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Taxable income closed end funds include a vast and diverse group of investment choices. The category has seen severe declines in market values, often out of line with declines in net asset values of the funds. In this first installment of a planned look at opportunities in taxable income CEFs, I present an overview of the space using available searchable parameters. I’ve been thinking a lot about income from closed-end funds recently, both taxable income and tax-free income. CEFs provide extensive opportunities for both. Income is, to a large extent, the raison d’être for CEFs. Even most equity funds are primarily designed around generating income. Several are pitched to investors as being tax-advantaged which helps avoid giving up a large fraction of the income to the government. Fixed -income funds come in many flavors, but the two primary categories are taxable and tax-free. Tax-free means municipal bonds. I’ve written on municipal bond CEFs recently. For the income investor in mid to high range tax brackets, they can provide stable income with excellent taxable-equivalent yields. Tax-free CEFs may be national, which means they are exempt from federal income tax, or state-specific, which means they are exempt from both federal and state taxes. In most cases, a resident of a high-tax state like California or New York will find better tax-adjusted returns from the state funds. In general, I would say that for a high-income investor, either tax-advantaged equity or municipal bond fixed-income are the preferable options for a taxable account. But what about income in a tax-deferred or tax-exempt IRA? Here, one might want to look at the taxable income funds. This is a remarkably diverse group ranging from straightforward corporate bond funds to funds that specialize in extremely complex debt instruments, from purely domestic to global, developed to emerging markets. I use three sources to start my research on closed end funds. Each uses its own set of categories and each is erratic in how it assigns funds to categories. This often makes comparisons at the highest levels difficult. Muni bond funds are all more or less alike: They invest in municipal bonds. They vary, of course, in portfolio quality, durations, leverage and other bond metrics, but comparisons are reasonably straightforward. This is much less the case in taxable income. With this in mind, I plan to start here on a series covering this broad category. In this first entry I am going to survey the landscape and try to give shape to the state of the broad category. In subsequent installments I plan to highlight individual funds or clusters of funds. As as start in making sense of the diverse categories I’m trying to cover, I’ve created a screen that includes the CEFs comprising the domestic taxable income categories from cefconnect ex. preferreds. This is a group of 129 funds. I’ve run those funds through cefanlyzer’s screening tool. Because liquidity is a real consideration in CEFs, I’ve dropped the bottom dectiles on market cap and average volume. This takes the list down to 105 funds. Each of the data analyses here is based on those 105 funds at the September 9 close. First parameter I want to discuss is discounts and premiums. This is a major consideration in evaluating CEFs. Note that I said a major consideration, not the major consideration. I tend to write a lot about discount status, both in absolute terms and relative to either an individual fund’s recent history or to its peers. This should not be taken to mean that discount is the overriding consideration. Funds often carry deep discounts for good reasons, good enough to dismiss them from my consideration. But I will always look at discount/premium status and for the most part, I’ll stay away from any fund priced at a premium. Other, successful CEF investors are willing to buy funds at a premium. I understand their motivation but, from my point of view, there is almost always an equivalent alternative that can be bought at a discount. Because CEFs are primarily income vehicles, the distribution will often drive the magnitude of the discount/premium for a given fund. Eli Mintz has discussed this in the context of municipal bond funds . In that category funds are more or less similar, facilitating this sort of comparison. In the diverse group I’m considering here, one has to be careful about trying to compare quite dissimilar funds using the same metric. Mintz argued that discount/premium levels adjust under the influence of market forces that look to equilibrate the distribution yield. He describes a relationship between NAV yield and discount/premium such that at higher NAV yields funds tend toward premiums and at lower NAV yields funds tend toward deeper discounts. For municipal bond funds, he looks for opportunities among funds that fall below the trend line describing that relationship. Emphasizing that there are many more differences among this population of funds that there are for muni bond funds, let’s take a look at that relationship. (click to enlarge) That chart is hard to sort out, so here it is with the high-end outliers cut off and some labels. (click to enlarge) Cut off at premiums above the scale on this chart are the two PIMCO funds, the PIMCO High Income Fund (NYSE: PHK ) and the PIMCO Global StocksPLUS & Income Fund (NYSE: PGP ) with sky-high premiums one sees on the first chart. On this chart Oxford Lane Capital (NASDAQ: OXLC ) looks interesting. OXLC has its supporters, and I’ve been among them in the past. On the whole, I have to say it’s been disappointing in the more recent past and at this time I cannot recommend it. But it does serve to illustrate how difficult a tool like this chart can be if the data set is not optimal for the analysis. OXLC is quite different from most of the rest of the funds in this group as it is, in many ways, more a business development corporation than a closed end fund. This may be part of the problem as closed end funds are, by definition, closed. OXLC on the other hand has expanded with new offerings, which may not have been in shareholders best interests. If I still held OXLC, I’d keep it; it is, after all, making a strong payment. But before I’d buy into a position, I’d want to be more comfortable with management’s concern for shareholders than I am right now. In the next chart I zoom in even more in an attempt to resolve the center. I’ve cut this view off at par value (P/D = 0), so everything here is priced at a discount. (click to enlarge) There are statistical measures of how far a given data point is from the trend line, but one can simply draw a line parallel to and below the trendline to subjectively filter for funds that look good on this basis. Readers who find this analysis of value interesting will want to look more closely as some of the funds below the red lines. Most evident would be the group: the Virtus Global Multi-Sector Income Fund (NYSE: VGI ), the Brookfield High Income Fund (NYSE: HHY ), the Credit Suisse High Yield Bond Fund (NYSEMKT: DHY ), the Avenue Income Credit Strategies