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What Do Rising Rates Mean For Closed-End Funds?

It’s a misconception that rising rates make it difficult for closed-end funds to deliver competitive results By Christopher Dahlin, UIT Product Strategy and Development Specialist It’s not a stretch to characterize closed-end funds as an often misunderstood investment vehicle. Perhaps that’s because the closed-end fund universe is smaller than those of open-end mutual funds and exchange-traded funds (ETFs), or because their market price and net asset value (NAV) frequently fluctuate. Whatever the reason, closed-end funds occasionally get lumped together as one asset class, even though they invest in a wide array of securities across styles and strategies, just as open-end mutual funds and ETFs do. But the prevalent misconception that closed-end funds generally have difficulty delivering competitive returns in a rising rate environment is of particular importance in light of the Federal Reserve’s (Fed) recent rate hike and the likelihood of more to come. Rising rate fears widen discounts Some investors believe that because many closed-end funds employ financial leverage – which is typically tied to short-term interest rates – increased borrowing costs may inhibit total return-producing capabilities. The graph below illustrates this bias. Starting about the time of 2013’s “taper tantrum” – shorthand for the market’s reaction to then-Fed Chairman’s Ben Bernanke’s indication of possible tapering of its stimulus program – and leading up to the Fed’s recent decision to raise the federal funds rate, fears of the first rate increase since 2006 have led to a broad sell-off among closed-end funds, causing discounts to widen considerably. During this period, the average closed-end fund progressed from trading near NAV to approximately 10% discounts, valuations not seen since The Great Recession. Taper tantrum to rate rise: Valuations not seen since The Great Recession Source: Morningstar Traded Fund Center, Jan. 24, 2013, through Dec. 16, 2015. The CEF average discount is a daily unweighted average of the entire domestically-traded closed-end fund universe. Past performance is not a guarantee of future results. Historical perspective: Returns and rising rates What’s interesting is that, contrary to the recent investor exodus preceding the rate increase, history indicates closed-end funds are capable of producing competitive returns during periods of rising interest rates. Investors need look no further than the last Fed tightening cycle in 2004 for evidence of such closed-end fund outperformance, from both an NAV and market price perspective. As the graph below indicates, closed-end fund valuations widened considerably prior to the Fed’s first 2004 rate increase similar to today’s market. Déjà vu: Closed-end valuations widened prior to the 2004 tightening cycle Source: Morningstar Traded Fund Center, Jan. 1, 2004, through Sept. 29, 2006. The CEF average discount is a daily unweighted average of the entire domestically-traded closed-end fund universe. Past performance is not a guarantee of future results. However, entering that tightening cycle with such large discounts actually allowed closed-end fund discounts to subsequently narrow throughout much of the period and produce outperformance across various asset classes on both NAV and market price, as show in the graph below. Narrowing discounts resulted in outperformance during the previous tightening cycle Source: Morningstar Traded Funds Centre. Index returns: S&P 500 Index, BofA Merrill Lynch Municipal Master Index and BofA Merrill Lynch US Corporate Master Index. Closed-end fund returns: US general equity peers, national municipal bond peers and investment-grade corporate bond peers. Past performance is not a guarantee of future results. An investment cannot be made directly in an index. Using leverage to enhance returns While borrowing costs did increase for most closed-end funds during the Fed’s last period of increasing interest rates, many managers were able to overcome that obstacle by delivering strong investment returns, as shown above. Although monitoring borrowing costs is an important consideration in closed-end fund investing, it’s not the only variable used to determine the effectiveness of leverage. It’s important to note that leverage is a tool that generally magnifies investment returns; as long as the cost of leverage is less than the total return generated by the investments within the fund, leverage may add positively to performance. When evaluating closed-end funds, it’s important to consider both the return potential of the underlying investments as well as the current premium/discount levels relative to historical levels to determine the current valuation of the closed-end fund itself. Although financial history never repeats itself exactly, it does often rhyme. Many closed-end funds today appear to be following a pattern similar to the last time the Fed initiated a cycle of increasing interest rates. Closed-end fund discounts within many sectors are trading in excess of their historical levels. Depending on an investor’s outlook for a particular asset class, this may be an opportune time to take a closer look at closed-end funds. Important information The S&P 500® Index is an unmanaged index considered representative of the US stock market. The BofA Merrill Lynch Municipals Master Index measures total return on tax-exempt investment grade debt publicly issued by states and US territories, including price and interest income, based on the mix of these bonds in the market. The BofA Merrill Lynch US Corporate Master Index tracks the performance of US dollar-denominated, investment- grade-rated corporate debt publically issued in the US domestic market. A closed-end fund is a publicly traded investment company that raises a fixed amount of capital through