INVESTING

Discount double check in CEFs

Apr 15, 2020
  • BlackRock

Closed-end funds are currently trading at a discount as equity markets have dropped. Here’s where to spot opportunities.

The Dow Jones Industrial Average just closed out its worst first quarter on record, after a dropping 23% since the start of the year1. The selloff has disproportionately affected equities relative to bonds, potentially resulting in an overweight to bonds in investor portfolios – and potential bargains for value investors.

We believe investors should consider rebalancing back to their strategic equity allocations. As you look to re-allocate to equities, today’s post focuses on equity closed-end funds (“CEFs”) and seeks to differentiate between what we believe are “value opportunities” and “value traps”.

Focusing on the long term

CEFs effectively have two values for investors to evaluate. One is fund’s net asset value (“NAV”), or the aggregated value of its underlying holdings. The other the market price of the CEF itself as it’s traded on the exchange. In the recent equity decline, CEF market prices have generally fallen more than their respective NAV’s as investors sought to de-risk their portfolios. We believe this presents a unique entry point for long-term investors to buy equity securities at a “discount” to their current market value and be well positioned when markets recover with time.

Additionally, our research shows that CEF discounts tend to mean-revert to historical averages (exhibit 1).

Avoiding value traps

Not all discounts are created equal, however. CEFs can trade at premiums or discounts for a number of reasons, including market and investor sentiment and fund-specific characteristics such as performance and distribution rate. It’s essential to focus on a CEFs historical premium or discount over various periods and factor in specific catalysts that may cause a fund’s valuation to re-rate.

One useful tool to weed out potential “value traps” is the z-stat which looks at how a fund’s discount has traded over a period time and adjusts for volatility. In simple terms, the more negative the z-stat, the greater the potential value relative to the fund’s historical trading range. Fortunately, the data are easily accessible. The z-stat for any CEF can be found on cefconnect.com under “Pricing Information” on the individual fund pages.

Monetizing total return

Many equity CEFs, including all of BlackRock’s CEF equity products, use a managed distribution plan, in which the fund sponsor aligns the fund’s distribution rate with the long-term expected total return of the portfolio. A large portion of the distribution will be funded through capital appreciation (realized or unrealized capital gains), essentially “monetizing” total return in the form of a monthly distribution to investors. This allows equity CEFs to potentially pay out more than their ETF or mutual fund counterparts. The median annual distribution rate for equity CEFs is 9.2%, compared to 2.5% for equity ETFs and 2.0% for equity mutual funds, according to Morningstar.

Invest in tomorrow’s potential winners

As you reallocate to equities, consider building an all-weather portfolio by focusing on higher-quality companies that can participate in bull markets and potentially deliver greater resilience when stock prices decline:

  1. High quality: High-quality companies tend to have strong balance sheets (e.g., low levels of debt), good earnings trends, and ample cash flow above ongoing business needs. These elements can provide companies with flexibility during periods of economic uncertainty and help them to endure and adapt to changing operating environments.
  2. Dividend growers: Dividend growers possess many of the quality characteristics noted above, as earnings growth and free cash flow are the fuel for increasing dividend payments over time. Importantly, these companies have demonstrated a history of outperformance versus non-dividend payers and the broader U.S. equity market (exhibit 3).

Below are some BlackRock CEFs with these themes:

Ticker Fund Category Premium/Discount Distribution Rate
BDJ Enhanced Equity Dividend Trust US Dividend -10.3% 9.2%
BOE Enhanced Global Dividend Trust Global Dividend -14.4% 9.1%
BGY Enhanced International Dividend Trust International Dividend -15.1% 9.0%

Source: BlackRock as of 3/31/20. Distribution rate is calculated by annualizing the latest declared distribution and dividing by market price return as of 3/31/20.

Investors may also with to be opportunistic in the current environment, by establishing positions in market themes underpinned by long-term structural trends, including:

  1. Healthcare: Healthcare is supported by a number of long-term secular growth drivers. Aging demographics and increased life spans should mean increased healthcare spending in the years to come. Innovation is happening across the industry, in areas such as drug development, digital technology and data science. Emerging market countries will increase their health care spending as their economies grow. All these factors should support long term growth in the sector.
  2. Technology: Technology has long been a driver of growth in investors’ portfolios. While technology stands alone as a sector, it permeates companies throughout the equity market. The use of technology is reshaping industries across the globe, creating unique growth opportunities, creating a strong structural backdrop for long-term growth in the sector.

Below are some BlackRock CEFs with these themes:

Ticker Fund Category Premium/Discount Distribution Rate
BME Health Sciences Trust Healthcare 0.6% 6.7%
BMEZ Health Sciences Trust II Healthcare -3.3% 7.1%
BST Science and Technology Trust Technology 0.4% 6.9%
BSTZ Science and Technology Trust II Technology -7.1% 7.2%

Source: BlackRock as of 3/31/20. Distribution rate is calculated by annualizing the latest declared distribution and dividing by market price return as of 3/31/20.

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