Continuing with last week's return-of-capital discussion.
Last week, we tackled the issue of return of capital in closed-end funds. The ideas and calculations presented were appropriate for evaluating most CEFs but, importantly, not master limited partnerships.
Master Limited Partnerships
MLPs are partnerships, not corporations. Buying a share of a corporation (that is, a stock) means the investor owns a portion of that firm’s equity. Buying a share of a partnership means the investor owns a unit of the partnership's business interests. Unlike a firm, partnership units are not taxed at the business level but at the investor (or partner) level. Thus, taxable income from a stock's dividends and MLP cash distributions are not the same. Under accounting rules, an MLP's pipelines (most MLPs own and operate energy pipelines) are depreciated as an expense. Because of the accounting treatment of depreciation expense, taxable income for MLPs is typically less than their actual cash flow generation. Conversely, the amount of cash available for distribution is usually higher than taxable income recorded.
That presents partnership unitholders with two distinct issues. First, partners have to report their proportion of the partnership's net income on their individual tax return, even if the partnership distributes none of that income and the partner does not sell any units. Second, any distributions received from the partnership are declared for tax purposes but are tax-advantaged relative to a dividend from a company. These distributions are often considered a "return of capital," and taxes on these distributions are deferred. We'll revisit that taxation issue below.
Covered-call funds are not special cases in the same way that MLP funds are, but they're worth mentioning separately.
Covered-call funds hold underlying equities and write call options on indexes or individual equities in an effort to generate additional income for distributions. Investors may notice that a covered-call fund tends to distribute more return of capital than an equity fund using a similar strategy without the call overlay.
When a fund writes a call option, it earns a premium. This premium is not "earned" by the fund until the option contract has expired or is closed. Once this happens, the fund will either book a gain or loss on the option contract (although it is also possible that a fund would break even) based on the price of the underlying security relative to the strike price and the premium received. Any option premiums distributed to investors are categorized as a combination of short-term and long-term capital gains for tax purposes. Because of netting of capital gains and losses, these funds may end up returning capital.
Let’s look at two oversimplified scenarios. They assume a fund is writing call options on an index and holding securities that mimic the index. At the start of the year, the fund’s net asset value is $10 per share. Assume that no trades are made throughout the year and that the fund does not earn income from dividends of underlying holdings.
First, take a declining market scenario in which the fund's underlying holdings fall 10% during the year (at a steady pace throughout the year, which means none of the fund’s options are exercised). The NAV at year-end is $9 per share. During the year, the fund sold call options and recorded a $1 per-share capital gain from those premiums. The fund pays an annual distribution of $1 per share. Thanks to the option premiums, this distribution is categorized as a combination of short-term and long-term capital gains. But the fund's total return (which includes distributions) is zero: The $1 per-share distribution perfectly offsets the $1 per-share decline in NAV. The table below illustrates this scenario.