June 2016 Closed-End Fund (CEF) Market Update
Senior Portfolio Specialist Allen Webb talks with Portfolio Manager Steve O'Neill about the closed-end fund market for the month of June 2016.
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[BEGIN VIDEO TRANSCRIPT]
ALLEN: Steve, as we sit here at the end of June, it's the end of the quarter and also it's midyear. I noticed that some closed-end fund price returns are quite attractive on both a monthly and a year-to-date basis relative to some broad asset classes. Can you kind of take us through performance and what's driven performance?
STEVE: Most closed-end fund investors if not all closed-end fund investors are happy with their 2016 returns. The average closed-end fund is up about 9 percent year to date. About two-thirds of that comes from net asset value performance. Stocks are up. Spreads are narrowing on corporate bonds. Interest rates are down. Most asset classes are positive, both risk-free asset classes and risky asset classes. That NAV return has contributed about 6 percent of the average closed-end fund's total return. Then you add about 300 basis points for discount narrowing.
ALLEN: Steve, where does this put us in the context of historical returns. Is this an outlier from a positive returns standpoint? Does this happen more frequently than people might expect?
STEVE: Again since two-thirds of the return is coming from net asset values, there have certainly been periods of time where closed-end fund NAVs have risen this way in the first 6 months or any 6-month period of time. To have 300 basis points of discount narrowing, that's certainly significant. It's not an outlier by any means. We started a very wide base. Discounts were too wide coming into 2016. The return certainly across capital markets, you're at near all-time highs in the equity markets. You're at near all-time low yields in the fixed-income markets. Again, everybody's happy for their performance year to date. That strong performance just from the net asset value perspective is really what's driving closed-end fund performance year to date.
ALLEN: Steve, you touched on discounts for a second. We've also talked about kind of the discount narrowing that's occurred for the last couple of months. Are you still feeling like at narrower levels of discount you're still able to put together an attractive portfolio from an evaluation standpoint?
STEVE: Yeah, we talk about the average discount often. I think it's around 4.7 percent as of 6/30. I think that that gives investors potentially the idea that discounts are potentially a little too narrow. When we look at the markets it's still — You're looking at taxable fixed income funds at eight to 10 percent. You look at equity closed-end funds both US, international, those discounts are still quite wide. You're looking at ten to maybe sixteen, 17 percent discounts there. It's muni closed-end funds that I think are very narrow and I'd say potentially going to expose investors to price volatility. I think that there's an air pocket in between where institutional investors would buy muni closed-end funds in where they're trading today. Those types of funds are holding the average discounts narrower for closed-end funds. When look we cross our portfolios we're still quite happy with the eight to 10 percent discounts on taxable bond funds. Again, equity closed-end funds haven't been more out of favor. Active management is out of favor. Investors want low-cost ETFs. Even the best of equity managers with strong trailing returns, it's hard for them to attract bids for their closed-end funds because investors have certainly a strong preference for passive investing.
ALLEN: Changing topics on you for a second, let's talk about macro-economic events, something that we don't frequently talk about. We're talking about the closed-end fund market and how RiverNorth sort of approaches that market. Obviously the market and market participants were deeply concerned about Brexit over the past four to 6 weeks. How did that impact closed-end funds both sort of leading up to the vote and then certainly around some of the capital market's volatility once the vote occurred?
STEVE: The closed-end fund market was rallying into the event. Closed-end funds sold off for maybe — let's call it 10 trading hours. They ripped higher. Ultimately most closed-end funds are at multi-year highs. If you would have asked us at the beginning of June whether if Brexit had occurred would we have thought closed-end funds would have hit multi-year highs... the answer is probably not. Ultimately investors have come to the conclusion that interest rates aren't going anywhere anywhere across the globe and this ultra-low interest rate regime is going to stay. That has resulted in a massive rally in both fixed income spread products, risk-free assets and even equities. You have this environment where net asset values are incredibly strong. Discounts are narrowing which makes the price returns on closed-end funds even better. You combine that with 6 1/2 to 8 1/2 percent yields and investors are clamoring to get closed-end fund exposure. It looks ridiculously good on a relative basis to high closed-end funds which are frankly still cheap relative to their historical averages and certainly cheap from a relative perspective to other kind of yield type securities investors are going for. The market, in my view, could not be more favorable to closed-end funds. Again, you're still looking at what I think are wide discounts and really the relative attractiveness of these securities hasn't really looked much better. Again, given the performance year-to-date, that's just kind of the warm fuzzies most investors need to put more capital to work. They want to buy securities that seem to be doing well.
