Primed for Income

By Eric Uhlfelder

September 01, 2005 at 04:00 AM

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When the bull market was peaking in the late 1990s, new issues of closed-end funds virtually dried up. According to Thomas J. Herzfeld Advisors, a Miami-based closed-end fund specialist, only one closed-end fund came to market in 2000, raising just $300 million. This led many market observers to suggest that the industry was becoming irrelevant. That call, however, turned out to be greatly exaggerated. Ironically, it was the subsequent collapse of stocks and interest rates that revived this moribund industry. A new generation of closed-end funds began targeting investors looking for steady income streams.

In 2001, 37 new closed-end funds came to market, led by municipals, raising nearly $6 billion. In 2002, 79 issues worth $16 billion were issued, buoyed by a newfound interest in preferred stock funds. Then 2003 and 2004 averaged 50 deals each year, boosted by more preferred funds and alternative equity products that generated about $26 billion, respectively. According to Cecilia Gondor, executive VP at Herzfeld, the pace is continuing this year: During the first half of 2005 alone, there were 31 deals worth more than $14 billion.

Does that mean the industry's structural anomalies, which have troubled investors, have disappeared?

No. Their market values will always deviate, sometimes significantly, from their net asset values. This is unlike open-end funds, in which every dollar you invest [less any acquisition and managerial expenses] actually gets you ownership of a dollar's worth of the fund's securities.

Take the closed-end China Fund (CHN). On July 22, 2005, it was trading at $28.77 per share, but its underlying securities were worth only $25.44. That meant new investors were paying a 13% premium to get into the action. And good action it's been. Over the past year, the fund's market value appreciated 29.2%, according to Barron's weekly listings of closed-end funds. However, according to Lipper, Barron's source, the fund's premium had soared beyond 41% late last year. So if you had bought shares in December 2004, you'd be deep in the red.

This deviation between NAV and market value can also work in investors' favor. Take the Korean Equity Fund (KEF), which rose 46.5% over the last 12 months. During that time, its discount of more than 14% narrow to below 6%. In fact, the fund has been enjoying a long-term improvement in the discount, which peaked in November 2001 at more than 21% but has been correcting ever since.

To help attract underwriters as well as investors, many closed-end funds committed themselves to managed distributions–a regular payout, measured as a percentage of NAV, which topped out as high as 10%.

Certainly the concept is attention grabbing. However, it doesn't take an MBA to realize that such funds could suffer from capital erosion to meet such commitments. But some funds and their shareholders have actually thrived under such arrangements.

Take the Blue Chip Value fund (BLU), which started in 1987 with an NAV of $9.27. It subsequently adopted a managed distribution of 10%. According to Don Cassidy, senior analyst at Lipper, the fund's NAV had declined to $5.64 as of the end of June 2005. However, because of the fund's ability to meet its managed distribution, aided through leverage, and helped by a premium that now stands at 14.6%, the fund's historic annualized returns exceed 9%.

Closed-end funds also earned a sour reputation from the financial hit investors almost always take when buying initial public offerings of a fund. While distribution fees have come down a bit since the 1990s, Michael Porter, senior research analyst at Lipper in New York, explains that the typical closed-end fund coming to market at $20 will see its initial net asset value set at $19.10 because the underwriters are taking a $0.90 fee.

"How IPOs can still be sold under this arrangement," queries Porter, "is the million-dollar question." But he believes that the recent revival in closed-end funds, despite the quirkiness in which they first come to market, is due to new income-oriented products offering investors intriguing alternatives to traditional investing that otherwise would be difficult to come by. A key means that helps them achieve these above-market income flows is leverage–a feature unavailable to open-end funds.

Leverage is achieved when a fund borrows against its assets. While the degree of borrowing varies widely, it is typically around 30% to 35%. This means funds can have a third more income-producing assets working for it, which can transform a 4.5% income security into a 6% yield.

