Select Closed-End Funds Can Provide Extremely Attractive Risk/Reward Investment Opportunities – Sometimes
Paul Borisoff - Oct 12, 2016
BlackRock’s A Guide to Investing in Closed-End Funds is a good four page primer on Closed-End Funds (“CEFs”) including some of the “Advantages” and some of the many “Important Considerations” unique to CEFs. From the guide: “Unlike open-end funds, CEFs have a fixed number of shares outstanding and do not issue or redeem shares to meet investor demand. Like other publicly-traded securities, the market price of CEF shares fluctuate and is generally determined by supply and demand in the market.”
In contrast to BlackRock’s definition, in Canada some CEFs have built in annual redemption dates at 100% of Net Asset Value (NAV) – so they do redeem shares in certain cases. Other Canadian listed CEFs have automatic rollover dates to an open-ended mutual fund – which then has daily liquidity at NAV. Over the past few years an increasing number of CEF IPOs in Canada have been issued with either a redemption date, or a roll over date, to get around a typical problem with CEFs – they often trade on the market at a significant discount to their NAV. Please note, that there have also been a few CEFs issued in Canada in recent years that have special redemption fees that may negate the attraction of redeeming at NAV. It is extremely important to do detailed due diligence (research) on both the CEFs investment strategy and the exact terms of any specific redemption features.
The extremely attractive risk/reward investment opportunity that select CEFs can provide - on occasion - is referring to the opportunity to buy desired investment exposure with active management (i.e. the CEF could hold bonds, convertible debentures, stocks, or a combination of some sort from a respected manager) - at an attractive discount to its NAV with an upcoming redemption date at 100% of NAV. We actively exploit these sorts of opportunities in our Diversified Income Portfolio – one of our discretionary Private Investment Management mandates – and will allocate up to 1/3 of the portfolio from time-to-time into these sorts of opportunities. Our largest positions this year – a CEF – is one of the big drivers of our performance this year - up 18.9% year-to-date to September 30th, 2016, and up 22.9% over the most recent 12-month rolling year period. More on this CEF position later.
In contrast to an open-end mutual fund, CEFs have two prices – their NAV and their market price. NAVs are usually updated daily (some weekly) on the issuing company’s web—site or on various third party sites. During times of market stress investors often panic and dump whatever they are holding onto the market without much consideration as to its underlying fundamentals. Liquidity further dries up as buyers that would otherwise be in the market bidding on desired positions “yank their bids” and retrench to the sidelines.
As an example, say a CEF focused on a Canadian stock portfolio is redeemable at 100% of NAV in 6 months – March 2017 – and has a NAV of $10 per unit as of the market close on Monday October 3rd (updated on their website Tuesday morning, October 4th). If the market opens up relatively unchanged on Tuesday morning and units are bought at $9.50 per unit – these units were bought at an estimated discount to NAV of ~ 5%. The return over the next 6 months will then be the change in NAV plus the $0.50 discount that the Fund was bought at. If the NAV remains at $10 – and assuming no distributions and a redemption at NAV - your realized return would be ~ 5.3% ($0.50 divided by your $9.50 cost). However, as is often the case, fear levels will skyrocket from time-to-time leading to market declines that quite often get exaggerated in the market price of CEFs due to poor liquidity. General market anxiety will also sometimes cause CEFs to trade at exaggerated discounts to NAV for days, weeks, or even months at a time. In the above example, if the market opened up down 2% it would be not be surprising to be able to buy the same position at $9.00 per unit, instead of $9.50. In this case you would be buying units at an estimated discount to NAV of 8.2% (knock 2% off the previous day’s closing NAV of $10 to reflect the market sell-off - so an estimated NAV of $9.80 per unit). In 6 months if the NAV remains at $9.80 per unit in this 2nd example – and again assuming no distribution payments and a redemption at NAV - your estimated realized return will be ~ 8.9% ($0.80 divided by your $9.00 cost). In this 2nd example, if the market continued to drop over the next 6 months – resulting in the Fund’s NAV dropping to $9.00 per unit at the redemption date (down 8.2%) your realized return would now be zero on the investment - not a bad outcome as buying the Fund at the discount provided you with 8.2% of downside protection or “insurance.” Alternatively, if instead the market goes up over the next 6 months driving the Fund's NAV up $0.80 to $10.60 (up 8.2%) the realized return would be 17.8% in this 2nd example ($1.60 divided by your $9.00 cost). In effect, buying the Fund at a discount “boosted” your return significantly from what the market delivered, or a comparable “open-ended” mutual fund or Exchange-Traded Fund (ETF) would have delivered.
In Canada CIBC Wood Gundy publishes a “Canadian Closed-End Funds Monitor” which most recently listed 144 CEFs traded on the TSX alphabetically, and also listed them by largest to smallest discounts to NAV. This report can be a good starting point to look for opportunities – but again it is extremely important to do some detailed due diligence on both the CEFs investment strategy and the exact terms of any specific redemption features. Note – many CEFs do not have any redemption features and trade at very deep discounts to NAV – and they may always trade at a deep discount to NAV - possibly in perpetuity… There are other reasons why one might want to buy one of these “non-redeemable” CEFs – but we are not focusing on those here. It is important though to know what the terms are for what you are buying if you don’t like surprises with your investments.
