January 2016 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 January 2016.
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[BEGIN VIDEO TRANSCRIPT]
ALLEN: So Steve, it's been a little while since we've gotten together. Last time I think you spoke was mid-December. So we finished the year with a little volatility but not too much. However, as people came in from the New Year right into the first trading day of the month, January started off with a pretty volatile capital markets environment. So, can you walk us through how closed-end funds performed in light of some the capital markets volatility?
STEVE: Sure. I think the last update was right before Christmas and I think we had a nice Santa Claus rally going into year-end and then, as the calendar year turned, there was an abrupt sell-off. The market sold off pretty hard. The S&P bottomed out at about down 9% intra-month and closed-end funds performed poorly as well. The end-of-month numbers weren't too bad. The S&P 500 was at about 5% loss, high yield bonds were about two percent and closed-end funds were down about two and half percent loss which on a relative basis isn't bad but, certainly not what closed-end fund investors typically expect. Usually after a sell-off in December from excess supply due to tax loss harvesting, closed-end funds tend to bounce back in January but, when the market drops the way it does, it's truly a risk-off environment and closed-end funds really are a risk-on asset. For the most, these are bond funds with corporate credit or equity funds which have traditional beta and so therefore, in this type of market when investors are truly rushing for the exits, closed-end funds were down similar to the broader market. But what was interesting was that discounts basically ended where they started. The beginning of the month of January, we had an 8% discount. At the end of the month, we were right around 8% too.
ALLEN: Steve, any distinction between sort of equity and fixed income performance or was this just a broad-based sell-off?
STEVE: Definitely. I think what's interesting is that people group closed-end funds as just one asset class, when underneath, you've got obviously, equities, taxable fixed-income and muni-bonds. And what was interesting was that the market is truly starting to differentiate between the closed-end funds that they want and the ones that they don't. For the month of January, muni closed-end funds did very well. The average price was positive, although just slightly above zero but, discounts remain very narrow and I think that's interesting. It's something to keep in mind which is for those investors that are frustrated with wide discounts, it's important to realize that munis, which are about half of the market, were, as recently as mid-last year...I mean, you had discounts in the low teens and a lot of those discounts have narrowed to mid- to high-single digits. And so, when investors like and asset class, like they munis today, discounts narrow because retail investors want to own more. Whereas equities and taxable fixed income, not many retail investors are looking to increase their allocations today, which is why discounts are wide. Since this is a retail market, it's not going be until retail investors come back to that market that those discounts narrow. And so, for the distinction, yes, there was a distinction which has taken a while to occur. But there is a strong preference for tax-exempt income and despite the overall volatility in the closed-end fund market, those discounts remain narrow and show that, when investors have a preference for an asset class, those discounts can narrow substantially.
ALLEN: So is it fair to say that the performance of munis, both from a discount narrowing and from a total return standpoint, is an example of what can happen to some of the other asset classes if retail investors sort of get behind that from liking that asset class?
STEVE: Definitely. I think when you think about closed-end funds, there's really two ways to own the asset class. One is to own it opportunistically, as RiverNorth likes to do for our strategies, and the other one is to essentially chase fund flows. When fund flows are positive, discounts will continue to narrow and oftentimes, they can go from discounts to premiums. In the muni space today, a lot of that seems to occurring. Discounts are narrowing to levels that don't seem that attractive given the relative volatility that they could incur. But on the taxable-fixed income and equity side, if you think about owning and asset and having the beta in your portfolio already, it makes a ton of sense to own that asset class at 90 to 85 cents on the dollar. Intra-month, we had an opportunity to buy great fixed-income funds at 15 to 20% discounts, equity funds at 20% discounts, which truly we haven't seen for quite a while. When you look at your portfolio, we've said this a number of time, just think about the beta you're already taking and realize that you're starting off at a huge advantage by owning a discount that's substantially wider than its historical average.
ALLEN: Steve, I get the pitch that investors might as well take similar beta exposure through a discounted closed-end fund but that's one side of the equation. Talk a little bit about the discount opportunity from here. We've been on the record for the last few months talking about discounts are kind of in the 90th to 95th percentile from a historical basis but what's the pitch from a discount perspective? What should attract investors about the ability for discounts to narrow from here?
STEVE: Again, when you think about buying equities or taxable-fixed income, for the most part it's a risk-off environment. People aren't looking to add equity exposure. People aren't looking to add taxable-fixed income exposure. When I say people, I'm talking about retail investors. This is a retail market and so, contrarian investors, which I would call institutional investors in the space and those that are looking to get opportunistic investments, cheap exposure to beta, you're basically along for the ride. You can't control when discounts are going to narrow for the most part because, you're relying on retail investors to buy the closed-end funds and narrow those discounts. And, so, oftentimes, it is impossible to predict when discounts, at an aggregate level, will narrow. But that doesn't mean that at the margin, closed-end fund discounts can't narrow by asset class. So if you're picking an asset class that you think will perform well and you like the beta of the asset class, then, if that performance plays out, the discount should narrow as other investors appreciate the return of that fund and then start to follow, essentially performance-chase that asset class.
ALLEN: Steve, thanks for your comments this month.
STEVE: Thank you.
ALLEN: One note to our viewers, for our February market video which we will shoot in March, we would like to know what's on investors' minds. So, if any investors viewing this video have questions they would like for Steve and I to answer next month, please send an email to firstname.lastname@example.org with your question, and Steve and I will take the best six or eight questions to review in our next video. Thank you.
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Video recorded 2.3.2016.
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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 BofA Merrill Lynch Non-Financial Developed High Yield Constrained Index contains all securities in the BofA Merrill Lynch Global High Yield Index from developed markets countries but cap issuer exposure at 2%. Developed markets is defined as an FX-G10 member, a Western European nation, or a territory of the U.S. or a Western European nation. The index tracks the performance of USD, CAD, GBP and EUR denominated below investment grade corporate debt publicly issued in the major domestic or Eurobond markets. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch). These unmanaged indices don’t reflect fees and expenses and cannot be invested in directly.
Beta reflects the sensitivity of a fund's return to fluctuations in the market index. A beta of 0.5 reflects half of the market's volatility as represented by the Fund's primary benchmark, while a beta of 2.0 reflects twice the volatility.
Source: Morningstar, Inc., BofA Merrill Lynch Non-Financial Developed High Yield Constrained Index
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