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3 Income Ideas for the Current Market Environment

With double-digit discounts persisting, these MFS funds are worth a look.

Steven Pikelny, 09/27/2013

Fund firm MFS doesn't stand out much in the closed-end fund universe. The firm has run the same 12 CEFs since 1999, nine of which have less than $300 million in total assets (including leverage). None of the funds are particularly special in terms of performance, each with an overall Morningstar Rating of 2 or 3 stars. A glance at the family of funds earlier this year wouldn't have raised many eyebrows in terms of valuation either: As of the end of March, six of its 12 funds traded at fairly narrow discounts, while five traded at premiums. Nevertheless, things have changed: Even though these funds follow fairly vanilla investment strategies, the CEF market sell-off during the second quarter of this year left eight of the funds trading at (or close to) double-digit discounts. And, in our opinion, several of these funds are now trading at attractive valuations on a relative basis. Let's take a look at the three largest (and most liquid) CEFs in the MFS lineup.

MFS Intermediate Income MIN
MFS Intermediate Income is nothing special on its own, but its nearly 10% discount makes it a decent choice for income investors worried about rising rates. The fund uses no leverage and generally gravitates toward the shorter and intermediate portions of the yield curve. As of August 2013, the portfolio had an average maturity of 4.3 years and an effective duration of 3.5 years. While it's hardly immune to interest-rate movements, it is certainly less sensitive than many other fixed-income CEFs (after taking leverage into account, double-digit durations are not uncommon in the CEF universe). The portfolio wasn't particularly risky in terms of credit quality either: About 70% of assets were rated either A or BBB, with the remainder rated higher. Sector exposure was also fairly diversified, with 61% of assets in investment-grade corporates, 16% in non-U.S. sovereign bonds, 10% in investment-grade emerging-markets debt, and 5% in mortgage-backed securities.

Back in April, we called on MIN to cut its distribution. The fund makes a regular practice of returning large quantities of capital to shareholders. In fact, more than 50% of the fund's total 2012 distributions were composed of return of capital, while roughly 40% of 2013's year-to-date distributions were composed of return of capital. As we've previously noted, return of capital is mostly innocuous when funds trade close to their net asset values. However, it becomes detrimental to investors when shares trade at a premium and accretive when shares trade at a discount. With MIN shares trading at a lofty 7.3% premium back in April, it was decidedly not a very good deal. The fund would have benefited its shareholders by avoiding return of capital altogether.

According to MIN's latest semiannual report, MFS estimates that only 36% of the fund's distributions for the six months ended April 2013 were composed of income. The fund pledges an 8.5% distribution rate at NAV, which means that the portfolio generated only about 3.08% in net investment income during the period. After accounting for realized capital gains (about 6% of the distribution), the fund distributed about 4.9% in return of capital. In all, returning this much capital at a 10% discount amounts to 49 basis points in extra return on an annualized basis.* In addition, the 10% discount boosts the earnings rate to 3.44% at share price, adding 36 basis points of additional return. Overall, this discount pricing leaves investors with 95 basis points of added return, which more than covers the fund's 0.70% expense ratio.

While the 9.49% official distribution rate at share price is drastically overstated, the "actual" distribution rate is closer to 3.93% (that is, the distribution rate at share price plus the benefits of the return of capital at a discount). Not bad for an unleveraged, relatively short-duration, investment-grade bond fund.

MFS Multi-Market Income MMT
MFS Charter Income MCR
Investors interested in MIN's valuation but looking for higher levels of income might also be interested in sister fund MFS Multi-Market Income. While notably riskier than MIN, MMT is essentially just a highly diversified high-yield fund: About 90% of assets are evenly dispersed across BBB, BB, and B rated securities, with 9% rated CCC and below. In all, 56% of assets are invested in high-yield corporates, 26% in emerging-markets debt, 18% in investment-grade corporates, and the remainder spread across various other fixed-income sectors. The fund also carries slightly more interest-rate risk with a 5.2-year duration. The fund uses a moderate degree of leverage (15% of total assets) but uses Treasury futures to pull in its duration.

Nevertheless, investors are compensated for this added interest-rate risk. The fund sports an earnings rate at NAV of 5.56%, which is boosted to 6.39% at share price after taking the fund's 13% discount into consideration. The extra 73 basis points offset a large chunk of the fund's 1.04% total expense ratio for the first six months of 2013. Although the most recent semiannual report estimates that the fund is overdistributing by a slight margin, this difference is technically classified as investment income, rather than return of capital. This means that investors looking to hold the fund in a tax-sheltered account might enjoy an extra couple of basis points of real return, but taxable investors will still have to pay tax on the extra income.

MFS Charter Income is in a similar boat: The fund has a nearly identical asset allocation, with the key difference being that it allocates a higher portion of its portfolio to developed-markets sovereign debt and a lower portion to emerging-markets debt (12% and 15% of assets, respectively). As a result, the portfolio is only generating an earnings rate of 5.35% at NAV (6.11% at share price). The fund also charges a slightly lower total expense ratio than MMT (0.93% for the first six months of fiscal 2013).

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