an initial public offering (IPO) and is then structured, listed and traded like a stock on a stock exchange. An open-end fund is a type of mutual fund with no restriction on the amount of shares issued; it will continue to issue shares to meet investor demand and will buy back shares when investors wish to sell. Net asset value is the per-share value of open-end and closed-end funds and exchange-traded funds (ETFs). Mutual funds’ NAV is computed once a day based on the closing market prices of the securities in the fund’s portfolio’ shares of ETFs and closed-end funds trade at market value, which can be a dollar value above (trading at a premium) or below (trading at a discount) NAV. Financial leverage refers to the use of debt to acquire additional assets. Shares of closed-end funds frequently trade at a discount to their net asset value in the secondary market and the net asset value of closed-end fund shares may decrease. In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions. Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/ or interest. Leverage created from borrowing or certain types of transactions or instruments may impair liquidity, cause positions to be liquidated at an unfavorable time, lose more than the amount invested, or increase volatility. There is no assurance a trust will achieve its investment objective. An investment in these unit investment trusts are subject to market risk, which is the possibility that the market values of securities owned by the trust will decline and that the value of trust units may therefore be less than what you paid for them. Accordingly, you can lose money investing in these trusts. The trust should be considered as part of a long-term investment strategy and you should consider your ability to pursue it by investing in successive trusts, if available. You will realize tax consequences associated with investing from one series to the next. Before investing, carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the products, visit invesco.com/fundprospectus for a prospectus/summary prospectus. The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE All data provided by Invesco unless otherwise noted. Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. ©2016 Invesco Ltd. All rights reserved. What do rising rates mean for closed-end funds? by Invesco Blog

Evaluating Sustainable Competitive Advantages: Entry And Exit Barriers

Originally published October 9, 2015 By Baijnath Ramraika, CFA and Prashant Trivedi, CFA Click to enlarge “If I have seen further it is by standing on the shoulder of Giants.” – Isaac Newton “In business, I look for economic castles protected by unbreachable moats.” – Warren Buffett In our earlier research papers on the topic of high quality, Investment Returns to Quality in Developed Markets and High Quality Stocks in Emerging Markets , we showed that high-quality stocks generate superior investment returns with lower risk compared to their benchmark indexes. While both papers laid out a quantitative framework for identifying high-quality businesses, the optimal investment selection process includes a significant non-quantitative component: the existence of sustainable competitive advantages. A strong competitive advantage and its sustainability are the most important attributes of a high-quality business. Much of the investment returns that accrue to investors from the quality factor depends on the ability of the business to persist with its supernormal returns on capital. However, the excess returns can persist only if the business is able to keep competition at bay, which is a factor of the sustainability of the competitive advantage of the business. While it is possible to develop quantitative models that can differentiate businesses that possess sustainable competitive advantages from those that don’t, this is best done within a well-structured human-decision-making process while recognizing its cognitive limitations. Our research paper on the limited rationality of the human mind further investigates the design of such a process such that errors of cognition are minimized. This article is the first in a series discussing an assessment process for existence or absence of sustainable competitive advantages. In this article, we discuss the basic building blocks of an investment process designed to identify high-quality businesses: the entry and exit barriers. There is nothing new about much of what is discussed here. The concept of sustainable competitive advantages and the building blocks to the assessment of sustainable competitive advantages have been discussed and elaborated by several market luminaries including Warren Buffett and Charlie Munger. Through this series of articles, we will present a structured investment process that lends itself to modification and adoption by the reader. Barriers to entry Buffett says that he looks for businesses with “unbreachable” moats. What does he mean by moats? Moats are deep, broad ditches that were filled with water and surrounded a castle. Historically, moat[1] served as the preliminary line of defense by restricting access to enemy forces and serving as entry barriers. If the playground of a business wherein it operates can be referred to as a castle, the entry barriers that protect that playground can be referred to as moats. So why are moats important? Let’s say that an industry or business is enjoying supernormal returns on capital. Those returns mean that every dollar of capital invested in the business will be valued at more than a dollar. The possibility of creating a superior asset by replicating such a business will attract other entrepreneurs to commit capital and resources. This is where entry barriers come into play. If entry barriers are low or non-existent, other entrepreneurs will successfully enter the business, driving supply upwards and returns downwards. This