Tue, 13 Aug 2013
CEF managers' ability to hold onto underpriced illiquid securities in times of market stress represents an advantage over open-end funds that may have to sell to meet unexpected redemptions, says Morningstar's Cara Esser.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's been a tumultuous couple of months in the fixed-income space both from a performance perspective and also from a fund-flows perspective. I'm here with Cara Esser. She is a senior fund analyst. We're going to talk about how this has impacted closed-end funds differently from open-end funds.
Cara, thanks for joining me today.
Cara Esser: Thank you for having me.
Glaser: Let's talk a little bit about fund flows and how they do or don't affect closed-end funds. Obviously, [closed-end funds] are closed. They don't have that new capital coming and going. Is this an advantage in times like this.
Esser: This is a big advantage for closed-end funds that I think a lot of investors discount because what we saw in the last couple of months are really big flows, generally out of but also sometimes into, in terms of bank-loan funds, flows from investors fleeing high yield. After the taper talk happened at the end of May we saw $14 billion in outflows in high yield just in the month of June alone for the mutual fund and ETF space.
This can wreak havoc on investment managers' portfolios because they have to meet these flows, particularly if they're large and unexpected, and a lot of managers did find the intensity of the flows to be rather unexpected. Some of them had cash on hand, but a lot of them didn't have enough. You have to sell holdings in your portfolio to meet these flows, and you're selling into a market that's already depressed. In terms of high yield, you're selling into a market that's fairly illiquid. It's a benefit in general for all closed-end funds, but it's particularly a benefit in some of the illiquid spaces like high-yield bonds, emerging-markets bonds, and municipal bonds, where selling into a down market would be rough for long-term shareholders.
On the flip side, as we've seen interest in some of these asset classes--a while ago it was munis, then it turned into high-yield bonds, and now we're seeing bank loans become an asset class of interest--managers of mutual funds are getting flooded with capital. We saw in June about $6 billion of inflows into the bank-loan category in the mutual fund and exchange-traded fund space, and there's been a 65% growth year-over-year into the bank-loan space. Managers are now forced to put this capital to work at higher and higher prices and richer and richer valuations. On the closed-end side, because you don't have to worry about capital flows waning with investor sentiment, the manager can stick to the strategy, can buy assets when they're cheap, and doesn't have to be forced to buy assets when they're getting more expensive.
Glaser: But closed-end funds do often trade at a premium or discount that net asset value. How does that factor in here? Do you see big changes in those premium/discounts in some of these popular, or now increasingly, less popular areas?
Esser: Absolutely, and this is another big advantage that investors have. It doesn't really affect the portfolio, but from an investor's standpoint, if you find a portfolio manager that you like and a fund that you like, you can create some sort of target valuation, where you would like to buy the fund on a share-price basis that may or may not equal the current net asset value. We've seen a big drop-off in share price for a lot of funds, particularly in the muni space. We saw it a little bit in the high-yield space, though some of those are coming back. Among bank-loan funds we saw a quick drop-off at first after the May taper talks, but we've seen an inflow of interest into the bank-loan market. You can really play the market price and really get in on a good, deep valuation discount for a lot of these funds, and you can't do this in a mutual fund space.
Glaser: Let's take a deeper dive into some of those asset categories. Starting with high yield, what does the performance look like there?
Esser: During the month of June and July, so it's a fairly short-term performance, we originally saw high yield fall off rather quickly, but then much to a lot of people's surprise, it turned around rather quickly. The search for income is still on. People still need yield, and they need to get it wherever they can get it. During the two-month period, we saw the high-yield closed-end fund category average up about 14% on net asset value, and we saw the mutual fund category up about 11%. The difference here has a little bit to do with flows, obviously, but it also has to do with leverage. The average high-yield closed-end fund is leveraged at about 20%.
Glaser: What about bank loans?
Esser: Bank loans, we've seen an even bigger shift in difference between closed-end funds and mutual funds. The average closed-end fund was up about 15% over the last two months, and the average mutual fund was up about 8% over the last two months. Again, as I said previously, the mutual fund space has seen a huge inflow of funds into the space over the last year as people are concerned about rising interest rates.
Glaser: People looking at bank loans. Are there any bank-loan CEFs that look attractive right now?
Esser: There aren't many CEF bank loans that look attractive right now because of expanded investor interest in any kind of product that will protect against rate movements on the upside. Most of them are fairly valued at this point in time.
Glaser: What about munis? Obviously, with the Detroit bankruptcy, there's been a lot of talk about possibly the safety of munis and whether they're priced correctly. How has that played out in the closed-end fund market?
Esser: Munis really got hit hard these last few months. First it was taper talk, and then we had the Detroit bankruptcy. In the closed-fund space, they were hit especially hard because most of the closed-end municipal funds actually hold a lot of long-term municipal bonds, and those bonds were hit particularly hard. We saw a lot of share-price dislocation. We saw a lot of net asset value dislocation. But investors need to be aware that when you're looking at what's particularly going on in Detroit, you need to be specific about what you're looking for.
We comb through all of the funds, all the national municipal funds, on the mutual fund side and on the closed-end side. We found that the important thing to look for is exposure to general-obligation bonds from Detroit that are not insured. Those are the ones that people think will have the most chance of not being paid fully back. We found that for the national municipal funds there are not any funds that have a huge exposure to these particular bonds. On the whole you shouldn't be concerned about your national muni fund and specifically exposure to Detroit.
Glaser: With some of that weakness in performance, has that opened up any opportunities in the muni space?
Esser: There are quite a few opportunities out there. One that we like the most is from BlackRock. The ticker is BAF. It's a high-quality portfolio. It's a national municipal fund, so they're investing across the United States. They have limited call exposure, which is a big deal in the next five years. It's also selling at a 12% discount, which is wider than historical standards.
Glaser: Cara, thanks for your thoughts today.
Glaser: For Morningstar, I'm Jeremy Glaser.