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When Are Discounted CEFs Bargains?

Expense ratios, distributions, and return of capital can offer some insight into valuation.

Steven Pikelny, 08/16/2013

In the active versus passive fund management debate, it's always important to keep one thing in mind: The reason passive funds are so popular has little to do with passive management. Instead, their popularity likely has more to do with cost. For investors skeptical of the value added by portfolio managers, choosing the fund with the lowest expense ratio is as good as any other option--it just costs less.  For this reason, some investors shun the high fees of many closed-end funds. But while fees are certainly an important consideration, the relationship between performance and fees is less clear when evaluating CEFs.

For starters, CEFs can be incredibly cost-effective vehicles for investors looking to gain leveraged exposure to specific markets. Leveraged funds borrow at institutional rates (which are much lower than those available to individuals) and pass these lower costs onto shareholders. This is likely a cheaper alternative for individuals than buying low-cost ETFs on margin. Ultimately, total expense ratios for CEFs are higher because leverage costs are typically included in the total expense ratio, and because management fees are usually based on total assets (i.e. net assets plus the proceeds attributable to leverage).

Even unleveraged CEFs, which typically charge average fees, potentially have an advantage in that a wide discount boosts distribution payments. For example, if a fund trading at a 10% discount pays a 5% annual distribution rate at net asset value (without overdistributing), its distribution rate at share price would be roughly 5.56%.[1] That's an extra 56 basis points without adding any risk to the underlying portfolio. From a cost perspective, the increased “yield” can offset some of the fund's expenses. Even if investors assume that managers add little to no value to the underlying portfolio's performance, the benefits of large discounts can offset the disadvantages of an above-average expense ratio.

ETFs vs. CEFs
After the recent sell-off in fixed-income CEFs, we've consistently noted that muni funds have become very cheap on an historical basis. But while we usually stress the importance of looking at CEFs under the light of relative valuation, it's also prudent to examine absolute valuations. In other words, investors should be happy buying (and holding) a fund at a specific discount, even it never closes. Using the ETF SPDR Nuveen Barclays Capital Muni Bond TFI as an initial benchmark (which charges an expense ratio of 0.23%), let's look at some funds with discounts wide enough to compensate for higher fees.

Nuveen Select Tax Free Income Common NXP, Nuveen Select TaxFree Income 2 Common NXQ, and Nuveen Select TaxFree Income 3 Common NXR are already among the cheapest options available to muni investors. The funds' expense ratios are 0.28%, 0.33%, and 0.33%, respectively, and they do not use leverage. While they are slightly more expensive than TFI, the funds look even cheaper after taking into account the currently wide discounts (8.0%, 9.2%, and 9.1%). In all, the funds' earnings rates (the amount of income generated by the portfolio per share) of 4.47%, 4.56%, and 4.44% at net asset value increase to 4.88%, 5.02%, and 4.79% at share price because of the discount. In addition, each fund is currently distributing in excess of their earnings rates, which is marginally accretive to shareholders at their current discounts. (Municipal income is not taxed, so this similar to a taxable fund returning capital.) The resulting 42, 47, and 36 basis point increases compensate for each funds' expense ratio and then some.

Of course, investors might argue that the cheap valuations are justified. With long-duration bonds out of favor, the funds' effective durations of 10-plus years hardly look attractive. Their high call exposure could also be unappealing for income-oriented investors concerned about the portfolios' reinvestment risk. What's more, the small amount of Detroit exposure in each portfolio may give rise to credit quality concerns. From a credit perspective, all of the Detroit debt held in these three portfolios is backed by water and sewer revenue projects most of which is insured (as opposed to the more questionable uninsured general obligation debt). In any case, looking for problems with the fund by nitpicking portfolio characteristics implies that either the securities in the portfolios are mispriced with respect to their risk, or that Nuveen's management team is actively detracting from the portfolio after fees are taken into account.

Leverage Also Plays a Role
In contrast, Eaton Vance Municipal Income EVN falls at the opposite end of the discount-benefits spectrum. This fund is similar to the above Nuveen funds in that it focuses on long-dated, investment-grade municipal bonds. However, EVN's 2.08 leverage ratio (total assets/net assets) makes it the most highly leveraged muni CEF. The fund's 8.79% distribution rate at share price looks appealing at first glance; the leverage-adjusted effective duration of 17.6 years looks notably less appealing. The fund is also underearning its distribution by 45 basis points at share price while shares trade at a 3.8% premium. Although the current premium is roughly two standard deviations below the fund's three-year average premium of 11.1%, investors are effectively giving up 34 basis points in income. Adding this to the already high total expense ratio of 2.02%, the fund doesn't look like such a bargain.

Looking at it another way, EVN's portfolio takes on enough duration risk to generate 10.36% in income (i.e. its earnings rate at NAV plus its total expense ratio), but investors see only 8.00% in distribution payments (after taking into account valuation, overdistribution, and high fees). This means investors are giving up 23% of the portfolio's income while taking on all of its risks.

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

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