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CEF Specialist

No Reprieve for Energy CEFs in October

As oil prices continued to tank, commodity and energy funds took a nosedive.

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Oil prices continued their descent in October, leading some to question the future health of the country's largest oil producers. Consumers of oil and gas, however, have benefited from this steady decline in prices. Airlines, for example, have fared extremely well this year, in part because of low fuel costs. Despite the hit that oil and gas firms and energy and related mutual funds took last month, the broader equity market did quite well. The S&P 500 Index gained 2.4% in October and was up nearly 11% for the year to date.

During October, the Federal Reserve officially wound down its bond-buying program, though it's still reinvesting the cash flows received from the mortgages on its books. The Fed communicated this plan clearly and well in advance of the announcement, so the move was mostly a nonevent. Making headlines this month in the bond market, however, was the swift decline in the 10-year U.S. Treasury yield on Oct. 15. The bond's yield started the day at about 2.20% and quickly dropped to 1.87%; just as quickly, though, the bond's yield rebounded, closing the day at about 2.10%. This rapid decline coincided with increased trading volume, and some market pundits are comparing it to the "Flash Crash" of May 2010. Whatever the reason, it highlights concerns that many fund managers have about the lack of liquidity and the impact of high-frequency traders in the bond market.

Best- and Worst-Performing CEF Categories
The table below lists the best- and worst- performing closed-end fund categories during the month of October, based on share price.

Topping the best-performing list last month were sector funds--real estate, health (health-care and science-related funds fall into this category), and communications. A recovering housing market has benefited real estate funds this year, and a sharp drop in mortgage rates in mid-October provided another boost. Real estate funds (closed-end, open-end, and ETF) tend to have higher payouts than other equity funds, adding to the appeal for income-starved investors. The average real estate CEF paid a 6.5% distribution rate at net asset value (7.2% at share price) at the end of October compared with an average of 5.8% at NAV (6.2% at share price) for the average equity CEF.

It should be no surprise that the five worst-performing categories, which include precious metals, energy, natural resources, and commodities funds, invest heavily in commodities and resources. Those categories saw NAV deterioration along with share price depreciation.

Most Expensive and Inexpensive CEFs
Last month's gap in returns across categories caused a divergence of valuations within the CEF universe. The four tables below list the five most inexpensive and expensive CEFs by broad category (taxable-bond, equity, municipal, and other).

The z-statistic measures how many standard deviations a fund's discount/premium is from its three-year average discount/premium. For instance, in these tables, a fund with a z-score of negative 2 would be two standard deviations below its three-year average discount/premium. Funds with the lowest z-scores are classified as Relatively Inexpensive, while those with the highest z-scores are Relatively Expensive. We consider funds with a z-score of negative 2 or lower to be "statistically undervalued" and those with a z-score of 2 or higher to be "statistically overvalued." That said, the z-statistic does have its flaws.

Taxable-Bond CEFs
The wariness in the bond market around the timing and magnitude of the Fed's expected hike of short-term interest rates has led to middling returns for many taxable-bond CEFs in recent months. Meanwhile, credit has taken a bit of a stumble in the second half of the year. For the year to date, the average high-yield bond fund gained 5.3% in NAV and 5.2% in share price through October, compared with an average gain of 20% and 10% in NAV during 2012 and 2013. Within the category there have been some clear favorites among investors. Pioneer High Income (PHT), for example, has seen its premium widen immensely, likely because of the fund's peer-beating 12% distribution rate at NAV. The fund's whopping 33% premium knocks that distribution rate down to 9% at share price, but that's still among the highest of its peers. Pioneer High Income's three-year z-statistic of 2.07 as of Nov. 12 was well above the z-statistics of its peers (the average was negative 0.93). 

Despite concerns and uncertainty around rising interest rates, four bank-loan funds appeared undervalued, and most funds in the category were selling at double-digit discounts. The category has experienced a significant discount-widening since the start of the year, but those cheap valuations haven't enticed too many investors to jump in, and a handful of funds appear undervalued. 


Source: Morningstar Analysts.



Equity CEFs
As a whole, the equity market has done quite well this year--the S&P 500 Index gained nearly 11% for the year to date through October--but certain sectors and individual stocks have posted incredible returns. Airlines have been particularly strong performers.  Southwest Airlines (LUV), for example, gained more than 100% for the year to date and was the best-performing stock in the S&P 500 Index as of mid-November. Technology and health-care stocks, including  Google (GOOG),  Apple (AAPL),  Microsoft (MSFT),  Gilead (GILD), and a plethora of small bio-tech stocks, helped the returns of many of the best-performing CEFs for the year to date.

