Black Friday discounts in the closed-end fund market

Nov 25, 2020
  • BlackRock

The closed-end fund market was marred by volatility in 2020, leading to the potential for tax loss selling in Q4 – this may provide opportunities to buy select high yielding sectors at attractive discounts

Historically, fourth quarter tax loss selling of closed-end funds (“CEFs”) has been prevalent in the market. CEFs may be more susceptible to tax loss selling given they trade on a stock exchange and market prices (investor return) can deviate from underlying net asset values (“NAVs”) (fund return).  Additionally, CEFs typically provide attractive income to shareholders through monthly distributions, which are paid out of the fund’s NAV.  These dynamics may create an opportunity for the investor to realize a “tax loss”, even in situations where the investor’s total return is positive.  This selling results in additional supply and may further reduce a fund’s market price.  Selling may be amplified in asset classes that experience elevated levels of volatility in a given year.

Exhibit 1 - The January effect
Average change in monthly premium/discount: 2000-2020

Chart the January effect

Source: Morningstar as of 9/30/20. Performance results reflect past performance and are no guarantee of future results.

Based on historical trends, investors that have purchased CEFs in the latter part of the fourth quarter have generally realized the benefits of tax loss selling through the short-term effect of discount narrowing (market price outperforms NAV) most prevalent in the month of January.  Notably, on average CEF discounts have narrowed in January in 16 out of the last 20 years.  This consistency may be attributed to the ‘January Effect’.  According to this theory, pent up demand following tax loss selling may be the factor driving the outperformance as investors re-enter the market after selling positions in prior months to harvest taxes and rebalance their portfolios.  Based on historical trends, tax loss selling in 2020 may present an attractive entry point for long term investors to reap the rewards of a temporary mispricing in the CEF market.

A Look Ahead

The market volatility in 2020 has resulted in negative market price returns in several CEF categories, however, NAV returns have held up relatively well, excluding the Master Limited Partnership (“MLP”) sector (Exhibit 2).  

Exhibit 2 – Year to date CEF returns

Category YTD Return (Market Price) YTD Return (NAV) Current Premium/Discount 1 Year Average Premium/Discount
MLP -70.0% -60.8% -26.3% -15.8%
Equity (Option Strategies) -10.5% -4.0% -10.0% -5.6%
Bank Loan -10.0% -3.9% -12.8% -9.7%
High Yield -8.8% -3.7% -10.7% -7.9%
Sector Equity -6.1% 1.5% -11.3% -8.8%
General Bond -5.3% -1.5% -3.5% -0.5%
State Municipal -1.4% 1.6% -7.3% -6.9%
Municipal -0.8% 1.5% -6.2% -5.6%
Investment Grade 3.4% 4.3% -6.9% -7.1%
All CEFs -9.2% -5.0% -8.9% -6.7%

Source: Lipper as of 10/31/20. Performance results reflect past performance and are no guarantee of future results. Returns are shown net of advisory fees paid by the fund and net of the fund’s operating fees and expenses.

Negative market price returns in the short term may present long term value opportunities for investors seeking to take advantage of tax loss selling in 2020.  Exhibit 3 illustrates the consistency of outperformance for CEFs relative to their mutual fund counterparts over the long term in certain select categories.

Exhibit 3 – CEFs have outperformed mutual fund counterparts over the long-term
5-Year Total Returns

CEFs have outperformed mutual fund counterparts over the long-term

Source: Morningstar.  Data as of 9/30/2020. Returns show the average annualized NAV return.  Past performance is no indication of future results.  Performance shown is the average for the funds in the category; individual fund performance could have been positive or negative.  CEFs represented by the following Morningstar categories: Municipal represented by US CE Muni National Long, High Yield represented by US CE High Yield Bond, Bank Loans represented by US CEF Bank Loan, Multi-Sector Bond represented by US CE Multisector Bond, Equity (option strategies) represented by US CE Options-based.  Mutual Funds represented by the following categories: Municipal represented by US Fund Muni National Long, High Yield represented by US Fund High Yield Bond, Bank Loans represented by US Fund Bank Loan, Multi-Sector Bond represented by US Fund Multisector Bond, Equity (option strategies) represented by US Fund Options-based.

