Risk in Closed-End Fund 'Yields'

Jeremy Glaser: Risk in closed-end funds. I'm Jeremy Glaser with Morningstar.com. As investor interest in closed-end funds increases, as people search for more yield, is everyone aware of the risks involved?

I am here with closed-end fund Strategist Mike Taggart to take a look at some of these risks. Mike, thanks for talking with me today.

Mike Taggart: Yeah. Thanks for having me down.

Glaser: So, one thing that people have been really interested in is the yield that comes in closed-end funds, with getting basically 0% everywhere else, these yields look really attractive. So anything investors should know about that number?

Taggart: Yeah, there are couple of things, Jeremy, when it comes to closed-end funds and yield. First of all, most investors in closed-end funds are income-oriented investors.

So there's two things I'd like to point out; first of all the payout that investors receive from closed-end funds, most investors are used to calling them yield, they are used to calling them dividends, but they are actually neither of those, they are distribution rates. And there's three categories, there are three places where this—the things that compose distribution can some from. They can come from income in dividends, they income from realized capital gains or they can come from something that's called return of capital.

So I've written an article on this, but let me just try to make it very simple for the video. If you give me four quarters, $1 and I give you $0.25 of that back, that's not a yield, okay? That's a return of capital. And a lot of times funds will do this and they'll return some of the capital to people, it bumps up the published, what people call, yield and then they want what they—investors will flock into these funds, not realizing that they are getting actually a return of capital.

So, there are three things I think in terms of the payout; the investor should keep in mind to make sure that the yield or the distribution rate that they are getting is sustainable.

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The first thing is, they should get out of the habit of referring to it as a yield or a dividend. The second thing is, they should understand what the payout is composed of.

And the third thing is, if it is—if part of the payout is from a return of capital, then they need to look at whether that's coming from unrealized capital gains, in which case it's – that's good, that's nothing to worry about, or whether it's actually from the actual money that they put into the fund, the fund's assets itself. And if that's the case, in a short term sometimes that's not a big deal, but if the fund consistently does that, runaway from those big headline yield numbers, because they aren't true yields. That's the first thing in terms of risk, I'd say just be careful where that payout is coming from.

The second thing is leverage. A lot of the funds in the closed-end fund space use leverage. And this was typically – historically, this has typically been from preferred shares or from debt. And unlike regular open-ended mutual funds, closed-end funds are allowed to employ leverage, and when it came from debt and preferred shares, it was called 1940 Act leverage, that's – in the industry that's what it's referred to. And the reporting of that is very standardized, it's regulated.

Because of new financial instruments, a lot of funds can now employ non-1940 Act leverage. And the reporting of this is largely left up to the fund companies. I mean it's in the annual reports, it's in the semi-annual reports if you know what you're looking for, but there is no standardized reporting.

Some of the larger fund groups report it; Nuveen, for instance, probably one of the largest [closed-end] fund families, reports this very easily on their website. But if you're an investor in a fund and you're worried about leverage, don't assume that the reported leverage is the actual leverage of the fund. If you can't find the information in the annual reports or on the website, or you are unsure, these investors and advisors should absolutely feel free to call the fund company.

And the second point with leverage is that – and everybody in the industry that I've spoke with seems to get this, is that leverage can increase the yield, but it also increases the volatility of the fund. So, if – right now, it's been a really good time for for funds to issue debt, because it's been a very like low interest rate environment, an easy hurdle rate. So, they don't pay much for the debt, they get that increased yield, they pay that out to their investors, which is fine, that's exactly what you want as an investor. The increased volatility, though, is going to come about, and I suspect it's going to come about when interest rates start to rise.

Everybody, advisors I speak to, professionals I speak to, they are all getting ready for interest rates to rise. And what I fear is going to happen is, the people are just going to – everybody is going to rush towards the exits on leveraged closed-end funds. And I would caution that people need to look first at what the discount is, because if everybody is rushing toward the exit, then any volatility, especially on the downside, may already be priced into the funds. So, just before hitting that sell button, I caution people just to take a second and think, well, is that – are the negative effects of leverage already priced into the shares.

Glaser: You mentioned discount, one of the things that's been a feature of closed-end funds for a while is that they tend to trade at a discount or premium to their net asset value. Is that a potential risk for investors that they'll never be able to actually get that net asset value after they invest in the fund?

Taggart: Well, you know, that's one of the interesting things about closed-end funds in general is that, a lot of the – on the surface, a fund trading at a 10% discount that looks great, right? Hey, I can buy a $1 worth of assets for $0.90 on the $1, that's perfect. Well, yeah, you can buy that $0.90, but the presumption that it's – that that $0.90 is eventually going to be traded in the market for the full dollar, may or may not be true. I looked at something about a month ago, where over the last three years, something like 80% of funds had indeed traded at one point or another at their net asset value, but what about the other 20% of the funds. So, they don't always trade at net asset value.

So if you are buying it for that reason, for the closing discount to NAV, then you might want to think – reconsider that or look little deeper into that, but if you are investing in a fund and the underlying portfolio is kicking off of 5% yield, like a true yield, and you're buying it at a 10% discount, I mean you just increased your effective payout to 5.5%. So, for income-oriented investors, the discount definitely works, it's called yield enhancement. But if you're a capital gains investor, you shouldn't look at the absolute discount, you should look at the relative discount, the discount relative to its historic average.

Glaser: Okay. Mike, thanks so much for talking with me today.

Taggart: Yeah, thanks for having me Jeremy.

Glaser: For Morningstar.com, I am Jeremy Glaser.