process will continue until all the excess returns are competed away. However, if entry barriers are insurmountable, efforts of competitors will fail and they will be unable to make inroads into the business, allowing the supernormal returns of the business to persist. Barriers to exit: The overpowering component Much of the discussion on moats focuses on entry barriers. However, exit barriers are extremely relevant when analyzing the ability of a business to persist with supernormal returns. While entry barriers determine the ability of competition to make inroads in the business, exit barriers determine the competitive structure that persists among the incumbents within the industry. Essentially, exit barriers dictate what happens once you are inside the castle. If you find that life gets miserable, exit barriers determine your ability to leave in search of greener pastures. Industries with exit barriers are hard to leave; even businesses with poor economics are forced to stay. In such businesses, the profitability of everyone is dictated by the dumbest competitor. Car markers: A case of exit barriers nullifying entry barriers Consider the case of automakers, an industry characterized by substantial entry barriers. One of the sources of entry barriers protecting auto makers is the cost of development of new models. The development cost of a new model varies significantly. Depending on the scope and complexity of the project, the costs of developing a new model can range from US$1 billion to US$6 billion[2] [3]. To be a viable competitor and occupy enough mind-space of consumers, an automaker requires about five to six models. Assuming the development cost per model of US$2 to 3 billion and useful life of a new model of five years, an automaker will need to sell 2.4 to 3.6 million vehicles per year in order to keep the development cost per vehicle down to US$1,000. With the U.S. market currently estimated at about 18 million passenger vehicles per year[4] [5], the market can accommodate five to six competitors. The problem with this industry structure is twofold. First, there are enough competitors vying for the consumer’s dollars that price competition is likely to be high. Second and importantly, there are substantial exit barriers. Development costs that served as entry barriers also serve as exit barriers. Once spent, development costs are essentially sunk costs and can be recovered only by sales of an ever-increasing number of vehicles. This results in substantial price competition such that excess returns, if any, are hard to maintain. Iron ore: Yet another case of exit barriers cancelling out entry barriers A similar dynamic is at work among commodity producers. Consider the case of iron ore miners. There are substantial entry barriers in the form of large initial capital investments, a large scale of operations and the time it takes to develop a new mine, which ranges from five to seven years. As per our calculations, the total capital cost for iron ore mining range from US$240-450 per tonne for the largest miners. Compared to these capital costs, the cash cost of production per tonne currently is at US$15 per tonne[6]. These large capital costs that serve as entry barriers also serve the role of exit barriers as an iron ore mine doesn’t have much of an alternative use. Again, the result of the exit barrier is sub-par profitability for the industry over the full business cycle. Mousetraps: Fixed costs and exit barriers Let’s say that we have an industry with strong but not insurmountable entry barriers. Let’s assume that the primary entry barrier in case of this industry is the production capacity and the only economically viable production size is at 30% of the industry size. Let’s further assume that there are three incumbent firms in the business with each one them operating at about 30% of the industry demand. The demand-supply imbalance that exists in this case will typically result in the existing firms earning supernormal returns on their capital. Attracted by excess returns earned by the industry, a new entrant commits enough resources to prevail over the entry barriers and enters the business. As the new competitor enters the business, the industry ends up with an oversupplied situation[7]. If exit barriers are high, either of the four firms will find it hard to exit the business with the result being a price war. The intensity of the price war in an industry with high exit barriers will depend on the underlying cost structures. The higher the proportion of fixed costs in the industry’s cost structure, the more intense the competition will be. For example, if any or all of the four competitors start to lose money if market share of a firm were to drop below say 26%, the price war will be extremely intense. The likely result of such an industry dynamic will be under-par returns on capital for all businesses in this industry, at least as long as the oversupply situation persists. This is the primary reason for poor profitability of the airline industry. The airline industry is characterized by high exit barriers. When faced with industry overcapacity, it becomes very hard for existing players to exit as it is hard to put the airplane to an alternative use[8]. Further, the industry has high fixed costs and so airlines engage in price wars to fill their seats. The result is extremely poor returns on capital. Extreme caution is appropriate when investing in an industry that is characterized by high exit barriers and high fixed costs, even if the industry has strong entry barriers. In such industries, there is always a competitor, typically the most inefficient one, who is willing to cut prices to grow market share. Typically, in such businesses, even the most efficient producer suffers as the cash cost of production of the marginal unit will be less than the total cost of production of the cost