Matthew Smith:
Hello and welcome to CEF Insights, your source for closed-end fund education and perspectives. I’m Matthew Smith with the Closed-End Fund Association and I’d like to thank you for joining us as we discuss the current closed-end fund environment, and what investors might be able to expect as we head into 2024.
I’d like to introduce Jeff Margolin, Senior Vice President with First Trust Portfolios, which manages a family of 14 closed-end funds. Jeff, it’s great to have you with us again.
Jeff Margolin:
Excellent. Thanks so much, Matthew. Very happy to be here.
Matthew Smith:
So Jeff, you author First Trust Quarterly Closed-end Fund Review. Let’s begin with your thoughts on the current closed-end fund environment as we move into the fourth quarter of 2023.
Jeff Margolin:
Sounds good, Matthew. It’s been a very challenging environment for closed-end fund investors, especially for the levered long duration, fixed income closed-end funds. They’ve been hurt as we’ve seen both short and long-term rates rise significantly this year, and that has created a very negative sentiment towards the closed-end fund structure. It’s led to distribution cuts, and it’s also led to very wide discounts to NAVs in the secondary market for closed-end funds, which we’ll talk about in a moment.
But first, let’s start with just some of the performance data year to date. And year to date through September 27th, the average closed-end fund is up barely about 1%, year to date. Equity closed-end funds are up 3%. Taxable fixed income funds are up approximately 5%. Muni closed-end funds are down 8%. I can talk more about that in a moment. Preferred closed-end funds also down about 6%. But some categories have benefited from the rising interest rate environment, specifically senior loan closed-end funds stand out this year, up 13% year to date. Limited duration closed-end funds, which tend to have shorter durations and focused on senior loans, shorter duration high yield, perhaps some mortgage backed securities, they’re up 8% year to date.
And another pocket of strength this year has been MLP closed-end funds, which are up about 14% year to date. And all that data, share price, total return data. Now, looking at the valuations of these very wide discounts to NAV, which currently exists in the secondary market, and this negative sentiment really is, in my opinion, centered around this aggressive Fed tightening that we’ve seen, which as I said, has led to a lot of distribution cuts, and certainly higher long-term rates has hurt the more longer duration fixed income funds. And it has led to unusually wide discounts in the secondary market, and an opportunity, in my opinion, as we’ll talk more about later, but through 9/27, the average closed-end fund was trading at a discount of 10%, that’s versus the 10-year average of a 6% discount.
And when I look at discounts, whether it’s an individual fund, whether it’s a category of closed-end funds, I always look at the current discount relative to the long-term average. And right now, most funds, many categories, are wider than their long-term average. Equity closed-end funds, average discount of 10% versus the 10-year average of 7%. Taxable fixed income funds, average discount of 7%, versus the 10-year average of only a 5% discount. Muni closed-end funds really stand out trading at significantly wider, or more inexpensive discounts than they historically trade at.
Indeed, through 9/27, or as of 9/27, the average muni closed-end fund was at a 14% discount to its net asset value. And that compares to the long-term average of only a 5% discount. And indeed, I went back over 20 years when looking at muni closed-end fund discounts, and as I said, we’re at a 14% discount as of 9/27. There’s only two other times in the past 20 years when discounts have been this wide. One was March of 2020, during the COVID shutdown, we saw discounts briefly get, indeed, wider than 14%.
And then the only other time was there were some moments during the fourth quarter of 2008, during the global financial crisis, when discounts from muni closed-end funds were this wide. But nevertheless, these are unusually wide discounts from muni closed-end funds and then preferred closed-end funds also really stand out, with average discounts of 11% versus the 10-year average of only 2%.
