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Where the Fixed-Income Closed-End Fund Opportunities Lie

Mike Taggart, CFA

Mike Taggart: Hi. I'm Mike Taggart, closed-end fund strategist at Morningstar. With me today is Patrick Galley. Patrick is a portfolio manager on the RiverNorth Core Opportunity open-end mutual fund. It carries a five star rating.

Patrick, thanks for joining me.

Patrick Galley: Thanks Mike.

Taggart: Patrick you recently launched a new open-end fund with Jeffrey Gundlach. He is a former Morningstar Fixed Income Manager of the Year. I was wondering if you could us tell us a little bit about that fund to start off with.

Galley: Sure, it's the RiverNorth/DoubleLine Strategic Income Fund. Jeffrey Gundlach recently formed DoubleLine. DoubleLine is a fantastic fixed-income team. The fund is unique blend of both firms' niche strategies. So DoubleLine is going to be a subadvisor for the fund. RiverNorth is the investment advisor. RiverNorth is going to be running a closed-end fund strategy inside the fund for approximately 25% of the portfolio.

Taggart: So 25% of the capital is in your hands, and you're going to be investing it across fixed income closed-end funds, right?

Galley: That's right. Yes. The fund's general objective is total return and income, so we're going to be focusing on the income universe of closed-end funds. There are approximately 440 fixed-income closed-end funds yielding over 5% today. So we think it's a great opportunity to take advantage of that space.

Taggart: Can we sit back for a second and just say, if we were to take this outside of this particular fund. I mean I think this is fascinating that this strategy you have and that's why I asked you over today. Just thinking as an individual investor, why would they want to allocate some of their own portfolio capital to fixed income closed-end funds?

Galley: First of all, closed-end funds are great way to take advantage of the inefficiencies that might be out there in the universe. Closed-end funds, as you know Mike, trade at discounts and premiums to net asset value. That difference is an opportunity for us to take advantage and generate additional return.

What I mean by that is, if the discount narrows on a closed-end fund, we are generating an additional return or excess return, what we call alpha, which is above and beyond the underlying asset's performance. So in times of fear and greed, that trading closed-end funds plays well into our strategy.

In addition, even if you own a fixed income closed-end fund trading at a deep discount, you are getting an additional return as well. So, for example, a fund that yields 10%, if it's trading at a 15% discount, you're actually going to be getting 17% additional return from its underlying assets.

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Taggart: So, 11.5% yield or distribution rate, we call that yield enhancement.

Galley: Yeah it's definitely a yield enhancement. And so a lot of closed-end funds, as you know, they utilize leverage in their capital structure, so you're getting the benefit of right now a very steep yield curve. But in addition you get the benefit of owning a fixed income closed-end fund at a discount, you're getting that yield enhancement.

Taggart: Just kind of over time, as you've looked at this, how does the yield in a closed-end fund, though I would put yield in quotes, because it's the distribution rate which we try to quote here. But how does the distribution rate on a closed-end fund going to stack up against maybe other investment vehicles?

Galley: Including the leverage its stacks out tremendously, and like I said before, with a very steep yield curve today, it's a fantastic comparison to Treasuries, for example. Like I said, there is 440 closed-end funds today, including municipal bond closed-end funds that are yielding over 5%. That's pretty good compared to a 3.6% 10-year treasury yield.

Taggart: Absolutely. I fully agree with you. You mentioned the steep yield curve. There is a lot of uncertainty out there in the market right now, especially in the fixed income space. What's the duration of the portfolio if interest rates rise? What's the risk, the interest rate risk? Could you just maybe share with me and our viewers where you are seeing opportunities in general? I realized you can't talk about specific holdings that you might be purchasing for the funds, but just in general where you are seeing opportunities right now in the fixed income closed-end funds space?

Galley: Backing up, in November really you started to see cracks in the muni bond market. That was just in muni bonds in general that fear of interest rates rising, credit fears, et cetera, spilled over into the closed-end funds space, where discounts widened out quite drastically. They actually widened out 5% intra months and since then they have been ebbing and flowing and widened out about 5% actually since the beginning of the year.

So we're seeing a lot of opportunity in the muni space. We're still patient there though. We think there is more fear to come. Our partner at DoubleLine, Jeffrey Gundlach, he likes to say that, this is the right time to buy, when you're hand is shaking when you are going to write the check. That plays well onto the closed-end fund space, because again those discounts tend to widen out when fear spikes.

We like that margin of safety when we believe we are buying attractive discounts to their underlying assets. So we are patient on the muni space, but we are also seeing short-term opportunity in the muni space.

On top of that, munis have also spilled into the taxable fixed income funds. Meaning that, taxable fixed income funds have seen some discount volatility as well. So there is a handful of taxable fixed income funds that we are also finding opportunity in. But I think it's definitely a closed-end fund picker's market. Why not just go buy the highest yielding closed-end fund? There is a lot of traps out there I think to be had, lot of funds are trading at a pretty high premiums et cetera.

Taggart: So, within the fixed income space, do you see any opportunities, are you more preferential to maybe like senior leveraged loan funds, the bank loan funds, where they have this floating rate that varies with underlying interest rates like LIBOR. Those have gained a lot of interest. A lot of people are willing to take on extra credit risks, so the high yield funds have been doing fairly well. Is there any particular sector that you like right now or do you just think the whole space is...?

Galley: Yeah, that's a good point. On the senior loan fund front that's an area where we think it has staying power, with rates so low, I think people are in the mindset that rates are going to increase in the future. So we think as far as discounts go on senior loan funds, they are going to stay narrow and even continue to trade at premiums, where they recently have been.

So, we do like the senior loan fund market, but we caution investors, we think you need to be opportunistic in buying senior loan funds, meaning that, if you see a recent widening in the discount, that might be a good time to jump-in. And we like to actively trade the senior loan funds, but longer term we are optimistic about that space.

Some other areas that we are finding opportunity are really just hybrid closed-end funds allocating across multiple asset classes or sectors in the fixed income market. I think investors a lot of times have a hard place to point what sector is this that I am getting and so they get lost in the mix and that tends to mean that they are trading at wider discounts than their peers. So we find that as a good opportunity as well.

Taggart: Just backing up, earlier you had mentioned that you are seeing a lot of discounts widening out, like back in November, where we saw that with the muni funds. My understanding is, as the fundamentals of the municipal market continue to hold up, it's the fears of future defaults. But you have the diversification in the closed-end fund and it's the people selling it that's causing the discount, but the fundamentals, the interest payments continue to be made. I mean have you seen any signs that this isn't in fact the case?

Galley: You are definitely seeing weakness in the underlying muni market. So there is definitely been losses in the underlying muni market. And then on top of it, if you have a closed-end fund structure which incorporates leverage in that capital structure, obviously, those losses are enhanced. Then you could put on top of that the discount risk associated with that as well.

So, we are patient in that muni space. So I think if you want to invest in the munis, like the asset class, at certain times when that fear increases, discounts widen out, I think it's a good time to buy some bargains in the muni space. But yeah, you definitely have to look at the underlying assets, do your fundamental analysis; it's not just plain vanilla that's for sure. Because munis have actually had the most losses in the last few months compared to other asset classes

Taggart: Well good luck with the new fund and thank you very much for joining me today.

Galley: Thanks, Mike.

Taggart: I am Mike Taggart, Closed-end Fund Strategist. Thanks for watching.