August 2015 Closed-End Fund Market Update
Portfolio Specialist Allen Webb talks to Portfolio Manager Steve O'Neill about the closed-end fund market for the month of August 2015.
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ALLEN: Steve, August was an interesting month in the capital markets. The S&P was down about 6%. You had interest rates declining instead of rising. You had weakness in the credit markets. We had the VIX over 40 for the first time since 2011. I noticed in the closed-end fund market, the average closed-end fund was down about 3.4% on a total return basis. Where does this put us on a year-to-date basis from a closed-end fund performance standpoint?
STEVE: Closed-end funds certainly have underperformed the broader capital markets year to date. Looking at each asset class individually, the equity funds are down about 12% year-to-date. About 2% of that comes from discount widening. Taxable bond funds are down 4% and 100% of that loss comes from discount widening. Muni funds are flat, the net asset values are up a percent, but the market prices were down from discount widening. So, you're flat for munis, down 4% for taxable bonds, down 12% for equities, and the whole group is down about 600 basis points, and about a third of that comes from discount widening. Now, what I think is interesting is all the talk about market corrections and bear markets and various asset classes. We look at the closed-end fund market, and just looking at equity funds specifically, about 40% of the equity closed-end funds are in a bear market, defined as down 20% from the year-to-date high and 80% of funds are down over 10%. On the fixed income side, the scale's going to be different, but, about 35% of fixed income funds are down 10% from their recent high. And 75% are down over 500 basis points. So you're having a lot of losses from discount widening in the closed-end fund market that aren't necessarily being felt by the broader capital markets.
ALLEN: Steve, a lot of people think about closed-end funds in terms of discounts, so how does this total return story sort of translate into where we are from a discount standpoint?
STEVE: Listeners will know that a lot of the discount widening happened since April. A lot of the underperformance occurred from April to the month of July, so we had a couple hundred basis points of discount widening during those months. This month, discounts didn't widen that much. The month started with a 9.2% discount and closed at a 9.8% discount. What I think is fascinating is that on August 24 when the Dow dropped 1,000 points, the VIX hit 40, discounts widened out 125 basis points for the day. And so what that shows us is that a lot of fear is already priced into the market. That doesn't necessarily mean that the asset classes, the net asset values have priced in all the fear in the broader capital markets, but the closed-end fund that owns these asset classes, many would have thought VIX 40 means 300 basis points of discount widening, and that really didn't occur because discounts are already at such a wide base. If the average discount was five, and the Dow drops 1,000 points, discounts could easily widwn out 300 basis points that day. That didn't occur because we started the month at such a wide discount. Where we are today, looking back on our last 20 years, discounts at the month end are narrower about 95% of the time.
ALLEN: So, Steve, in overly simplistic terms, does that imply that maybe closed-end funds were a little bit of a leading indicator for some of the market volatility and market declines we saw in August?
STEVE: Yes. Sometimes the discount discounts future events. But, you know, in this case, discounts have been wide for such a prolonged period of time that bond funds were wide in 2013, 2014, obviously, the fixed income market performed well in 2014, and so that wasn't a good indicator of future performance. To be determined whether wide discounts today are a leading indicator for the future, but again, discounts have been narrower 95% of the time. The average closed-end fund discount is 4.4. We're right around 10% today and that average has occurred during periods of high capital markets volatility, low capital markets volatility, you know, rich asset classes, cheap asset classes, fair... it's a long term average. So where we are today looks pretty good.
ALLEN: Steve, the last couple of months you've talked about the overall backdrop of discounts being pretty attractive. Are there any parts of the market specifically that you find more interesting than others as you look around?
STEVE: Equity closed-end funds certainly haven't grabbed as many headlines because discounts haven't widened out quite as much, but when we think about the equity closed-end fund space, it's very attractive to pick up some actively managed equity funds at 17% discounts. Discount volatility is going to be lower on the equity funds, as it's been historically. On the fixed income side, the story is the same as what we've been saying for the last few months. You can by over a hundred funds at discounts wider than 15%, and so that gives you plenty of ability to choose your asset class, choose your manager, and really get that nice margin safety of buying that asset class at 85 cents on the dollar. Specifically, when we look into the fixed income space, we like funds that have had strong year-to-date performance and there are many cases where funds have actually increased the dividend, so you have a good fundamental setup, and then you have a good story in the closed-end fund space. We think those funds would be some of the first to snap back if and when discount volatility subsides.
ALLEN: Steve, thanks for your comments this month. Anything else you'd like to add?
STEVE: Yes, I'd add that RiverNorth will be hosting a webcast on September 17th. The time will be 3:15. Patrick Galley, our Chief Investment Officer, will be leading the call and I think that will be a great opportunity to learn more about the closed-end fund space, our views on the opportunities and specifically how those opportunities impact the RiverNorth funds.
