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Bond CEFs Only in First Inning of Discount-Volatility Game

Mike Taggart, CFA

Mike Taggart: Hi. I'm Mike Taggart, head of U.S. closed-end fund research at Morningstar. With me today is Patrick Galley of RiverNorth Capital Management. Patrick manages over $800 million in closed-end funds. Patrick, thank you for joining me today.

Patrick Galley: Thanks for having me, Mike.

Taggart: Patrick, the last time we sat down and spoke, it was at the Morningstar Investment Conference back in June, and we shot a video; you were on one of my panels. At that time, we were about a month into the Federal Reserve's tapering talk and interest rates in the market had just started to creep up. Everybody was concerned about what the summer might hold. It's kind of played out. What's happened this past summer?

Galley: Well, obviously, interest rates continued their trend up and touching 3% on the 10-year Treasury, I think, is definitely a milestone for a lot of investors in their heads, from a psychological standpoint. So that fear is still going through the closed-end fund market. Discounts on fixed-income closed-end funds specifically have widened and continue to widen. I think that it's only probably the first inning of future volatility in discounts of fixed-income closed-end funds.

Taggart: Now, the one thing I try to remind investors through my articles and when I speak with them is, a discount or a premium is simply the relationship between the share price and the net asset value. So when you say discounts have widened, what you're really saying is that the share price has fallen considerably faster than the net asset value, and the net asset value is made up of a diversified basket of funds. So, it goes back to what I see a lot with closed-end funds, is that the investors in closed-end funds, when they want to get out, they race to the exits. They don't care how many shareholders are clogging those exits. And when they are selling their shares, they are selling them to folks like yourself, who are opportunistic and look for the discounts to widen.

Galley: Yeah, exactly. At RiverNorth, we're opportunistic investors, we're total return investors. So a lot of times closed-end fund investors are focused on the yield. So, just a short few months ago and over the past couple of years, in fact, investors were focused on that yield and yield only. Today, because yield is inversely correlated with interest rates and fear is going through the marketplace because interest rates are rising, now investors can only think of one thing, that's to get out. It's like screaming fire in a crowded theater and everybody is running for the door. There aren't enough buyers. So the supply/demand dynamic in a closed-end fund means, guess what, the discount is going to be widening out. So, RiverNorth is buying--we're buying those closed-end funds at attractive discounts to net asset value.

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Taggart: Hopefully setting yourself up for those discounts to mean-revert in the future and helping out your own investors in your funds.

Galley: Exactly. Mean-reversion to us is not necessarily go back to where they were a few months ago, but rather just narrow from where they are today. So if we can systematically buy as those discounts widen and sell as they narrow, that means excess return for our investors while maintaining a core portfolio in exposure to fixed income, specifically in our RiverNorth/DoubleLine, and we have our other strategies as well.

Taggart: You mentioned earlier the discounts in fixed-income funds in particular have widened out; we also have seen that in equity funds. Can you go into a little bit more detail along those lines? What's going on? What you've seen?

Galley: It is definitely fixed-income closed-end funds taking the brunt of the discount widening. About two thirds of the whole closed-end fund space, as you know, are fixed-income closed-end funds; municipal bonds make up about a third of the space. So, municipal bonds is one of the biggest-hit sectors for discount widening and also performance losses. They are down about 15%-20% year-to-date, with discounts widening approximately 7%-8% on average. Today, you can get a tax-equivalent yield of roughly 12% in a municipal bond closed-end fund versus last year it was around 8%. So, that's the irony of the closed-end fund space, more-attractive yields today given the prices, but investors don't care about yield. They just care about the volatility.

Taggart: They are looking at their paper losses from--maybe the first quarter, they are looking at them here.

Galley: Exactly. Investors get their statement and they look at the losses, and unfortunately that's investor psychology--they follow what their fear and their sentiment and their psychology tells them is that if I'm having losses, I should get out. But I think pretty basic Investing 101 is buy low, sell high, and unfortunately, in closed-end funds, you can see that a lot of investors end up buying high and selling low.

Taggart: They do that with all security types it seems, but then there's professional managers like you that come along and take advantage of that market. Now going forward here we're coming up into the fourth quarter, end of the third quarter into the fourth quarter, do you see this volatility kind of pulling back? Do you see it increasing, continuing?

Galley: Yeah, number one, you've got interest rates continuing to edge up. We try to not make an interest-rate call or speculate where interest rates are going, but we can be reactive to what the market actually does. But what we are concerned about is tax-loss selling in the fourth quarter. Closed-end funds are notorious for tax-loss selling in the fourth quarter. This year, like I said before, municipal bond closed-end funds are down 15%- 20%, and when investors are, obviously, tax-sensitive investing in those securities, they can easily swap those securities--sell them, buy something else. That's going to create more discount volatility. So we're cautious. Even though we are excited about the opportunity, we're cautious about more volatility in the fourth quarter.

Taggart: Any advice for our viewers who invested in closed-end funds?

Galley: Well, my advice is, number one, most investors are not going to actively and opportunistically trade their closed-end funds throughout the day and monitor those discounts. So my advice is to, when they do look at the closed-end funds, look at the discount, has it been widening. It might be too late to sell if it's already widened and actually you might want to have some-- use some dry powder that you have and buy opportunistically at more attractive valuations.

Taggart: Okay, excellent. Well, Patrick, thank you for that update and thanks for joining me today.

Galley: Thanks, Mike.

Taggart: For Morningstar, I'm Mike Taggart. Thanks for watching.