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CEF Weekly: Medalist Edition

Two more funds get the Bronze. 

Cara Esser, 12/06/2013

During the last month, we added coverage of two new closed-end funds, or CEFs, bringing the total number of funds rated to 125, accounting for 45% of the net assets in the CEF universe. (For those closely following our ratings count, that number was 126 at the start of November, but it dropped because of a merger of four rated BlackRock High Yield funds. BlackRock Corp High Yield VI Common  HYT, the surviving fund, earned a Bronze rating.) For a detailed discussion of the Morningstar Analyst Rating for CEFs, you can find the methodology document here.

Flaherty & Crumrine Total Return FLC 
Bronze-rated Flaherty & Crumrine Total Return has benefited from a strong and experienced management team, a unique strategy with a heavy reliance on traders, and a favorable preferred-share environment.

Investors are in good hands with the firm's deeply experienced and tight-knit management team that has spent decades managing preferred-share assets together. While managers and analysts perform fundamental research on new deals as well as existing issues, the firm's traders play an integral role in the process, making all transaction decisions. This experience has given the fund an added leg up in what has been an advantageous environment for preferred shares.

The current shape of the yield curve is one of the biggest helpers for this fund over the past several years because it's one of the most leveraged in its category (34% versus 29% for a typical peer). Managers are taking full advantage of the low short-term interest rates at which it can borrow, reinvesting at higher, longer-term yields. While leverage increases volatility of returns, managers actively manage it through a flexible credit facility--since the end of 2006, the fund's leverage ratio has been as high as 44% and as low as 32%. Over the years, managers have been adept at using leverage, including pulling back when they believed it to be prudent.

Many investors are attracted to preferred-share CEFs for their high distribution rates, and FLC fits this bill. Its 9% distribution rate at share price is slightly higher than the CEF peer average, but managers have been warning of impending reductions thanks to falling yields in the preferred market. In an effort to avoid returning capital to investors as income is harder to earn, this and three other Flaherty & Crumrine funds lowered distribution rates by about 3% each over the past year. These were the only preferred share CEFs to lower distribution rates in the past year, and two funds actually raised their distribution rates.

Because most funds in this category invest similarly by industry (concentrated in banks and utilities), peer-beating returns are generally the work of leverage and security selection. The firm's unique valuation and trading-focused process has allowed this fund to put up peer-beating returns over the long term. Compared with its CEF peers, the fund beat the median risk-adjusted return in each of 61 five-year rolling time periods ended Nov. 30. It also landed in the top quintile over the trailing five- and 10-year periods ended Dec. 3. But investors should expect a decent amount of volatility for these peer-beating returns. For example, the fund lost 44% in 2008. Its Sharpe ratios, however, have also landed in the top quintile over the trailing 10-year period, indicating that the fund's risk/reward trade-off has been generally better than its typical peer.

Overall, investors looking to add preferred-share exposure to their portfolios may want to consider this fund, though investors should also be mindful of the credit and interest-rate risk inherent in such a portfolio. This fund tends to hold more investment-grade preferreds but leans toward the lower end of the quality scale with generally more than 50% in preferreds rated BBB. Because preferred-share securities are long-term (often perpetual) in nature, duration risk is a concern. This fund has taken a beating as the Fed contemplates the timing of tapering its easing monetary policies, but this has also created advantageous entry points for interested investors. The fund's 7% discount as of Dec. 3 was much wider than historical measures.

Western Asset Managed Muni MMU 
Longtime manager Joe Deane's departure from Western Asset in mid-2011 resulted in a key shift to this fund's approach to the municipal-bond market, says senior analyst Michelle Canavan Ward.

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

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