The four funds that appeared overvalued as of Nov. 12 invested in some of those strong-performing names. For example, Nuveen Equity Premium Advantage (JLA) replicates the returns of the S&P 500 Index and the Nasdaq 100 Index. That fund had a small allocation not only to Southwest but also to other airlines that have benefited from industry consolidation and low oil prices. The fund also had a 9% allocation to Apple and a 3% weight to Gilead. Strong returns and the fund's nearly 8% distribution rate attracted investors, narrowing its discount from more than 10% at the start of 2014.


Source: Morningstar Analysts.

Municipal CEFs
Municipal-bond funds have the benefit of tax-free distributions, and in the current low-yield environment, that advantage is meaningful. During the height of the bond bull market, muni CEFs traded at large premiums, only to collapse after news of trouble in Detroit and Puerto Rico spooked investors. The average discount for muni funds has been steadily falling since late 2012, despite assurances that a rush of municipalities declaring bankruptcy is unlikely. Uncertainty within the retail market and the long durations of most municipal CEFs are keeping a lid on valuations for now.


Source: Morningstar Analysts.

Other CEFs
As investors look to diversify away from bonds but still want high income generation, convertibles funds have become more popular, narrowing the average discount significantly from 8.0% at the start of the year to 4.7% at the end of October. Calamos Convertible & High Income (CHY) invests in both convertible securities and high-yield bonds, and its three-year z-statistic is the highest in the CEF universe.


Source: Morningstar Analysts.

News You Can Use
Two new funds launched in October, bringing the number of IPOs this year to nine and the total net proceeds to just under $4.5 billion. A few more funds may make it to market by the end of the year, but 2014 is likely to be among the slowest years for fund launches in more than a decade. The table below lists IPOs for each calendar year, starting in 2000, ranked by net proceeds (2014 IPO data is through Oct. 31).


  - source: Morningstar Analysts

Fund Mergers and Launches
On Oct. 8, Eagle Point Credit Company (ECC), raised $127 million in net proceeds. The fund will invest in the equity and junior debt tranches of collateralized loan obligations.

On Oct. 29, BlackRock launched a new technology CEF, BlackRock Science and Technology (BST), raising $357 million in net proceeds. The fund will invest in both high-growth and high-dividend-paying technology and science stocks domestically and internationally. The fund will also write call options on a portion of the underlying portfolio to generate additional income for distribution.

Nuveen Investments continued its merger trend with the announced union of four New Jersey funds. Shareholders approved the merger of Nuveen New Jersey Investment Quality Muni NQJ, Nuveen New Jersey Premium Income Muni NNJ, and Nuveen New Jersey Dividend Advantage Muni 2 NUJ into Nuveen New Jersey Dividend Advantage Muni (NXJ) in mid-October. In connection with the merger, three of the funds announced special distributions. See the distribution table below for more details and other significant distribution changes announced in October.


Source: Morningstar Analysts.

Reverse Stock Split
In an effort to raise the share prices of Cornerstone Strategic Value (CLM), Cornerstone Total Return (CRF), and Cornerstone Progressive Return (CFP), the funds' board approved reverse stock splits. The splits will be one-for-four and are expected to be effective on Dec. 31, 2014. It is Morningstar's opinion that these funds are not suitable for investors. The excessively high distribution rates are propped up by return of capital, and the funds typically sell at high premiums. This combination causes the fund's underlying NAVs and share prices to deteriorate, leading to actions such as this reverse stock split to artificially raise the funds' share prices.

Name and Policy Changes
H&Q Healthcare Investors (HQH) and H&Q Life Sciences Investors (HQL) changed their names to Tekla Healthcare Investors and Tekla Life Sciences Investors, respectively. The funds' managers, process, advisor, and tickers remain the same.

LMP Capital and Income (SCD) announced that its board of directors approved a change to its investment policy guidelines. The fund can now invest, without limit, in both energy and nonenergy master limited partnerships. The fund does have certain restrictions around the maximum allocation to certain types of MLPs. Read more here.

Discount Trends
CEF discounts continued to converge in October. For each of the broad categories, the average discount was about 7.5% at month-end versus 8% for equity CEFs, about 7% for taxable-bond and muni CEFs, and more than 9% for "other" CEFs at the start of the year. Historically, equity funds sell at wider discounts because of the lower distribution rates compared with bond funds. But the large and persistent disparity between the high premiums of bond funds and wide discounts of equity funds following the crisis was unusual. That trend seems to be normalizing, though the average discount of bond funds remains wider than it's historically been. That said, the taxable-bond group's average discount did narrow a bit this month.


Source: Morningstar Analysts.

As 2014 draws to a close, investors should be preparing to evaluate their portfolios and are likely making buy and sell decisions based on taxes. Because CEFs are a generally retail-oriented product, the end of the year typically brings tax-loss selling, which can cause funds to sell at cheap valuations. To take advantage of this yearly "sale," investors should begin making a watchlist now. Morningstar's CEF QuickRank tool can help by sorting CEFs by category, discount/premium, and performance over various time periods.

Cara Esser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.