9 points that every investor should address before buying a fixed-income CEF.
Premium Income Muni 2 NPM and Nuveen Premium Income Muni 4 NPT truly significant?) With this in mind, a systematic approach to picking CEFs might be helpful for investors worried about covering all their bases. While the following checklist is by no means fully inclusive of all CEF-related concerns, it is a good starting point.
1. Portfolio Composition
Take a look at the fund’s latest available portfolio. Although certain metrics such as weighted average credit quality can give some indication of a fund’s credit risk, it can still leave out some red flags. Watch out for funds with high exposure to unrated debt, concentrated sector bets, and large positions in illiquid assets. For global and municipal-bond funds, geographic and sector concentration can also be important. For example, Puerto Rico debt still hurt some muni funds with otherwise innocuous credit profiles this year.
An even more important point is to check the fund’s derivative positions. While it is not uncommon to see international-bond funds hedge their currency exposure through forward contracts, others take obvious speculative bets on currency movements. If you cannot understand the logic of the portfolio's derivative positions with a simple spreadsheet, move on.
One of the most well-known advantages of investing in CEFs is that they provide easy exposure to leverage. But investors should not blindly rush into a fund because of this benefit. Make sure to compare the leverage ratio (total assets/net assets) with other funds in the category and determine whether the type of leverage being used is suitable for the fund. More important, do a gut check. Keeping in mind regulatory requirements for leverage in CEFs and the risk of deleveraging, ask yourself whether you are comfortable with the magnitude of the fund’s leverage. (For more of the specifics on analyzing leverage, click here.) Also worth keeping in mind is that most forms of leverage are tied to short-term rates. Even though the Federal Reserve pledges to keep short-term rates low for the foreseeable future, skeptics might want to find funds that utilize fixed-rate financing or avoid leverage all together.
To draw a more accurate comparison between funds’ distribution rates, one hard and fast comparison is to divide the distribution rate by the leverage ratio to derive the “core” distribution rate. This gives an approximation of the portfolio’s ability to generate income if no leverage were used.
Duration is a rough measure of the percentage change in a fund’s net asset value given a 100-basis-point change in interest rates. Although the metric is highly imperfect (it does not account for portfolio convexity and assumes interest rates uniformly increase across the yield curve), it gives a general idea of a portfolio’s interest-rate risk. Leverage-adjusted effective duration is an even more useful metric, as it accounts for embedded call options in the portfolio and any amplification due to the fund’s leverage. But keep in mind that fund families often use different assumptions in arriving at this number, and may not account for leverage in the same way. This means comparing funds across the same family will often be more useful than between families. Nevertheless, the metric can still be generally useful. Expect a fund with a double-digit duration to be highly sensitive to changes in interest rates, despite the method of calculation used.
4. Distribution Coverage
For most fixed-income funds, looking at how net investment income (NII; that is investment income earned by the portfolio holdings net of expenses) stacks up against total distribution payouts is a fairly reliable measure. For example, a fund that earned $1.00 per share over a given period, but paid out only $0.80 in distributions, could sustain a 20% drop in income before having to make a cut. Funds that have accumulated excess NII over time (undistributed net investment income, or UNII) can dip into this balance instead of lowering the distribution. However, it is important to remember that this is just an accounting convention: Taking money out of the UNII balance still lowers a fund’s NAV. Also, be on the lookout for funds that supplement their distributions with return of capital or realized capital gains. While this is not always detrimental to the fund, it can give a false impression of how much income it is generating.
We generally recommend looking at the portfolio’s earning rate over the distribution rate. Moreover, beware of funds in danger of a distribution cut: Even when they are justified, such actions can have negative effects on share prices in the short term.