leader. Interaction of entry and exit barriers Figure 1 shows the interaction of entry and exit barriers. Within this framework, there are four market structures: Free flowers – Low entry barriers with low exit barriers: Existence of low entry barriers along with low exit barriers give rise to perfectly competitive markets. This is because any demand-supply imbalance is quickly resolved by entry or exit of market supply. Junkyards – Low entry barriers with high exit barriers: Such market structures give rise to nightmarish experiences to entrepreneurs. Demand-supply mismatch conditions where demand exceeds supply are promptly resolved by increased supply as new supply enters attracted by excess returns. However, once supply exceeds demand – which is how most demand excesses are resolved – industry’s returns on capital drops below cost of capital. This happens due to the existence of high exit barriers as existing players drop prices to acquire higher market share. Mirage – High entry barriers with high exit barriers: Such market structures give rise to cyclical markets. Depending on the number of competitors that the industry can support, returns on capital over time can range from miserable to reasonably good. Cyclicality of profitability for businesses in such industries is mostly driven by the existence of exit barriers. Any demand-supply mismatch where supply exceeds demand is resolved by price cuts as existing competitors compete to acquire market share[9]. Natural moats – High entry barriers with low exit barriers: Such markets give rise to natural moats. High entry barriers help keep competition away, allowing existing competitors to earn superiors returns. Further, low exit barriers allow excess supply to be weaned out such that any supply excesses are quickly resolved in favor of lower supply, reinstating industry’s profitability. Figure 1 : Interaction of Entry and Exit Barriers Just as Buffett talks of multiple components when discussing the desirable attributes of a good business[10], there are multiple components that determine the strength and sustainability of the competitive advantage of a business. However, barriers to entry and barriers to exit serve as the basic building blocks of that process. An investor who is able to appropriately judge the existence and strength of these two barriers is on his way to investment genius. [1] https://en.wikipedia.org/wiki/Moat [2] http://www.autoblog.com/2010/07/27/why-does-it-cost-so-much-for-automakers-to-develop-new-models/ [3] http://www.reuters.com/article/2012/09/10/us-generalmotors-autos-volt-idUSBRE88904J20120910 [4] http://online.wsj.com/mdc/public/page/2_3022-autosales.html#autosalesD [5] http://www.motorintelligence.com/m_frameset.html [6] http://www.smh.com.au/business/mining/bhp-inches-ahead-of-rio-in-game-of-cents-20150906-gjg4yl.html [7] 30% times 4 means supply now exceeds demand by 20%. [8] It is important to note that exit barriers do not refer to the ability of an incumbent to exit the business by selling out to another incumbent or a new entrant. The important consideration is whether or not the assets of the industry can be employed for an alternative use. If not, entry barriers will assert themselves whenever the industry suffers from overcapacity. [9] Such industries run into significant problems if a determined new entrant is willing to throw in enough capital and resources to overcome the entry barriers. If such a competitor is able to overcome the entry barriers and enter the business, the existence of exit barriers result in sub-par profitability for all players until such time that demand grows to match supply. [10] “…. it’s a simple business. It’s not an easy business. I don’t want a business that’s easy for competitors. I want a business with a moat around it. I want a very valuable castle in the middle. And then I want…the Duke who’s in charge of that castle to be honest and hardworking and able. And then I want a big moat around the castle, and that moat can be various things.” – Warren Buffett This article first appeared on Advisor Perspectives .

Time To Extract Value From CEF Investment Recommendation

Payoff Pitch Update – Time to Extract Value from CEF Investment Recommendation On July 20, 2015 we wrote a strategic article entitled “Finding Value in the Ninth Inning of the Great Bond Rally” which made the case for an investment in closed end mutual funds (CEF’s) backed by municipal bonds. This article reviews the original investment thesis, updates the reader on the performance and attributes of the securities we recommended and concludes with new advice on the position. In the original article, we analyzed 50 muni-backed CEF’s in order to select a manageable sub-set of securities offering the most potential. The analysis supporting the recommendation relied upon many self-imposed factors and risk constraints, many of which we will not rehash in this article and some of which we did not detail in the prior article. There are three factors, however, which are worth reviewing as we evaluate and potentially change our investment recommendation. They are as follows: Discount to Net Asset Value (NAV) – Closed end funds frequently trade at a premium or discount to their net asset value (current market value of the securities held by the fund). One of the driving factors behind our investment decision was the fact that many muni-backed CEF’s were trading at historically large discounts to their NAVs. We believed at that time, barring severe credit dislocations in the municipal bond sector that CEF investors would benefit from the normalizing discounts. Interest Rate Forecast – We have written numerous times that we expect the U.S. economy will continue to be plagued with weak economic growth and increasing deflationary pressures. Such an environment typically bodes well for fixed income assets, specifically those that are investment