Looking at distributions, as the Fed has embarked on this very aggressive tightening campaign, which started early last year, it’s increased borrowing costs, leverage costs, for the roughly two thirds of closed-end funds that employ the use of leverage. And that’s led to a lot of distribution reductions. But despite that, we still have very attractive distributions, from my standpoint, in the secondary market for closed-end fund investors. The average closed-end fund as of 9/27 had a distribution rate of 8.5%. Equity funds were 9% taxable, fixed income funds 11%, and muni closed-end funds at 4.8%. So attractive distributions to be had, again, from my standpoint in the secondary market right now.
Matthew Smith:
Jeff, going back to discounts which have remained quite wide for a majority of closed-end funds throughout this year, when do you see discounts beginning to narrow, and what would you expect to be the catalyst for this?
Jeff Margolin:
Yeah, well, it’s tough to know for sure. My opinion is that when the Fed reaches its terminal rate, and indicates that they’re done raising short-term rates, that could be a catalyst to get discounts narrowing, for really two reasons. One, our fixed income strategists have looked back at prior tightening cycles, and historically when the Fed reaches that peak level, that terminal rate, many fixed income asset classes after that point, including municipal bonds, corporate bonds, mortgage backed securities, historically perform well once the Fed reaches that peak rate, that terminal rate.
So, if you can look forward six months or a year after the Fed stops raising rates, historically many fixed income asset classes perform very well. So, I think that could be a catalyst, the other catalyst which could help get discounts narrowing. I just think that this constant worrying about borrowing costs moving higher, roughly every six weeks or so, when the Fed meets that will be behind us when they signal that they’re done raising rates.
And I think that will improve the overall sentiment for closed-end funds. It could potentially lead to more distribution stability, which I think will be a positive. And I think it could, again, begin the process of seeing discounts narrowing.
Now, I am well aware that if the Fed does stop now, or maybe they raise one more time, borrowing costs will still be at a fairly high rate. But that constant drip, drip, every six weeks, of rates moving higher, having to worry about the Fed raising rates, and borrowing costs moving higher, that will be behind us and we’ll have a more stable borrowing cost environment, which I think could have a positive impact on the sentiment for the closed-end fund structure.
Matthew Smith:
Great. And Jeff, of course you have a background as an analyst. In your opinion, what factors should investors be evaluating as they look for investment opportunities among closed-end funds?
Jeff Margolin:
Yeah, we could probably do a whole podcast just on this topic, but if I had to summarize, or look at perhaps the most important four or five factors, and there really are a lot of factors to consider, here are a handful that really stand out. One, and most important, this is the top of the list in my opinion, you have to like the underlying fundamentals and the valuations of the underlying asset class that the fund is invested in. Because over time, the share price of the closed-end fund will be highly correlated to the fund’s NAV. So I think it’s very important to focus on funds where you think the underlying asset class is poised to perform well. Because over time, if you’re right, then the share price should track it.
So number one, from my standpoint, you’ve got to focus on the underlying asset class, and you like the fundamentals and valuations.
Two, certainly the portfolio manager, the portfolio management team, their expertise in that asset class is important, that their track record with other funds that they manage, that’s an important consideration. Three would be the valuation. I think the valuation, what we pay for anything, whether it’s a new car, a new suit, a bond, a stock, a closed-end fund, the valuation, the price we pay, is important. And so, I think the valuation of a closed-end fund, the premium, and or discount, is important. And again, I look at that discount, or that premium, relative to the funds historical average, to try and get a sense of if there’s value in that fund.
So, that would be third. Fourth, the distributions. After all, most funds, many funds have as their investment objective the goal of providing income. Many investors who invest in the closed-end fund structure are indeed looking for distributions, looking for income. So, the ability of a fund to maintain its distribution is important, and you can look at a fund’s earnings rate relative to what it’s paying out. And then the composition of the distribution, how much of the distribution is interest income, earned income, how much is capital gains, or return of capital?
We are seeing more funds for a portion of their distribution pay out a return of capital, so I want to look at that composition of the distribution as well. But realizing in this environment, with the Fed so drastically raising borrowing costs, it has been harder to find funds that have been able to maintain their distributions. Not impossible, but more of a challenge.
