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CEFA:
Welcome to CEF Insights, your source for closed-end fund information and education, brought to you by the Closed-End Fund Association. Today, we are joined by Doug Bond, Executive Vice President and Portfolio Manager with Cohen & Steers. Doug will discuss the closed-end fund market and the potential for a diversified portfolio of closed-end funds to provide solutions in a challenging market environment for income-oriented investors. Doug manages Cohen&Steers Closed-End Opportunity Fund (NYSE:FOF).
Doug, thank you for being with us today.
Doug Bond:
It’s my pleasure. Thanks for having me.
CEFA:
Doug, I want to start by looking at how the current market environment has impacted the closed-end fund space. Looking first at interest rates, the Federal Reserve has raised interest rates in five consecutive meetings and is likely to do more. How have closed-end funds historically behaved as the Fed initiated a cycle of interest rate increases?
Doug Bond:
Historically, closed-end fund discounts have widened out when the Fed has raised rates. That’s been the case here in 2022, and it’s a pattern we’ve observed going back decades. The fundamental reason for this is that most closed-end funds use leverage in their capital structure to enhance the level of income that they can pay to their shareholders. When the cost of that leverage rises, the funds typically have less total earnings and the expanding discounts reflect investor uncertainty about the levels of future earnings and dividends that the fund can pay.
CEFA:
The economic environment also has inflation running high and economic growth slowing, while significant geopolitical tensions have added to volatility. How has this market volatility impacted closed-end funds generally? And are you seeing greater impact in certain asset classes?
Doug Bond:
So far, most asset classes have suffered from hotter inflation and slower growth. Away from energy and commodity-focused funds, most NAVs and market prices are down. As to asset classes, fixed income funds have seen more pronounced discount widening while equity discounts on average have remained below their long-term averages. Perhaps we can attribute this to the company’s relative ability to protect earnings and dividends by raising prices in a higher inflation environment.
CEFA:
Many closed-end fund investors are income-oriented. Does the general widening of discounts benefit an income-oriented investor looking to put new money to work in the space? How should a fund’s use of leverage affect that investor’s consideration of a potential investment?
Doug Bond:
New money going into closed-end funds today benefits from improved discounts as well as higher current distribution yields. For instance, today, an index of taxable bond fund closed-end funds yields over 9.5%, whereas last year at this time, the yield was less than 8%. In general, buyers of closed-end funds today should expect potential dividend reductions in the future. As thus far, during the tightening cycle by the Fed, borrowing costs have risen for most funds and only a minority have cut the monthly dividend.
CEFA:
Doug, we mentioned FOF, the fund you manage, which focuses on investment in a diversified portfolio of closed-end funds. What is your process to evaluate potential investments? And how do you then make specific security selections and allocate those positions as you build your portfolio?
Doug Bond:
For FOF, we combine a top-down and bottom-up assessment in our investment process. In making specific security selections, we focus a lot on relative value while maintaining a focus on our overall objectives of high current income and potential for capital appreciation via a portfolio broadly diversified by asset class, fund sector, asset managers, and funds. Currently, because of uncertainty over the economy and company profits, our equity fund weight is at the lower end of its historic range, and we’re currently finding more bargains among the taxable bond closed-end funds than either the equity or muni parts of the market. Having said that, many of the more recently issued so-called 2.0 equity closed-end fund IPOs do offer compelling values today, and we’ve been adding to those.
CEFA:
What are the key factors that would lead you to sell a particular portfolio security?
Doug Bond:
The biggest drivers of the sell decision are relative value. If a fund is expensive to its own history or competition in the same sector, it becomes a candidate to reduce. If it’s expensive relative to its peers, adjusted for its track record as a steward of capital, it’s a candidate to be sold. If we feel there’s a risk of a distribution cut, it’s a candidate to reduce.
CEFA:
Are valuations in the closed-end fund space currently at attractive levels?
Doug Bond:
Coming into 2022, equity, taxable bond and muni funds all sold at valuations expensive to their 25 year long-term averages. Today, taxable bond and muni funds are cheap to those averages while equity remains expensive. But across all three major groups, we’re finding quality funds available at above average discounts with high current income.
CEFA:
Where do you see the best opportunities?
Doug Bond:
We would characterize the best opportunities today as fitting one of three profiles. First, the recent closed-end fund taxable bond and equity IPOs done on the so-called 2.0 structure. Based on our work, many of these are selling at between one and two standard deviations cheap from a best fit line, explaining the relationship between discount and dividend that describes the more seasoned group of 1.0 funds. Second, seasoned large-cap broadly diversified equity funds, selling at double digit discounts to NAV with good long-term track records. And then third, credit-sensitive taxable fixed income funds selling at double digit discounts and yields between 8.5% and 9.5% or greater. Groups where you can find these include multi-sector high yield, senior loan, and preferred.
CEFA:
What do you see as the key risks for closed-end funds in the current environment? Or are the risks more specific to a fund’s asset class?
Doug Bond:
The two most significant risks for closed-end funds are, one, structural, the leverage in the capital structure. This leverage amplifies the NAV, market price, and dividend risks associated with the closed-end funds, and two, the asset class risk. In the current environment with the Fed tightening, disentangling the structural, the leverage, from the asset class risk is tough because a policy error from the Fed, excessive tightening, could have profound consequences for many different closed-end fund sectors and funds with high degrees of economic sensitivity.
CEFA:
Doug, how would you see a diversified portfolio of closed-end funds being best positioned in an income-oriented investor’s portfolio?
Doug Bond:
For most investors, I think a diversified closed-end fund portfolio should be a high income complement to the equity portion of a client’s portfolio. The reason we think this is that the market prices of shares of closed-end funds are often quite volatile. Regardless of the underlying asset class target, the market price volatility is often quite equity-like.
CEFA:
Doug, thank you for sharing your thoughts with us.
Doug Bond:
It’s been my pleasure.
CEFA:
And we want to thank you for tuning in to another CEF Insights podcast.
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