A real example of what I believed was a very attractive risk/reward CEF investment opportunity – and still is in my opinion:
PIMCO – a division of Allianz – is one of the largest asset managers in the world and specializes in Fixed Income Investments. Globally the firm has 2400 employees and manages approximately $1.5 trillion, including $30 billion in Canada. The PIMCO Global Income Opportunity Fund was launched as a CEF onto the TSX in March of 2014 with a built-in redemption date in March of 2017 at 100% of NAV. This Fund pursues income opportunities across global fixed-income sectors – managed from a Canadian investor perspective in regard to currency hedging. The Fund’s multi-sector approach allows it to seek out PIMCO’s best income-generating ideas in any market climate, targeting multiple sources of income from a global opportunity set. It also employs some leverage.
Fund highlights from PIMCO’s website:
- Offers access to PIMCO’s best income-generating ideas across multiple global fixed-income sectors.
- Investments may include mortgage-backed securities, investment-grade and high-yield corporates, developed and emerging markets corporate and sovereign bonds, other income producing securities and related derivative instruments.
- Dynamic sector allocation reflects PIMCO’s macroeconomic views and assessments of relative value and credit market trends.
- Closed-end vehicle allows the fund’s managers to invest in less-liquid securities, which tends to increase risk and potential returns.
- Benefits from PIMCO’s robust credit research capabilities and risk management.
This Fund closed at $8.60 per unit on September 30th, 2016 (NAV of $9.05) – and has a current monthly distribution rate of $0.0569 per unit ($0.683 per year) – which PIMCO increased on September 21st, 2015 from an annual rate of $0.65 per unit– a good sign. At the end of September the Fund was therefore yielding 7.9% based on its on closing market price and yielding 7.5% based on its NAV. At approximately $600 million in size it is one of the largest CEFs in Canada – and one of the most liquid (easy to buy and sell).
I value PIMCO’s skill as a fixed income manager, and I like the flexibility and positioning of this particular ‘strategy.’ The opportunity to buy this Fund at significant discounts to its NAV – with an upcoming redemption date at 100% of NAV - was and still is an attractive risk/reward proposition in my opinion. Close to a “No Brainer” as they say.
Between June 30th, 2015 and December 31st, 2015, we increased our exposure to this Fund from 4.9% of our Diversified Income Portfolio discretionary mandate to 20.2% via 16 separate transactions that we acquired at average discounts to NAV of ~ 7%. In our January 6th, 2016, update to clients we highlighted that we had an expected return for this position of 16.5% over the next 15 months (to the March 2017 redemption date) plus or minus the change in the Fund’s NAV over this period. The Fund closed 2015 at $7.92 per unit – a 5.5% discount to its year-end NAV of $8.38 per unit. We had an expectation of receiving $0.85 of distributions over the next 15 months ($0.0569 per unit per month) – and planned on redeeming it at 100% of NAV as of March 31st. If the Fund’s NAV was stable over this period we would redeem at ~$8.38 per unit (receive the proceeds in April) and would have collected ~ $0.85 over the 15 month period. $8.38 plus $0.85 is $9.23 – less the $7.92 per unit starting point in this example works out to a $1.31 gain – or an expected 16.5% return over the 15 month period assuming a stable NAV.
Year-to-date (9 months in) this Fund has returned 15.0% based on market price appreciation and 9 distributions payments. The Fund has increased in market price to $8.60 per unit as of September 30th from $7.92 at the beginning of the year – and has paid out $0.51 in distributions. The market price has increased because PIMCO has done a great job with the portfolio (their job)– growing the NAV from $8.38 at the beginning of the year to $9.05 as of September 30th after distributing out $0.51. This is a 9-month return of ~ 14.1% on a NAV basis.
Also, this CEF closed September 30th at a 5.0% discount to its NAV. This is actually a more attractive discount than it was when we acquired most of our position in 2015 (~7% discount to NAV), and at the beginning of the year (~ 5.5% discount to NAV) as we are now only 6 months away from triggering the redemption at NAV. As of September 30th we now have an expected return for this Fund of 9.2% over the next 6 months (to the March 2017 redemption date) – again plus or minus the change in the Fund’s NAV over this period.
In summary, buying “discounted” CEFs with upcoming redemption dates at 100% of NAV will either “boost” your return by the “acquired discount” or provide some “downside protection.” Not a bad outcome in either case.
Please note that investing in CEFs may not be suitable for all investors as there are unique characteristics and risks involved that can include, but not limited to, liquidity risk, market risk of the underlying portfolio, and the magnifying effect of leverage in certain cases.
Please call me if you would like to find out if CEFs are suitable for you or more information our Diversified Income Portfolio.