Fund (NYSE: ACP ) and the Ivy High Income Opportunities Fund (NYSE: IVH ). I am not familiar with any of these funds and can add nothing of substance on them at this time. I am simply pulling them out to indicate how this tool may be used. At the high end of the NAV distribution scale we find two Nuveen funds below the trendline. The AllianzGI Convertible & Income Fund (NYSE: NCV ) and the AllianzGI Convertible & Income II (NYSE: NCZ ) are interesting. These have seen a severe distribution cuts and have fallen from a high to modest premiums to the discounts seen here. Both have been solid funds over time and each may present value at their newly reduced distribution levels. They may be appropriate in a speculative niche of an income portfolio. I recently wrote about these two funds here where I suggested they are worth consideration. My opinion right now is that I will wait for the dust to settle a bit more before making any moves. Continuing on the subject of premium/discount status here’s a look at the full spectrum of funds under consideration. (click to enlarge) As we see in this chart all but a handful of funds in this category are priced at a discount to NAV. The stats on the distribution are shown in the table. The fact than only five of the funds are priced at premium valuation is unusual and reflects the fact that investors have been selling off taxable income CEFs. The statistical measure for how much current premium/discount varies from values over time is the Z-Score which can show how unusual the present situation is. The Z-score compares current valuations to average valuations. Negative Z-scores indicate discounts deeper than the average (more negative) and positive values indicate current prices is at a greater premium to the historical average. The absolute number tells us how far from the average the current values is. Z-score can indicate how likely or unlikely current status is based on historical distribution, but for that to be valid, the distribution must be statistically normal. Most premium/discount distributions do not satisfy that condition, so I’ll not put probability values on them here. However, if one has reason to believe a fund’s discount/premium is likely to revert to its mean value then negative Z-scores below, say, -1.5 would be strong indicators that a close examination of the fund could be worthwhile. Here then is the distributions of Z-scores for the funds in the taxable income group. (click to enlarge) (click to enlarge) (click to enlarge) The preponderance of negative Z-scores over 3, 6 and 12 month scales shows just how strong the selloff in this category has been. Looking at the distributions in tabular form shows the following. The median Z-score for 12 months tells us that the current discount for half the funds stands at more than 2 standard deviations below the average value. One will certainly not choose to purchase a fund on the basis of Z-scores alone, and I certainly do not recommend doing so, but these distributions are, to my eye, a clear indicator that something is amiss in the taxable-income space. Sufficiently so, that bargain shoppers should be able to find opportunities here. The next aspect of these funds I want to explore is distribution yields. When a fund is in discount territory (as more than 95% of these funds are) distributions at market price are greater than the distribution yield at net asset value. To me, this is one of the advantages of buying a fund at a discount. Here then are charts showing the distribution yields on price and NAV for the funds. (click to enlarge) (click to enlarge) Here are the stats. The median fund is paying just shy of 8% to its shareholders. Again, this is a space where an income investor should find appealing opportunities. “But,” you ask, “how safe are those distributions?” That is, of course, a very reasonable question in the current bleak environment for income opportunities, particularly in light of several recent sharp reductions in distributions by taxable income funds (discussed recently in this article). One measure of distribution stability is undistributed net investment income (UNII). If a fund is paying out more than it is earning, i.e. UNII is negative, it should be seen as a red flag. It does not necessarily mean a distribution cut is imminent. Nor is positive UNII a guarantee that distributions will not be cut. In addition, fund sponsors vary widely in the timeliness of reporting the UNII values for their funds, so the screeners and aggregators of data often are reporting data that is out of date. With these caveat in mind, let’s look at a picture of how the UNII that funds are reporting at this time. The chart shows the percent by which a fund’s UNII exceeds its distributions. Negative values indicate that a fund is (or was at last reporting) paying out more than it is taking in. The decline of the high-flying Pimco High Income Fund over recent months, culminating in a sharp distribution cut last week, is a consequence of a fund paying out distributions beyond its earnings. (click to enlarge) This tells us that roughly three-quarters of funds may be in situations where their distributions are in trouble. There is considerable unreliability in these data, but the fact remains that there is a cautionary tale here. Fund managers are extremely reluctant to cut distributions. Many will go too long before they do so. Clearly recent conditions are highly unfavorable for high income investing, so any potential buyer will want to research this matter thoroughly. No general discussion of closed end funds would be complete without consideration of leverage. Most of the funds under discussion here are leveraged. This is a primary tool in the CEF manager’s kit for generating high income. But leverage necessarily comes with risk, particularly as we start to move into a rising-rate environment. Here is the distribution of leverage among the funds. (click to enlarge) Median leverage is just below 30%. Fewer than 10% of funds have leverage below 3.5% and at the high end several funds exceed 40%. This is, of course, a meaningful risk factor. There are, of course, many other considerations that go into an investment decision in one of these funds. Portfolios vary enormously in terms of credit quality, portfolio duration, geographic distribution, and types of investment. Some are primarily invested in corporate bonds; others hold and trade all sorts of esoteric debt instruments that all but the most sophisticated investors fail to fully understand. Portfolios change quickly, so even careful research may be based on out-of-date information. These are but a few of the considerations that go into evaluating a fund. What I’ve tried to do here is give a broad brush picture of the space using screenable metrics. Such metrics are only a start. At best they can only provide a list of candidates for further research. In my future installments I plan to report on funds that emerge as candidates from analyses like those described here. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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