Tue, 21 Aug 2012
As fixed-income CEFs appreciate, investors seeking yield should be cognizant of bond rollover into lower-yielding assets as well as the added risk of leverage, says RiverNorth's Patrick Galley.
Mike Taggart: Hi, I am Mike Taggart, director of closed-end fund research at Morningstar. With me today is Patrick Galley of RiverNorth Capital.
Patrick, thanks for joining me.
Patrick Galley: Thanks for having me, Mike.
Taggart: Patrick manages $2 billion in assets across three open-end mutual funds that invest in closed-end funds. He's joined me today to talk about recent performance in closed-end funds and distributions in closed-end funds.
Patrick, in 2011, closed-end funds had a pretty decent year just looking across all the asset classes that they can invest in. The share price went up a little bit more than the net asset value, and that trend's continued so far this year. Do you attribute that to any specific factors?
Galley: Yes. Out of the 630 closed-end funds, about two thirds are fixed-income closed-end funds, and I think that's really investors showing that they are reaching for yield. They want yield, and so fixed-income closed-end funds, specifically, had discounts narrow, which means their market price outperforms the net asset value total return.
Taggart: Absolutely, and I think that mimics what we see on the open-end side over the past 18 months and even longer, with the flows coming into the bond funds and out of or trickling into the equity funds. You mentioned the premium and discount. Typically historically over a long period of time, the average closed-end fund is traded at about a 4.0%, 4.5% discount. Looking at it [recently], it was 0.2% discount, so it's essentially flat. In the past two years, since I've been looking at closed-end funds, people have been talking about how the investing public stretches for yield. They want that income. Right now, the average closed-end fund distribution rate is about 6.5%. Can you break that down a little bit for us?
Galley: Yes. I think, first, you do have to break it out into major asset classes, so you have equity and fixed income. Again, fixed-income closed-end funds are trading very narrow, even at premiums, on average. So municipal-bond closed-end funds are now back up at premium levels. High-yield bonds are at premium levels. Preferred securities are at premium levels. And conversely to your point, equity closed-end funds are trading at very wide discounts, as sentiment is very negative toward equities.
As far as distributions go, that 6.5%, that's diluted a little bit because munis are in that category. If you just look at taxable fixed-income closed-end funds, the average distribution yield is approximately 7%, and that is a lot lower than it was last year which was about 8.5%. So, distributions have come down quite a bit, and that's predominantly because discounts have narrowed, even gone to premiums, and also the underlying assets have appreciated, as well.
Taggart: Is it the underlying assets that have appreciated, or is it because over the past year, as they've been rolling over their investments, they are going into lower-yielding bonds. I think that would be an interesting study to see what the attribution is there.
Galley: Yes. It's a combination of both. A lot of fixed-income closed-end funds, obviously as fixed-income yields have come down as their bonds roll over, they have to reinvest that lower yield, and so distributions are coming down. And I think that's a risk for investors to be looking at going forward. Is the dividend stable for their closed-end funds, especially the funds that are trading at large premiums?
Taggart: Do you look at the risks that the fund takes on to accomplish its distribution rate?
Galley: For certain, and one of the major risks is how are they achieving that distribution. Is it through leverage? As you know, a lot of closed-end funds implement leverage their capital structure. So if they are borrowing $0.33 for every dollar that they have in capital, obviously they are getting $0.33 of more exposure. And I think investors really have to be cognizant of that additional risk. I think a lot of investors have short-term memories, because in 2008, that came to light quite prevalent, and here we are again as investors are just reaching for yield and essentially being greedy on the fixed-income side of the equation.
Taggart: That's a really good point with the leverage. We try to bring that to people's attention constantly, and you have to look at 2008. Some of these funds are very, very highly leveraged, and the incremental distribution that they are offering compared with the amount of risk just through leverage alone that they are taking in the portfolio is a little unsettling when you dig down and look at it.
Now your main fund, which I believe is closed to new investors, is RiverNorth Core Opportunity. That's an opportunistic fund in that it spans equities and fixed income. Then you also have RiverNorth DoubleLine Strategic Income, where you're teamed up with Jeffrey Gundlach, and that's the fixed-income slant.
You just recently launched a new open-end fund, the RiverNorth/Manning & Napier fund, where you've teamed up with an equity manager. You manage a sleeve that invests in equity closed-end funds for total return. So since you are looking at equity funds for both the Core Opportunity fund and this new fund, can you kind of walk us through how do you go about assessing the total-return opportunity for a fund?
