on day-to-day volatility can be negatively affected should they want to reinvest part of their distribution while the fund is trading at a premium. [1]

Academics have long suggested that premiums and discounts shouldn't exist in the first place, and that they represent a market inefficiency. While seasoned CEF investors will note that some persistent premiums and discounts can be justified, they would be hard-pressed to argue that CEF prices are "efficient" in aggregate. When premiums emerge, investors should (theoretically) sell shares of the CEF short and buy the underlying portfolio. Conversely, they should buy shares of the CEF and sell the securities in the underlying portfolio short when the fund trades at a discount. However, the academic literature often concludes that share prices persistently deviate from NAV because of difficulties relating to arbitrage: Replicating an entire portfolio (which sometimes includes illiquid assets) can be cumbersome for both long and short positions. Moreover, it can be difficult and expensive to short shares of some not-so-liquid and high-distribution-paying CEFs. Although we've recently touched upon approximate arbitrage strategies in recent articles, there is no easy way for investors to do it with precision.

Exchange-traded funds sidestep this issue by partnering with an authorized participant (AP) and facilitating persistent arbitrage. The ETF has the ability to create and redeem shares, which it trades with the AP for either cash or a basket of securities. This allows the AP to collect the spread between share price and NAV, which closes the premium or discount. Investors enjoy a less volatile ETF, and everyone wins.

Although CEFs don't partner with authorized participants, they do have a variety of corporate actions available to create and redeem shares. With this in mind, the logical question is whether CEF shareholders can somehow benefit from price dislocations.

Rights and Tenders
Last year, the big CEF stewardship question on many investors' minds was about shelf offerings. While CEFs trade at premiums, instituting any kind of secondary offering is somewhat like arbitrage: The fund creates shares, sells them at a premium, and buys assets for the portfolio. The difference between NAV and the amount raised is an added bonus, giving the NAV a slight boost and increasing its income-generating capabilities. Fund companies (unsurprisingly) like doing this because it raises assets under management and increases total revenue collected from fees.

Similar to shelf offerings, rights issuances are a type of secondary offering that give existing shareholders first dibs on contributing more capital to a fund. But opinion among many CEF investors remains mixed. The concern principally revolves around the ability to reinvest the new assets at an adequate yield. This is a legitimate concern in many situations. If the fund cannot easily buy more securities with similar income-producing characteristics and the premium is small, for example, then raising more assets will likely only dilute the portfolio's distribution potential. For illiquid assets, even a premium as high as 20% can be too small to make a shelf offering worth it. But as the premium becomes larger, the potential benefit of raising more capital becomes less ambiguous. One has to question whether actively managed funds trading at 75% premiums (such as PIMCO High Income PHK circa June 2012) really can't make use of raising new capital at $1.80 on the dollar.

With many premiums collapsing or falling to discounts over the last month, concerns about rights offerings have become much less pressing. Now, the issues on many investors' minds are volatility and poor share price returns. But as much as fund families don't want to admit it, discounts present another arbitragelike opportunity to benefit shareholders. With shares undervalued relative to NAV, there are two primary ways. First, and most directly, funds can conduct tender offers. In other words, the fund can sell assets at NAV and buy back discounted shares from investors. Shareholders, rather than an AP, would realize the profit spread between share price and NAV.

Second, the fund could simply return capital. As we explain here, returning capital while the fund is trading at a discount can be accretive to shareholders, provided they do not treat the extra distributions as income. Some funds, such as MFS Intermediate Income MIN, return large amounts of capital indiscriminately. MIN could benefit from a more thoughtful policy relating to return of capital. While we previously called on the fund to cut its distribution because of its high premium, its current discount suggests that a distribution cut is not the appropriate course of action.

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