This year has seen the issuance of multi-strategy funds seeking to deliver steady income flows. They rely on various assets, many of which make up the individual funds discussed below:

Master Limited Partnerships

Alex Reiss, a senior closed-end fund analyst at Ryan Beck & Company, with $18.5 billion of assets under management, believes that while closed-end funds are not a distinct asset class, they should be looked at as a means of improving allocation strategy. For instance, he's keen on master limited partnerships to enhance energy exposure. "They aren't bets on commodity prices," Reiss explains, "but investments in gas and oil pipelines and other energy infrastructures that generate toll-like revenue as resources flow through them."

Last year, four MLP funds came to market, raising $1.6 billion. With average yields of about 6%, the group has enjoyed a solid year so far, up an average of 10.6% through July 7. Despite its rather high expense ratio of 2%, Tortoise Energy Infrastructure [TYG] is pacing the industry, up nearly 20%, trading at a 7.8% premium, well above the group's average of 1.2%.

Corporate Loan Funds

Mariana Bush, closed-end fund specialist at Wachovia Securities in Washington, D.C., likes prime rate, a.k.a. corporate, loan funds, which are made up of debt issued by below-investment-grade companies. "But they are generally more secure than high-yield bonds," Bush explains, "because they are higher up the capital structure than bonds; i.e., first-lien loans will be paid off ahead of nearly all other debt."

Further, their NAVs are generally less volatile than high-yield debt because their income adjusts on average every two months. Dividends are based on 30-day LIBOR plus 200-400 basis points–depending on credit quality.

Loan funds were trading up to a 5% premium in early 2005 as costs of borrowing remained relatively inexpensive, portending the bottoming of default rates at 2.2% in May. However, Moody's believes default rates will rise moderately over the next several years as the cost of borrowing increases along with the Fed Funds rate. This has helped transform premiums into discounts ranging down to 9% as of the end of June.

Bush believes institutional selling has driven down market prices, as money managers liquidated carry trades that are proving less profitable as short-term rates rise. But she arguees that "while increasing defaults may push down NAVs, investors should be rewarded by rising yields as short rates continue to increase, boosted further by discounted pricing."

Among the more attractive loan funds, says Bush, is the $1.46 billion Van Kampen Senior Income Trust (VVR). This trust invests exclusively in first-lien loans, which Bush believes will outperform higher-yielding, lower-structured debt during a rising rate environment. It doesn't have the highest yield [6.2%] or three-year annualized returns [10.8%] as some other funds, but has very low volatility [5.8%], a below-average expense ratio of 1.59%, and is trading at a 5.7% discount, helping to mitigate risk.

Covered Call Funds

With the broad market having been largely rangebound over the past couple of years, covered call funds have been considered by many observers a conservative way of drawing a steady flow of income out of a market that can't make up its mind. While these funds date back to the 1980s, the current universe is composed of 23 funds issued over the past 14 months. In the first half of 2005, underwriters raised $10.7 billion with more funds in the pipeline.

Typically, a covered call, or buy-write, fund will go long stocks and then sell short-term call options on shares or an index. The good thing is that such funds are generating yields averaging between 8% and 10%, even when the market is heading south. The bad thing is that if stocks start to run, as they did in July, the fund's upside will be limited to the premium income as shares get called away.

Being relatively new, these funds don't offer much historical data. The oldest fund, the $270 million Madison/Claymore Covered Call Fund (MCN), launched in July 2004. It has a current yield of 8.3%, and through the first half of 2005 has generated a return of 11.6% as investors have pushed its market price to a 6.4% premium.

Preferred Stock Funds

While preferred stock funds date back to the late 1980s when dividend received deductions enhanced the total returns for qualified investors, the retail versions took off in June 2002 after 10 funds came to market over the prior 12 months, raising $7.7 billion. An additional $3.7 billion was raised by another three funds with more than half their assets dedicated to preferred shares.

The reason for this rediscovered interest in preferred stock was made clear as the bear market sunk its teeth in and interest rates started to descend. Preferreds were offering above-market yields through conventional means and with only slightly more risk than senior bonds. Moreover, in a number of instances, they involved the same risk as bonds in that they were actually bonds wrapped in a preferred veneer.

