September 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 September 2016.

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ALLEN: Steve, capital markets were pretty benign in the month of September, with the S&P 500 up a couple of basis points and the Barclay’s Agg down a couple basis points. How did that translate to the closed-end fund market?

STEVE: Closed-end funds were pretty flat. The average fund was down about 14 basis points. The real story was muni closed-end funds that were down about 75 basis points, which was a fairly large loss relative to the gains that they’ve had recently, but, really, looking across the board, gains here today have still been positive. You’re looking at 10 to 15 percent returns across asset classes for closed-end funds.

ALLEN: See, I’m glad you brought up munis. We have talked in some previous videos about the strength in the muni market, and now you bring that up as one of the weakest sub-asset classes in September, and then I also notice where in the first two weeks of October, munis are down about five percent on a price-return basis. So, can you walk us through what’s happening in the muni market? Is this simply kind of reverse into the mean for an over-bought asset class or is there more to the story than that?

STEVE: Sure. I mean, I think from the closed-end fund perspective, munis has been extraordinarily positive. Investors have generated very significant total returns. Something in the neighborhood of 10 percent annualized returns on muni closed-end funds for the last three years, and so when things are going well, people tend to buy more of them.

ALLEN: Right.

STEVE: So that pushed a lot of closed-end funds to par or premiums, and we’ve said on a number of these videos that we think the market looks technically overbought. What’s happened recently is investors are more fearful of rising rates. The asset class has underperformed treasuries recently, and so you’ve had some losses and investors have reacted to small losses, the small loss in September, by selling more aggressively. That selling pressure has pushed closed-end funds down, as you said, about five percent. I think that’s kind of the technical setup, but fundamentally, which I don’t necessarily think the market’s bracing in today, but it’s a growing risk, because the fundamental picture is weakening for you average muni closed-end fund. Borrowing costs are up at about 150 basis points today. That’s really up, maybe on average, about 100 basis points this year. So your borrowing costs are rising while your income is declining. I mean, muni bonds are getting called away. When they reinvest, they’re generating lower yields, so the spread is narrowing. That can put pressure on distribution rates in the future. So, fundamentally, the muni market has been weakening in the closed-end fund space. Technically, up until about September, it was priced to perfection, and so there was a mismatch and something had to give. Part of this correction is just, you mentioned mean aversion, but it’s reverting to more of a less overvalued position.

ALLEN: So Steve, in light of that, staying with munis for a moment, does this create opportunity or, in your opinion, is there still repricing to come? Is the fundamental deterioration something that bears watching before you view this as opportunity from your closed-end fund team?

STEVE: Sure. I think, from the fundamental standpoint, it’s already happening. There’s really no changing the situation that the yield curve is flattened and the earnings power is declining. When you buy a closed-end fund, in my view, in the muni market today, you should expect a distribution cut at some point in the future. That could change. The yield short-term rates could go back down and the earnings power could stay strong, but, fundamentally, I think you should prepare for just a drumbeat of bad news from the fundamentals. From a technical side, a lot of closed-end funds are down five percent. Many funds are down 10 percent. I think there’s more losses to come for many closed-end funds, because the premiums that went to small discounts still aren’t attractive enough to basically pull in crossover buyers. I think there’s air pockets beneath a lot of closed-end funds, because a lot people don’t care about closed-end funds at two to three percent discounts. They have to drop another four or five percent to get people interested. You’re probably going to see your average closed-end fund have more weakness. That’s the direction of the market. I think the new buyers don’t step in until you see wider discounts. That said, the market, there’s been a parallel shift. There are a lot of funds before the sell-off, maybe not a lot, but a handful of funds that looked pretty good, and now those funds have widened out in sympathy, really, directly proportional to the average. So a lot of funds that started off OK before the selloff are now not only relatively attractive but absolutely attractive. I think there’s probably maybe two dozen funds that look pretty good today. I wouldn’t go out and buy a market-cap-weighted basket of closed-end funds, but I think if you do your research there are some good opportunities today. It’s going to be very volatile. When you have a 10 percent drop, you’re probably going to see a couple points bouncing back either way, but it’s important to keep in mind that the fundamentals are becoming more negative. It’s not imminent the distributions will be cut, but we all know that yields are coming down and borrowing costs are rising. It’s just simple math that distributions can be less if this continues. So, fundamentally, expect weakness, but that doesn’t mean that you can’t own closed-end funds. I mean, distributions have been cut for years and discounts, and most market participants realize the distribution are going to be cut, because yields have come down. I don’t think it’s going to be a huge surprise, now that the market has dropped where it was, but it’s something to consider. Any time you’re buying a muni closed-end fund today, discount is important, but also analyze the fundamental picture.

ALLEN: Steve, thanks for your comments.

STEVE: Thank you.


Video recorded 10.19.2016.

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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.

Par is a term that refers to a financial instrument that is trading at its face value.

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.

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.

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.

The 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. The indices cannot be invested in directly and do not reflect fees and expenses.

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.

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity. There are three main types of yield curve shapes: normal (steep), inverted (negative), and flat. A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields. A flat yield curve is one in which the shorter- and longer-term yields are very close to each other. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.

Market Capitalization (Market Cap) is the total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying a company's shares outstanding by the current market price of one share.

Source: RiverNorth, Morningstar, Inc.