Discount narrowing methods of CEF managers

By James Quackenbush The Daily Record Newswire Investors are continuously looking for undervalued investments that over time have the opportunity to increase in value and offer superior investment returns. One investment vehicle that is frequently undervalued relative to its underlying assets are closed-end funds. CEFs are investment companies that issue a limited number of shares to investors through an initial public offering. The fund company uses the investment capital raised from the IPO to invest in a portfolio of securities, typically stocks, bonds, or a combination of both. After the IPO, shares are bought and sold on a stock exchange (secondary market), and the market price of the shares is determined by supply and demand reflected by the secondary market price, not by net asset value (NAV). Since CEFs trade on a stock exchange, some funds may become vastly undervalued, trading at discounts of 15 to even 20 percent of their NAV price. When CEFs persistently trade at large discounts to NAV, fund management can implement discount management programs to help narrow or even eliminate the discount at which the fund is trading. These programs consist of implementing a managed distribution policy, conducting tender offers, and performing an open-market share repurchase program. When these programs are utilized by CEF management, existing shareholders stand to benefit through the increase demand for the fund, which will increase the price of the fund in the secondary market, reducing the discount from NAV. One of the most effective discount narrowing methods used by management of CEFs is to offer shareholders a managed distribution policy. A managed distribution policy is the fund's commitment to shareholders to provide a predictable amount of cash flows through the form of cash distributions. Normally, a fund will commit to an annual distribution rate of 6, 8 or 10 percent of the fund's assets, typically distributed on a monthly or quarterly basis. The payout will generally be comprised of dividend income, interest income, capital gains generated from the fund's investment portfolio, and in some cases return of capital. However, when a CEF adopts a distribution policy, the payout rate can be misinterpreted as yield. When a CEF has distributed all dividends, interests and realized gains generated from assets in the fund, the fund will payout return of capital to meet the distribution obligation. The portion of a payout that comes from return of capital is actually the fund company giving shareholders part of their original investment back, which cannot be considered yield. However, when a fund is purchased at a discount, the portion of the payout that is return of capital is receiving full dollar value for an investment that was originally purchased at a discount, adding extra value for shareholders. Another discount narrowing method used by CEF management is to offer shareholders a tender offer, which gives shareholders the opportunity to sell a portion of their shares at or near NAV. Tender offers can vary in structure but in essence the fund management will offer to buy (tender) a percentage of the outstanding shares of a CEF near the current NAV price. In many cases the fund will tender shares for cash but in some circumstances shareholders may receive securities held within the fund instead. For example, if a CEF is trading at a 15 percent discount to NAV, management could propose a 20 percent tender offer at NAV. If the NAV price of a fund is at $10 and the secondary market is trading at $8.50, shareholders would receive $10 for shares tendered through the offering. Once shareholders have received their cash from the tender offer, they would have realized a 17.6 percent profit over where the fund is trading at in the secondary market. Lastly, management of a CEF can facilitate an open-market share repurchase program to help narrow the trading discount of a fund. A share repurchase program is an anti-dilutive technique that allows the fund company to repurchase their own shares in the secondary market if the fund is trading at a discount level that management feels will add value for existing shareholders. Usually management of a CEF will consent to purchase a percentage of the outstanding shares on the secondary market over a specified period of time if the fund is trading at a discount wider than a stated discount -- typically if the fund is trading wider than a 10 percent discount. When an open-market repurchase program is adapted, it is intended to increase the fund's net asset value per share and also provide additional liquidity in the secondary market, which will help narrow the discount the fund is trading. Additionally, shares that are purchased by management are retired, reducing the amount of outstanding shares of the fund, which increases shareholder value. While CEF may overtime trade at wide discounts to their NAV, management of the funds have discount narrowing techniques that can be used to address persistently wide discounts. When these techniques are used, it usually results in decreasing the discrepancy between the price a CEF is trading for in the second market relative to the fund's NAV. It also demonstrates that the management of the CEF is monitoring the trading discount of the fund and is willing to take steps to address the trading discount if needed. ---------- James Quackenbush is an analyst/portfolio manager for Karpus Investment Management, an independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. He can be reached at (585) 586-4680. Published: Thu, Apr 12, 2012