Galley: Sure. First, you hit the nail on the head. Total return is most important to us at RiverNorth. We're not just looking at yield. So, today equity-based closed-end funds are trading at very wide discounts, as I mentioned before, and when you can buy discounts at 10%, 15%, that becomes attractive. So, first and foremost we look through the underlying assets, so what exposure are we getting? Is it country-specific, or is it U.S. domestic? Is it diversified? Are there concentration risks in individual companies or sectors? And after we go through that risk-management assessment, and we combine a lot of closed-end funds together, ultimately, typically they are company-specific risk. The sector risk is diversified away, and we're left with equity exposure. We're trying to keep a very diversified portfolio.
Then on top of that, our excess return comes from if the discount narrows, let's just say for an example, from 15% to 10%. That 5% of narrowing is our excess return that we didn't have to take a bet on an individual company or sector. And so we think that's a pretty good risk-adjusted trade. If nothing happens to the discount, we're getting paid to wait because a lot of these equity closed-end funds have distributions, and when we're getting a distribution at a 15% discount, that in itself that distribution is coming to us from the net asset value. So, that's excess return in itself.
Taggart: One of the things we try to caution investors about is those just looking at that absolute return and saying, "Hey this fund's trading at a 15% discount and so, if it does narrow, then I get 17 percentage points, in addition to whatever the underlying NAV gets."
We try to point them toward looking at where that fund historically trades in a range or using z-statistics to figure out a little statistically and see how many standard deviations it is from the norm. Do you go through the quantitative steps, as well?
Galley: Yes, for sure. We have quantitative screens that look at the discounts, [looking at] where are they trading relative to the historical self of that closed-end fund, relative to their peer groups, and then, of course, relative to the overall closed-end fund space. One thing I caution investors about when they are looking at means--means are only what you make of it. So is it the mean last week or is it the mean three months ago or is the mean three years ago. It's a little subjective. But we definitely look at statistics, and we have to input a lot of different variables and assumptions.
One thing we do look at is the behavioral aspect of it and what investors absolutely dislike and probably will distance themselves from for very long time. A good example of that is real estate. Real estate was a hated asset class, but more recently it's coming back into vogue as investors are being more comfortable with real estate. And so you are starting to see discounts narrow on real estate closed-end funds.
Taggart: I think maybe one example, like last year I believe in August when the Federal Reserve notified the world that it was going to put interest rates on hold for a couple of years at least. We saw the premium on senior loan funds spike down to a negative at the beginning of the August, and if I remember correctly, you were able to take opportunity in that. Is that because you realized that it was overdiscounting the scenario that would play out?
Galley: The bank-loan [scenario] is a great example. When the Fed came out and said rates are going to stay low, the discounts did go from a premium all the way to an 8% discount in a matter of a week, and that was an overselling. Given that closed-end fund discounts are driven by supply and demand, when you have an exodus of investors, they are just pushing out the discount. They don't have any regard for that discount level. It's just a matter of getting me out of that closed-end fund which usually RiverNorth taking the other side of being a contrarian to those investors, and we're coming in and going against the herd typically.
Ultimately, those discounts did narrow, and especially if you compare it back with high yield, high yield stayed at a premium to its net asset value. Bank loans and high yield are very similar animals, other than bank loans I would say are a better risk given that they are senior-secured and they are floating-base, so you're not getting maybe just as much yield compared with high yield.
Taggart: For the risk you're taking on, it pays off.
Galley: Exactly. Given that it was a 10% discount spread to high yield, we thought that was a very good risk-adjusted trade.
Taggart: I think it shows how an institutional investor such as yourself and some of the very smart individual investors that I have heard from, they are contrarian and opportunistic, but that only comes about because they are patient and they wait. They don't just jump on something because it's trading at a 15% discount. They wait to see that it's spiked down, and I think that maybe speaks to the behavioral finance aspect that you mentioned earlier where everybody is just heading for the door in an illiquid security, which most closed-end funds are, with total disregard that their fellow shareholders might also be crowding out the door.
Well thanks for walking us through the closed-end fund details, your new fund, and how you guys have your strategy. Best wishes to you.
Galley: Thanks Mike.
Taggart: I'm Mike Taggart for Morningstar. Thanks for watching.