Closed-end fund discount narrowing techniques

James Quackenbush, The Daily Record Newswire

Investors are constantly looking for undervalued investments. One investment vehicle that is often undervalued relative to its underlying assets are closed-end funds (CEFs).

CEFs are SEC registered 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 and in accordance with a stated investment objective. Typical investments include stocks and bonds, as well as alternative investments.

After the IPO, shares are bought and sold on an exchange, and the market price of the shares are determined by supply and demand reflected by the secondary market price, not by aggregate market value of their underlying assets, or net asset value.

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 the fund trade closer to its true intrinsic value. These programs could include implementing a managed distribution policy, conducting a tender offer or performing an open-market share repurchase program.

When these programs are utilized by CEF management companies, existing shareholders usually benefit because demand for the fund will increase, which typically increases the secondary market price and causes the fund to trade closer to its 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 provide a predictable amount of cash flows through the form of cash distributions (dividends). Normally, a fund will commit to an annual distribution rate of 6, 8 or 10 percent of the fund's assets, depending on the fund investment strategy, which is 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.

When looking at distribution policies, though, it is important to remember that the payout rate is not yield. When a CEF has dispersed all dividends, interests and realized capital gains generated from assets in the fund, the fund will resort to returning capital to meet its 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 and is also not taxable income. Furthermore, 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 investors.

Another discount narrowing method used by CEFs is to conduct a tender offer. Tender offers give shareholders the opportunity to sell a portion of their shares (that are trading at a deep discount) back to the fund company at or near NAV. For example, if a CEF is trading at a 15 percent discount to NAV, management could propose a 10 percent tender offer to investors of the fund 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. After the tender is complete, shareholders would receive cash from the shares tendered, and would realize a 17 percent profit above the fund's secondary market price.

Lastly, management of CEFs can facilitate an open-market share repurchase program to narrow the trading discount of a fund. A share repurchase program is an anti-dilutive technique that allows a fund company to repurchase their own shares in the secondary market if the fund is trading at a discount level that management feels will be accretive to NAV and also add value for existing shareholders.

Usually, management of a CEF will authorize the fund to purchase a certain percentage of the outstanding shares over a period of time if the fund is trading wider than a double-digit discount. Shares that are purchased by the fund at a discount are retired at NAV, reducing the amount of outstanding shares of the fund and the difference is accretive to NAV, which increases shareholder value.

While CEFs may, over time, 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.

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James Quackenbush is a senior domestic equity analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.

Published: Mon, Mar 02, 2015

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