ALLEN: Great Steve, and I'm assuming everybody can go to the RiverNorth website to sign up.
STEVE: Yes.
ALLEN: Steve, thanks for your comments this month.
STEVE: Thank you.
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Video recorded 9.3.2015.
Produced by RiverNorth Capital Management, LLC ("RiverNorth" "we" or "us").
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Definitions
The High Yield CEF index total return and discount statistics are based upon the Morningstar Un-weighted High Yield CEF Index, which is the average of all closed-end funds categorized by Morningstar as utilizing a high yield investment strategy. High yield closed-end funds are defined as funds that seek high current income through investing in non-investment grade debt instruments.
The Preferred CEF index total return and discount statistics are based upon the Morningstar Un-weighted Preferred CEF Index, which is the average of all closed-end funds categorized by Morningstar as utilizing a preferred investment strategy. Preferred closed-end funds are defined as funds that invest primarily in preferred and/or convertible preferred stocks.
The Municipal Bond CEF index total return and discount statistics are based upon the Morningstar Un-weighted Municipal Bond CEF Index, which is the average of all closed-end funds categorized by Morningstar as utilizing a municipal bond investment strategy. Municipal bond closed-end funds are defined as funds that invest in a diversified portfolio of investment-grade municipal bonds in a variety of sectors and States.
The Global Income CEF index total return and discount statistics are based upon the Morningstar Un-weighted Global Income CEF Index, which is the average of all closed-end funds categorized by Morningstar as utilizing a global income investment strategy. Global income closed-end funds are defined as funds that invest primarily in a mixture of U.S. and foreign government and corporate debt, with an emphasis on developed countries.
The Investment Grade CEF index total return and discount statistics are based upon the Morningstar Un-weighted Investment Grade CEF Index, which is the average of all closed-end funds categorized by Morningstar as utilizing a investment grade investment strategy. Investment grade closed-end funds are defined as funds that invest primarily in investment grade debt instruments.
The Emerging Income CEF index total return and discount statistics are based upon the Morningstar Un-weighted Emerging Income CEF Index, which is the average of all closed-end funds categorized by Morningstar as utilizing an emerging income investment strategy. Emerging income closed-end funds are defined as funds that invest primarily in emerging market government and corporate debt securities.
The Multi-Sector Bond CEF index total return and discount statistics are based upon the Morningstar Un-weighted Multi-Sector Bond CEF Index, which is the average of all closed-end funds categorized by Morningstar as utilizing a multi-sector bond investment strategy. Multi-sector bond closed-end funds are defined as funds that invest across several fixed income asset classes, with typically less than 50% in any one of these asset classes.
The Bank Loan CEF index total return and discount statistics are based upon the Morningstar Un-weighted Bank Loan CEF Index, which is the average of all closed-end funds categorized by Morningstar as utilizing a bank loan investment strategy. Bank loan closed-end funds are defined as funds that invest primarily in collateralized senior bank loans issued by corporations. Most of these securities are typically rated below investment grade.
The Convertible CEF index total return and discount statistics are based upon the Morningstar Un-weighted Convertible CEF Index, which is the average of all closed-end funds categorized by Morningstar as utilizing a convertible investment strategy. Convertible closed-end funds are defined as funds that invest primarily in Convertibles bonds / Convertible preferred stock.
The Mortgage Bond CEF index total return and discount statistics are based upon the Morningstar Un-weighted Mortgage Bond CEF Index, which is the average of all closed-end funds categorized by Morningstar as utilizing a mortgage bond investment strategy. Mortgage bond closed-end funds are defined as funds that invest primarily in a variety of mortgage-backed securities and mortgage derivatives.
The Government and Agency CEF index total return and discount statistics are based upon the Morningstar Un-weighted Government and Agency CEF Index, which is the average of all closed-end funds categorized by Morningstar as utilizing a government and agency investment strategy. Government and Agency closed-end funds are defined as funds that invest primarily in U.S. Treasuries and Agency debt.
The price at which a closed-end fund trades often varies from its NAV. Some funds have market prices below their net asset values - referred to as a discount. Conversely, some funds have market prices above their net asset values - referred to as a premium.
S&P 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy based on the changing aggregate market value of these 500 stocks. The Barclays Capital U.S. Aggregate Bond Index is an unmanaged index of investment-grade fixed-rate debt issues with maturities of at least one year. This unmanaged index does not reflect fees and expenses. The S&P 500 and Barclays Capital U.S. Aggregate Bond Indices are indices only and cannot be invested in directly.
A basis point is a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.
The VIX is ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge."
Source: Morningstar, Inc.
