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10 Inexpensive Medalist Closed-End Funds

These highly rated funds appear inexpensive based on historical valuation trends. 

Sumit Desai, CFA, 06/13/2014

Morningstar’s methodology for investing in individual stocks is based on buying high-quality firms trading at a discount to intrinsic value. This is easier said than done--intrinsic value is determined by forecasting a company’s future cash flows and discounting those cash flows back to today, a task that is extremely difficult to do with much accuracy. As such, intrinsic value for a stock could be viewed as a range of values that incorporate different best- and worst-case scenarios for the company’s future prospects. 

It’s much easier to determine if a closed-end fund’s shares are trading below its "intrinsic value," which is (presumably) the fund’s net asset value. But investing in these vehicles based solely on discounts or premiums presents a different set of challenges. Investors can find the NAV and share price of any fund on the quote pages on Morningstar.com. This is just a snapshot of a single point in time. Investors should consider a CEF’s historical valuation trends. Some funds trade at persistent discounts or premiums over time, so it’s important to understand how a fund’s current discount or premium compares with its historical valuation trends. As we’ve discussed before, a fund’s z-statistic measures the number of standard deviations the current premium or discount is from a fund’s historical average, as is calculated as follows: 

z= (current discount or premium – average discount or premium)/standard deviation of discount or premium

A negative z-statistic (also called z-score) indicates that the current discount (premium) is wider (lower) than its average, and a positive z-statistic indicates the current discount (premium) is narrower (higher) than average. In our opinion, a z-score of less than negative 2.0 suggests that a fund is relatively inexpensive, and a z-score greater than 2.0 suggests that a fund is relatively expensive. Morningstar.com provides six-month, one-year, and three-year z-statistics on all CEF quote pages.

Z-stats can tell you when a CEF is historically cheap, and Morningstar Analyst Ratings can point investors toward high-quality funds. The table below lists 10 of the most undervalued and positively rated CEFs using one- and three-year z-statistics as of June 11, 2014. 

Energy limited partnership, municipal, and bank-loan funds make up most of the cheapest highly rated CEFs. While these funds appear cheap based on their three-year z-statistics, investors should also understand where these funds' strategies are in terms of valuation and market cycle. For example, bank-loan funds provide insulation against a rapid increase in interest rates, but valuations are also near all-time highs and arguably priced for perfection. Energy limited partnerships and municipal funds are also highly interest-rate-sensitive and could sell off if rates shoot higher. Of these 10 funds, only one fund, Kayne Anderson Energy KYE, remains on the list from our last update. Since then, the fund’s shares have performed well, returning 12.3% compared with its NAV growth of 9.6%. 

BlackRock Municipal Income BFK 
BlackRock Municipal Income is a good vehicle for investors looking to generate high levels of income exempt from federal income taxes. The fund is backed by an experienced investment team at BlackRock, and its managers use leverage to gain exposure to long-duration and some mid- and low-quality municipal debt. In all, the fund takes on substantial interest-rate risk and an above-average level of credit risk. This approach has led to good performance over the long haul but also can lead to losses in more-difficult muni markets. Adding in the costs of leverage, the fund's total expense ratio is above-average. In all, this fund shares the strengths of its siblings in BlackRock's municipal closed-end fund lineup, and we recently raised its Morningstar Analyst Rating to Bronze from Neutral.

AllianceBernstein Global High Income AWF 
AllianceBernstein Global High Income invests primarily in high-yield corporate (mostly U.S.) bonds and emerging-markets debt to meet its high-income objective, which tends to result in a credit-risk profile that is relatively aggressive compared with its multisector-bond peers'. Lead manager Paul DeNoon and his team have been willing to trade above-average volatility for higher-income opportunities, and the fund takes on varying degrees of leverage as they see fit. Still, the fund has a good track record, relatively low fees, and a well-staffed management team. Also, unlike its open-end sibling, AllianceBernstein High Income AGDAX, liquidity risk is less of an issue. Our negative view on AllianceBernstein as a parent detracts somewhat from the fund's appeal, but overall, it has earned a Morningstar Analyst Rating of Silver. 

Western Asset Managed Muni MMU 
Unlike more-aggressive rivals, the managers keep minimal exposure to below-investment-grade bonds (3% compared with 7% for its typical peer as of March 2014) and avoid the rocky tobacco sector. They also continue to prefer revenue-backed sectors over general-obligation bonds: The fund held less than 1% of assets in state and local GOs as of Sept. 30, for instance, which comprised nearly 30% of the fund's Barclays Municipal Bond Index benchmark. Instead, Rob Amodeo and David Fare will load up in sectors and issues that they think offer the best relative value, relying on the team's bottom-up, fundamental research to identify attractive opportunities. As of late, the managers have focused on midquality revenue bonds that offer plump yields, and they typically favor yield-rich sectors--including health care and transportation, which comprise roughly 37% of assets combined--in which they argue their research can uncover bonds whose fundamentals are stronger than their credit ratings suggest. Overall, the fund has earned a Bronze Analyst Rating. 


Sumit Desai, CFA is a senior stock analyst with Morningstar.

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