grade. This theory which would result in even lower interest rates was another factor supporting our recommendation. Municipal Yield Spread to Treasuries – Like all bonds, municipals trade at a yield spread, or differential, to U.S. Treasury bonds. Statistically, the relationship between municipal bond yields and Treasury bond yields exhibits a strong correlation. The spread can help astute investors create more dependable risk/reward forecasts. When the original paper was written, we calculated that municipal bonds were trading at a premium versus U.S. Treasury bonds. While the risk existed that the yield spread would normalize, we thought the advantages of the discount to NAV and our overriding interest rate forecast would more than offset the potential yield spread risk. Performance and Investment Attributes Since recommending the trade, the selected CEF’s have performed very well. The first table below highlights the performance of the CEF’s and the second set of tables, on the following page, compares the original attributes table to an updated version. Click to enlarge Data Courtesy: Bloomberg — A negative number in the premium/discount to NAV column represents a discount Within the tables are a few points worth detailing. First, the CEF’s, on average, have a total return of +10.39% or nearly +20% annualized. The graph below compares the cumulative total return of the CEF’s to that of the S&P 500 (-8.64%), IEF a 7-10 year U.S. Treasury ETF (+2.82%), and MUB a municipal bond ETF (+3.51%). The returns include both price appreciation and dividends. Cumulative Total Return CEF’s vs Popular Investment Alternatives Data Courtesy: Bloomberg Second, the discount to NAV, for all of the securities, improved. The CEF’s, on average, witnessed a 3% decrease in the discount. Think of this as appreciation in the value of the fund above and beyond changes to the value of the fund’s holdings. While all of the securities still trade at attractive discounts, they are currently trading back in line with their 3 year average. Third, the CEF’s also benefited from a drop in yields during this holding period. The lower CEF yields were a function of the aforementioned decrease in the discount to NAV, as well as a general move lower in municipal and Treasury yields. During the period, the average yield on the selected CEF’s fell by .43% while comparable Treasury yields fell by .22% and the Bond Buyer GO 20 Municipal Bond Index fell by .32%. The bonds underlying the funds, likely saw yields on average decrease more than Treasury bonds during this period. In bond market parlance one would say the municipal -Treasury yield spread tightened or became richer, to the benefit of municipal bond holders. Investment Review As previously mentioned at the time we wrote the article we were comfortable with the risk that municipal bond yields might underperform Treasury bond yields. Our thought being that any widening of municipal/Treasury spreads would likely be more than offset by our expectation for lower yields in general and the normalization of discounts to NAVs. Given the improvement in the discounts to NAV and lower yields, we need to re-address the risk that municipal yields underperform Treasury yields. Said differently, it is worthwhile here to assess the risk that the municipal-Treasury yield spread could widen or cheapen. The scatter plot below compares municipal-Treasury spreads as a percentage of Treasury yields through different interest rate environments since 2000. While there are many ways to evaluate the spread, the method shown is attractive as it accounts for spreads with consideration for the absolute level of rates. The effectiveness of this model is supported by an R-squared of .93, which denotes a very tight relationship between the factors. Data points that lie below the regression trend line are instances where the spread is considered tight or rich, with the difference between municipal yields and Treasury yields being lower than average. The opposite holds true for data points above the line. Municipal/Treasury Spreads as a % of Treasury Yields – January 2000 – Current Data Courtesy: St. Louis Federal Reserve (NASDAQ: FRED ) – Ten Year Treasury CMT vs Bond Buyer G.O. 20 Index The current spread is represented by the red dot, and the spread from July 2015 is yellow. By comparing the two highlighted data points, one notices the spread tightened further over the last 6 months. Statistically this can be quantified by measuring the distance between each dot and the trend line. During this period the spread moved from 1.40 standard deviations to 2.25 standard deviations below the trend line. The current spread, is now the tightest (furthest from the trend) that it has been since at least the year 2000. Current recommendation Given that the factors driving our original recommendation (discount to NAV and lower yields) are not as compelling today as they were in July, coupled with a probable widening of the municipal-Treasury spread, we are not as comfortable with the risk-reward scenarios as we were. To further appreciate the tight spread, consider that if the spread were to instantly revert back to trend, the prices on the bonds underlying the CEF’s, on average, would decline by about 3%. Given that the CEF’s employ leverage the likely price drop of the CEF’s would be greater than the drop in the bond prices underlying the CEF’s. Due to our concern over the potential for spread widening and weakened prospects for further discount normalization we are recommending that investors sell LEO (Dreyfus Strategic Municipal Fund) as the discount to NAV is nearing zero. We also recommend investors sell half of their shares in the other holdings. Take well-earned profits and remain vigilant on the remaining holdings, perhaps consider employing a stop loss order to sell shares. The remaining CEF’s still offer a sound value proposition.