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No Free Lunch With CEF Income

Wed, 24 Oct 2012

Morningstar's Steve Pikelny cautions closed-end fund investors to be aware of the risk/reward trade-offs as well as high premiums when searching for extra yield.


Video Transcript

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many investors have turned to closed-end funds looking for high distributions. I'm here today with CEF analyst Steve Pikelny, and we're going see how a lot of funds create those distributions.

Steve, thanks for joining me today.

Steve Pikelny: Great to be here.

Glaser: So, first off, closed-end funds really certainly have become a very popular vehicle for investors looking to eke out a little bit more yield during this era of financial repression. Do you think that that's a good place to look? Does that make sense as a general strategy?

Pikelny: I think a lot of times, it's a good place to look, but investors just have to recognize that there's no free lunch. There is always a risk/reward trade-off, and if an investor sees a 6% or 7% distribution rate, they kind of have to understand where exactly that's coming from.

Glaser: Let's start with leverage. Certainly, that's a tool that a lot of CEF managers use. What should investors know about it, and how should they assess how much leverage is too much?

Pikelny: Well close-end funds are a good vehicle to use leverage because they generally get lower financing rates than you can in say a margin account. I think if you have over $0.5 million just in an individual retail account, the best rate you could really get on that is somewhere around 3.5%-4.0%. But close-end funds can borrow at much lower rates, usually the 2% range at absolute maximum, sometimes less than 1%.

So it's a good vehicle to kind of get that leverage exposure, but at the same time you're also increasing the volatility of your investment because if you have a leverage ratio of 2 to 1 and the fund goes up 10%, then you're going to get a 20% total return. But if you have a negative total return of 10%, then the leverage is going to amplify that on the downside also. So, you really have to be aware of that sort of risk.


Glaser: How about a return of capital? I know that's always a hot topic in the closed-end fund world. Can you explain it a little bit of what that is and how it could potentially boost that distribution?

Pikelny: That's another thing. A lot of funds return capital. And while from a total-return perspective it doesn't really have any consequences either way, it kind of just obscures what the actual distribution rate is.

Let's say, I am a closed-end fund and I have a 6% distribution rate, but my underlying portfolio is only earning 4%. Then what I can do as the fund manager is I could just pay back assets that are already in fund. If I have a cash position, for example, I could just reach into that cash position and pay you the shareholder to make up for that extra gap there. So, while the portfolio might only be yielding, maybe 4% or so, the distribution rate could be 6%, and you really giving the investors their money back.

Glaser: But that's not sustainable over the long term. Eventually that cash would get depleted.

Pikelny: Right.

Glaser: So, what are some of the other things that the managers might do? Do you see a lot of managers kind of moving into riskier bonds, moving into riskier investments, to try to kind of juice their distribution? How can investors look out for that?

Pikelny: One way is that a lot of close-end funds kind of go out longer on the yield curve, and while longer-dated securities typically have higher coupon rates in the fixed-income sector, they are a little riskier. They are more volatile, and they are more sensitive to interest rates.

A lot of funds, of course they go lower on the credit-quality spectrum. A lot of high-yield funds might have weighted average credit qualities of BB minus or some even go into the high CCC range. So, if you see a high distribution rate and the fund isn't using a lot of leverage, then maybe the fund is just taking on a lot of credit risk in that.

Another way is that funds can just go into emerging markets or kind of riskier countries to kind of get that yield. And while that's not necessarily a bad thing, the fund might not necessarily advertise that, so you kind of have to be aware of that also.

Glaser: So, it sounds like this really is a bit of a risk/reward trade-off. What are some funds that kind of strike that balance pretty well?

Pikelny: It's difficult because if you're actually investing in a fund--closed-end funds do trade at premiums and discounts. I think a lot of investors are aware of funds that do strike a good balance. One of my favorite examples is KTF which is a municipal-bond fund. It has a pretty high distribution rate, and in terms of call risk and credit quality risk, it's not as bad as some of its peers.

But the thing that you have to accept when you're buying that is that it's trading at a 7% premium, which is pretty much higher than a lot of the rest of the category. And at the end of the day, that kind of cuts into what investors actually realize on that investment. So, I think a lot of funds out there are kind of in the same boat where if they do strike a good balance, you have to watch out for a high premium that kind of cuts in that.

Glaser: Like you said, there really is no free lunch when looking for income.

Pikelny: Right. There might be a couple cheap lunches out there, but none that are entirely free.

Glaser: Well Steve, thanks so much for your thoughts today.

Pikelny: Yes, thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.

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