Thu, 25 Jul 2013
As investors ditched certain income-producing assets on worries of rising rates, an abundance of fixed-income CEFs moved into undervalued territory, according to Morningstar's Cara Esser.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Has the recent sell-off in closed-end funds created any values? I'm here today with Cara Esser, a fund analyst here at Morningstar to answer that question. Cara, thanks for joining me.
Cara Esser: Thanks for having me.
Glaser: Let's talk about what's precipitated the sell-off in the closed-end funds space. Why are investors fleeing closed-end funds right now?
Esser: We're seeing this particularly happening in the fixed-income space and that has largely to do with the Fed's announcement in May about the potential rise in interest rates. The interest rates did actually rise a little bit, and as any other bond-type investment, the net asset value will fall as interest rates rise. We are seeing that, but then you are also seeing people just getting scared. A lot of these closed-end funds had bid up the prices to quite large premiums. Investors are getting nervous about rising interest rates and what it will do to the underlying portfolio, so they are just fleeing.
Glaser: With closed-end funds, you're obviously not worried about managers having to potentially sell positions, to meet those outflows, but what impact do investors not being interested in those kinds of funds anymore have on this space? Has it created a lot of opportunity?
Esser: Yes, and that's a big advantage of a closed-end fund. The underlying portfolio doesn't have to be sold off en masse as people leave like you do with a mutual fund. The only thing that's really happening is that the share prices are falling faster than the underlying net asset values are falling. Therefore, you're seeing a lot of funds selling at better valuations. There are larger discounts or much smaller premiums than we've seen in quite some time particularly since a lot of these premiums had been bid up as people were searching high and low for income anywhere.
Glaser: But how do you know if these discounts are real values? Are these funds really going to get hit even harder as rates rise? And what's the impact of rising rates on these funds?
Esser: The impact of rising rates in the future will definitely, like I said, lower the net asset value over the long term. It's just the relationship between interest rates and underlying net asset value. The flip side of the coin is reinvestment rates will be higher. The fund can sell off some of its current holdings, and it can reinvest in higher-yielding bonds in the future. Distribution rates may or may not change depending on what the manager does with the underlying portfolio. But you also have to be concerned with leverage because these funds often utilize leverage and many of these fixed-income funds utilize leverage based on short-term interest rates.
As the short-term interest rates rise, the cost of leverage will also rise, which means there might be less left over to distribute. That could also impact the distribution rate, as well. There are a number of impacts that rising interest rates will have on closed-end funds. What you really need to do is understand the portfolio and understand what's going on under the hood before you can just leave a fund for any reason.
Glaser: There are a lot of moving parts there. When you're thinking about valuation then, how do you approach the analysis? How you decide if something really has become cheap?
Esser: From a pure valuation standpoint, we like to use a Z-statistic. So, this is a relative measure and it looks at the historical trading pattern of the fund itself compared with the current discount. For example, if there is a fund that's selling at a 10% discount, you might think. "Oh, that's a great deal." But what if the historical discount is usually closer to 15%? It doesn't sound like actually that good of a deal at that point. We look at the Z-statistic, and we use six-month, one-year and three-year data, which are available on Morningstar.com on any of the closed-end fund quote pages. Generally, we say if a Z-statistic is less than negative 2, it's considered undervalued. That just means the current discount or premium is either much wider or much smaller than historical patterns over the time frame that you are looking at.
Glaser: If that gives you a list of potentially undervalued funds, how do you then go to the next level to make sure that they are not going to be maybe particularly affected by rising rates or have some of those leverage issues that you discussed earlier?
Esser: We cover about 125 closed-end funds for our Morningstar Analyst Ratings. The first step is to look at whether we actually have the fund under coverage, and you can get a better idea of what they are doing and also whether we think the underlying portfolio is positive, negative, or neutral based on our rating.
The next step is to look at things like the distribution rate, the distribution coverage ratio, and undistributed net investment income balance. All of this information is available on Morningstar.com, as well, and that will give you an idea of how much cushion the fund has in the current distribution rate and how long it can sustain paying [the distribution], which is a big deal for closed-end fund investors because they like the distribution rate. It also can affect the future share price if there is a change in the distribution rate.
Glaser: Given all of this, are you finding a lot of values? Overall, are you seeing things to buy right now?
Esser: There are as of recently [at the beginning of July] there were 200 funds that had one-year Z-statistics of less than negative 2. That's a large number of funds, most of them being fixed income and a lot of them municipal-bond funds. If you are not interested in muni funds, you may not be finding too many good deals, but there are four funds that we like, in particular, that are all relatively undervalued on a one-year Z-statistic basis.
Two of them are from Templeton. They are emerging-markets bond funds. One is ticker GIM and the other is ticker is TEI, and these are managed by Michael Hasenstab, who we like at Morningstar. He's done a great job with these finds.
For the two other funds that we like, both of them are fixed-income funds and both of them are positively rated in our Morningstar Analyst Ratings. One is from Aberdeen. The ticker is FAX. It's an Asia-Pacific bond fund, and we also like Nuveen Municipal Value, ticker NUV, if you're looking to jump into a national muni fund.
Glaser: Cara, thanks for your insights today.
Glaser: For Morningstar, I'm, Jeremy Glaser.