But again, distribution is an important factor. Excuse me. And then finally the leverage, the leverage structure, that there’s roughly 440 closed-end funds, approximately two thirds employ the use of leverage. So, I want to look at how much leverage is in a fund, have they locked in any of their leverage costs? They have a floating rate leverage, so that would be another factor. So that’s a handful, five factors, which I certainly would start with from my standpoint.
Matthew Smith:
Absolutely. And are there any particular asset classes or sectors where you believe closed-end funds currently offer opportunities that investors should consider?
Jeff Margolin:
I do. I think there’s a lot of opportunities right now in the secondary market. I like to use these periods of weakness that we’ve been going through, I know they’re frustrating in the short term, but ultimately I do think they can provide potential opportunity for longer term investors, willing to take advantage of the weakness and discounts. So, there are four areas, and this is not the only four areas that I find compelling, but certainly four that I want to focus on.
One, I’m a big believer in the long-term benefit and potential of investing in equity income, income closed-end funds, closed-end funds that are focusing on dividend paying stocks. And so, given the attractive valuations, the discounts in the secondary market, the distributions, I do think this is a good time to dollar cost average, and dollar cost average into equity income-oriented closed-end funds.
So, that would be one area. Two, and I guess three, while it’s clearly been a tough environment for some of the longer duration fixed income, closed-end funds, particularly levered long duration funds, they’ve been hit on both sides, short-term rates have gone up, so leverage costs have gone up long-term rates have gone up, so the value of the securities has gone down. But two areas that have been hurt recently, but I think are compelling for investors, would be municipal closed-end funds, and closed-end funds investing in preferreds. I think we’re closer to the end than the beginning of this Fed tightening cycle, and that, coupled with the wide discounts to NAV that exist in the secondary market, are compelling to me right now and attractive.
So, those would be two other areas along with equity income funds, muni closed-end funds, preferred funds, that I’d want to take advantage of this weakness and dollar cost average. And finally, I would look to add some shorter duration, limited duration, multi-sector funds. These are funds, again, which tend to have shorter durations, three or four years or less. They tend to be focused on shorter duration, fixed income asset classes like floating rate senior loans, sometimes shorter duration global bonds, or mortgage backed securities, or high yield. So, I think that can be an area to get attractive income, but also balance some of the duration risk associated with municipal closed-end funds and preferred funds.
So, those four areas right now I think blend well in a portfolio, at this point in time. I think there’s attractive valuations. I like the underlying asset classes. So again, looking longer term, I want to take advantage of this weakness, and add exposure to those four areas at this point.
Matthew Smith:
Great. Thanks Jeff. And before we wrap up our discussion, do you have any final thoughts as we go into the final months of 2023, and begin to think about 2024?
Jeff Margolin:
Well, I would encourage investors to remain patient, to remain disciplined, to remain focused on the long term. Again, it’s not necessarily fun to go through these volatile difficult periods, but historically they do create opportunities, but potentially for the longer term. And historically discounts this wide, as I said, 10% for the average closed-end fund, and wider for many individual funds, wider than their historical average by a significant amount in some cases, they historically don’t last forever. And eventually the good old-fashioned price discovery takes hold, discounts begin to narrow, and you historically see performance improve.
And again, I don’t know, I don’t think anyone knows, it’s hard to know when exactly that point in time will occur, but in my opinion, as I said earlier, I think the process could start when the Fed signals that they are done. So in the meantime, I want to… Again, I think this remains, from my standpoint, a compelling time for longer term investors to dollar cost average across several categories. I just named four that I find compelling right now. There’s attractive valuations, attractive distributions, let the distributions compound in your favor.
And again, I would just encourage investors to be disciplined and patient and focus on the longer term. And with that, thank you very much for having me today, Matthew.
Matthew Smith:
Great perspectives, Jeff, thank you so much for joining us. As always, it’s a pleasure to have you with us. And we want to thank also our viewers for joining us for another episode of CEF Insights. Thank you.
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