While the non-DRD funds also have too short a history to discern their viability, they have racked up attractive one-year returns through the end of June, led by BlackRock Preferred Opportunity Trust (BPP) and Nuveen Quality Preferred Income Fund 3 (JHP). Their total returns of 19.3% and 13.2%, respectively, were supported by price yields of around 8% and reduction in their discounts. They are about one-third leveraged, have below-average volatility of 10.6%, and sport expense ratios that are a bit above the industry average of 1.35%.

Global REITS

REITs are nothing new. But in the closed-end fund world, their increasingly international makeup is. James Corl, CIO of real estate investments at Cohen & Steers in New York, explains that more foreign countries are permitting the creation of REIT-like structures. "This helps us diversify our holdings and income streams," he explains, "protecting investors by gaining exposures to economies that are in different economic cycles. Even more compelling, they offer us the significant gains that accrue when real estate companies convert into REITs."

He points to the French experience in 2003 when the country legislated creation of REIT-like structures. Before the rule change, the bulk of real estate companies were traded at more than a 20% discount to their NAVs. By early 2005, they were trading at more than a 20% premium, largely driven by multiple expansion in dividend payouts.

There is plenty of potential left in the global market for capturing this conversion premium. According to Corl, before 2000 only four developed markets had REIT-like structures. Since then, Japan, Korea, France, and Hong Kong joined the list. Germany, Italy, Spain, the U.K., and Finland are considering adopting such measures.

Two global closed-end real estate funds came to market since last year. ING Clarion Global Real Estate Income [IGR], which IPO'd in February 2004, has a yield of 7%, one-year total returns through August 2 of 35.3%, and trades at a 12.4% discount. Cohen & Steer's Global Real Estate Fund [RWF] came to market in March 2005, offers a price yield of 7.5%, and over the past three months has generated total returns of 8.72% and trades at a 3% premium.

TIPS

Treasury-inflation-indexed securities (TIPS) have gained popularity as a means for investors to secure real yields through debt that regularly adjusts for inflation. Increasing demand has also produced capital gains for many of these securities. Over the past two years, three TIPS funds have come to market with total assets of more than $1.4 billion. Western Asset/Claymore issued two of the three funds [WIA and WIW], which offer yields of 6.13% and 7.88%. But expanding discounts, both currently around 9%, have eaten away at total returns over the past year through July, bringing them down to 3.31% and 6.71%, respectively.

Foreign Country Funds

While these shares have been around for a while, the past 12 months has witnessed some extraordinary performance, in dollar terms, as investors have sought more remote opportunities where improving economies and regulatory conditions are attracting foreign capital.

Despite such performance, double-digit discounts can still be found. But to Thomas Herzfeld, this can spell opportunity. Over the past several years, he observed that the discount on the profitable Korean Equity Fund [KEF] was steadily improving from the 20% level of late 2001. In March 2005, it turned into a premium. But within two months, the fund reverted to a discount exceeding 10%. Expecting the discount to correct and wishing to avoid equity exposure, Herzfeld went long the fund and shorted the corresponding South Korean i-Share. "This made our play market-neutral," he explains, "and enabled us to pick up 5% by July as the discount closed."

If closed-end funds sound like they ought to have a place in your clients' portfolio, George Coles Scott, president of the Richmond, Virginia-based Closed-End Fund Advisors, with $85 million of assets under management, suggests first identifying the asset class to which you're looking to add. Then discern management's ability to exploit opportunities and manage risk, determine whether the fund regularly outperforms its benchmark, and finally review its leverage and overall volatility. If everything looks in order, see where the shares are trading relative to their NAV. It takes an extraordinary offering to attract Scott into a premium-priced fund.

But if he discerns that a fund's discount has disconnected from the quality of its underlying assets, he may see opportunity in buying $1 worth of assets for $0.75 to $0.80. While there's nothing that will guarantee a discount will correct or not expand further, Scott says he is observing increasing evidence of shareholder activism that's forcing management to correct protracted deep discounts through share repurchases, enhanced distributions, and even replacement of investment advisors. "This improving oversight," Scott believes, "should help address an industry weakness that in the past has turned investors off from participating in some unique opportunities now being offered in the closed-end fund world."

New York-based financial writer Eric Uhlfelder can be reached at [email protected].