Further, with central banks keeping interest rates low and negative yielding bonds increasing across the globe, we believe investors seeking high income should consider CEFs in this environment. For example, CEFs are currently yielding an average of 7.3% on market price, which compares to 3.8% for the average mutual fund. The increasing need for income could boost the demand for CEFs, potentially leading to tighter discounts in the future.

Potential long-term value and opportunities in the CEF space

Credit:
Credit CEFs (high yield bonds and bank loans) were decimated in early 2020, however, aggressive measures taken by central banks and the structural demand for income have helped recover losses sustained earlier in the year. Despite these strong price returns, credit spreads remain wider than where they began the year (Exhibit 4).

Exhibit 4: High Yield and Bank Loan credit spreads are still wider than the beginning of the year
Historical high yield and leveraged loan spreads

Historical high yield and leveraged loan spreads

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and it is not possible to invest directly in an index. Sources: 1. S&P LCD, Barclays as of 11/13/20. HY Index is the BBG Barclays US Corporate High Yield Index and HY spread = OAS. Loan Index is represented by the S&P Leveraged Loan index and Loan spread = Spread to Maturity.

Long term investors seeking above-average income with a higher risk tolerance may want to consider credit CEFs.  The High Yield CEF category is currently trading at an average -10.7% discount, wider than its 5-year average discount of -7.9%.  Similarly, Bank Loan CEFs are currently trading at an average -12.8% discount, wider than its 5-year average discount of -7.3%.  The potential for spread tightening, in addition to the potential for discount narrowing, may provide attractive capital appreciation opportunities longer term.  Moreover, with the average High Yield CEF yielding 8.8% and Bank Loan CEF yielding 8.1%, investors have the potential to receive a healthy income stream while they wait. 

Below are some BlackRock CEFs with these themes:

Ticker Fund Category Premium/ Discount Distribution Rate
FRA Floating Rate Income Strategies Fund Bank Loan -13.0% 8.0%
DSU Debt Strategies Fund Bank Loan/High Yield -12.4% 8.5%
BGT Floating Rate Income Trust Bank Loan -12.1% 7.9%
HYT Corporate High Yield Fund High Yield -4.0% 8.3%

Equity:

Equity CEFs that use covered calls (Equity – Option Strategies) are currently trading at a -10.0% discount, wider than their five-year average of -3.1%. Historically, equity covered call strategies have produced lower downside capture ratios than their underlying index for the funds. In addition, the funds have achieved higher upside capture ratios than their downside capture ratios since their respective inceptions. This asymmetric capture ratio means that, on average, the funds have achieved greater participation in rising markets with comparably lower participation in declining markets. The use of covered calls also provides cash flow to the portfolio and helps support higher distribution payments. For example, the average Equity (Option Strategies) CEF is currently yielding 9.0%.

Below are some BlackRock CEFs with these themes:

Ticker Fund Category Premium/ Discount Distribution Rate
BCX Resources & Commodities Strategy Trust Natural Resources -18.1% 7.7%
BOE Enhanced Global Dividend Trust Global Dividend -13.9% 7.4%
BDJ Enhanced Equity Dividend Trust US Dividend -13.2% 7.8%
BGY Enhanced International Dividend Trust International Dividend -12.4% 7.3%
BGR Energy and Resources Trust Energy -12.4% 8.8%
CII Enhanced Capital and Income Fund US Large Cap -11.0% 6.5%
BSTZ Science and Technology Trust II Technology -10.2% 4.8%
BMEZ BlackRock Health Sciences Trust II Healthcare -6.5% 4.7%
BST Science and Technology Trust Technology 1.6% 4.9%
BUI BlackRock Utilities, Infrastructure, & Power Opportunities Trust Utilities 3.3% 6.1%
BME Health Sciences Trust Healthcare 4.4% 5.2%

Source: BlackRock as of 11/15/20. Distribution rate is calculated by annualizing the latest declared distribution and dividing by market price return as of 11/15/20.

Tax loss selling into year-end may continue to pressure CEF discounts in the short term, however, these wide discounts may offer long term investors the potential to benefit from price appreciation in addition to attractive levels of income.