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A Rocky Ride for CEF Investors in the First Half of 2013

After a startling end to the second quarter, 2013 is shaping up to be a roller-oaster year.

Cara Esser, 07/19/2013

While the first quarter of 2013 was relatively calm and, overall, pretty good for closed-end fund investors, the second quarter ended with an explosion that few expected. Fund managers were surprised by the fervor with which investors fled bond funds, dumping shares with little regard to long-term investment strategies and overall portfolio allocations. After the dust settled, CEF investors saw many high-premium bond funds trading at historically narrow premiums or even discounts. Technical investors, specifically hedge funds and mutual funds investing in CEFs, have had a field day with the carnage left by tapering fears.

The fall-off hit bond and emerging markets funds the hardest, dragging down year-to-date returns dramatically. Nearly all bond-related Morningstar category averages have posted negative total returns for the year to date on both a net asset value and share price basis. Interestingly, the high-yield bond category remains in positive territory through June 28 based on NAV (2.4%), but it's negative on share price (0.19%). At the end of the first quarter, it was one of the best-performing fixed-income categories on a NAV basis, up 3.6% on average. Of the 70 Morningstar categories for CEFs, fully half have posted negative NAV returns for the year to date and just over half have negative share price returns over the same time period. Table 1 presents the five best- and worst-performing CEF categories for the year to date.

Déja Vu All Over Again
The list is very similar to our list of best- and worst-performing categories from the first quarter of 2013, though the order varies a bit. The top spots remain firmly on the equity side of the equation (aggressive-allocation funds do hold bonds but generally have 70%-90% in equities at any given time). Each of the five categories posted high returns for the six months compared with the first quarter, despite three of the five categories posting losses in June. Interestingly, share prices continued to outpace underlying net asset value moves in each of the top five categories, indicating that investors have not tired of these funds just yet.

On the worst-performing list we also see some familiar faces. In fact, all five landed on the same list at the end of the first quarter, though losses are much steeper as of June 28. The equity precious metals category, for example, was the worst-performing at the end of the first quarter, down 10% on NAV and 6.5% on share price. During the second quarter, the average fund in the category lost a staggering 30% on NAV and share price. Unlike the top performers, the bottom performers have seen share prices fall more rapidly than NAVs in the first half of the year (communications being the only exception). Funds in these categories have been beaten down.

Table 2 lists the five best- and worst-performing individual CEFs for the year to date. Again, the list is similar to our first-quarter best- and worst-performing funds list with a few exceptions.

Not surprisingly, the best-performing funds were all MLP funds (equity energy category). These funds are high-distributing equity funds, attracting attention from both income-hungry and sector-focused investors. Kayne Anderson MLP KYN is the only fund whose share price outpaced NAV for the year to date (note that Kayne Anderson MLP's share price has fallen off in the last week, down 3%, while its underlying NAV has risen 2.25%), while the other funds have seen NAVs outpace share prices. This is not surprising, as many of these funds had reached large premiums even as underlying portfolios performed well.

Hot Off the Presses
While bond funds were hit hard by tapering talk, the initial public offering market, especially for bond funds, has been hot this year. There were 18 fund launches in the first half of the year, more than the 10 at last year's midpoint. Thirteen of the launches this year were bond funds, two were allocation funds, and three were MLP funds. We see  continued interest in high-income-producing funds on both the equity and bond side. This year also boasts four $1 billion-plus IPOs and the largest IPO since 2007: PIMCO Dynamic Credit Income PCI raised nearly $3 billion in net proceeds. Table 3 lists the 18 IPOs this year along with net proceeds from the launches. So far this year, CEF IPOs raised more than $12 billion in net proceeds, compared with just $4 billion last year at this time.

Discounts and Distributions
At the midpoint of 2013, the average equity CEF was selling at a nearly 6% discount, far from the average 1% discount at the close of the first quarter. At the start of the year, the average discount was 7%, more in line with historical standards. For taxable fixed-income funds, the average discount was 3%, surprisingly only a bit narrower than at the end of the first quarter (4%) but wider than the start of the year (1%). Finally, municipal CEFs saw a big valuation change from an average premium of less than 1% at the end of the first quarter to a discount of 2.5% at midyear. The average premium for muni funds at the start of 2013 was 2.5%.

From a distribution perspective, broadly speaking, there were more distribution reductions than increases in the first half of the year, but changes were generally modest. The average equity CEF had a distribution rate of 6% at NAV and 6.5% at share price at the close of the second quarter. For taxable fixed-income funds, the average distribution rate was just over 7% at NAV and share price. The average muni fund had a distribution rate of just under 6% at NAV and share price.

The second quarter proved tough for bond investors in general and CEF investors in particular. Of the 586 funds with at least six months of returns, 311 (53%) posted negative NAV returns for the year to date and 346 (59%) saw share prices decline over the last six months. As noted in Tables 1 and 2, differences between funds and investment style led to wide differences in total returns. Although the second quarter ended in an extreme fashion, with many investors heading for the exits, long-term investors should remember why a fund was added to their portfolio. This helps keep long-term portfolio goals in perspective. What's more, investors can use these market extremes to add shares of 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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