ALLEN: Steve, last question, and I'm going to play devil's advocate for a second due to your last comment. Performance has been very good year to date. Discounts have narrowed. The market both in closed-end funds and broader capital markets sort of shrugged off Brexit after twenty-four to 48 hours. Do you at all feel concerned about things having been so good that the future looks less bright for this market or to your point it still looks attractive, closed-end funds versus other types of asset classes?
STEVE: Sure. I think it's important to say that the net asset value returns are always difficult to forecast. At the end of the day, risk markets are near all-time highs. Yields are at near all-time lows. The reality is the net asset value risk of most closed-end funds is certainly higher than it's been in quite a number of years. That risk is higher than it was really at any point in recent memory. That said, from a discount perspective you need to keep in mind that the components of the closed-end fund return, the net asset value — If you're going to buy a closed-end fund, you have to be comfortable with the risk in the first place. Knowing that risk, your second risk is "Is the discount going to widen or narrow?" I think when we look at it today there's a lot of room for discounts to narrow from here. Thinking about the last time investors were this hungry for yield, we were looking at the beginning of 2013. Most closed-end funds were trading at a premium. They owned bonds and stocks at near-record highs. They were paying premium valuations to get that wrapper. We're nowhere near that. Again, looking back on that it's really night and day from a relative valuation perspective. That doesn't mean again that high yield bond spreads aren't going to narrow back out to 650 or seven hundred or the equity market is not going to retrace the 8 percent rally and just have it — That’s hard to forecast. From a closed-end fund discount perspective you're not really paying up for the privilege to — I shouldn't say the privilege... you're not paying up for the investment vehicle today. You get the attractive yield. You actually get a nice discount. You get the asset class exposure you presumably already won. i think that discounts will continue to narrow so long as capital markets continue to go higher or kind of tread water. It's just a good environment, low-interest rates, investments aren't worried about leverage. You've got cheap securities on a relative basis from a discount perspective. Our expectation would be that we'll see discounts continue to narrow. Like any other investor, we're not going to let discounts kind of dictate our overall portfolio positioning. We need to consider the fact that markets are near all-time highs and spreads are certainly narrow, causing us to look to kind of monetize some of the risk assets we have in the portfolio. I think you have to think of it two ways. Are you comfortable with the risks of the markets today? If you are, I think closed-end funds are a great place to get back.
ALLEN: That's a good point. Steve, thanks for joining me. We'll see you next month.
STEVE: Thank you.
[END VIDEO TRANSCRIPT]
Video recorded 7.21.2016.
Produced by RiverNorth Capital Management, LLC ("RiverNorth" "we" or "us").
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This information is provided for informational purposes only and should not be considered tax, legal, or investment advice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Opinions referenced are as of the day recorded and are subject to change due to changes in the market, economic conditions, or changes in the legal and/or regulatory environment and may not necessarily come to pass.
Past performance is not a guarantee of future results. Diversification does not ensure a profit or guarantee against loss.
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Definitions
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.
Muni is short for municipal bonds.
Basis Points (BPS): 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.
A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. Widening credit spreads indicate growing concern about the ability of corporate (and other private) borrowers to service their debt. Narrowing credit spreads indicate improving private creditworthiness.
Brexit is an abbreviation of "British exit", which refers to the June 23, 2016 referendum by British voters to exit the European Union.
Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value.
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.
Source: RiverNorth, Morningstar, Inc.
