Closed-End Funds

Expanding your search for income

Summary

Recent action by the Federal Reserve and central banks across the globe have pushed yields lower, leaving investors searching for income. We think Investors should consider taxable fixed income closed-end funds to meet their cash flow needs.

The coronavirus induced sell-off has created extreme volatility across markets. This has led to a strong wave of monetary and fiscal stimulus to stabilize markets and support economic activity. For example, a dovish Federal Reserve (the “Fed”) lowered its policy rate to close to zero for the second time in the last decade. This seems to be the new normal, as the Fed stated that they may keep the policy rate at close to zero through 2022. Central banks across the globe have also been very accommodative, keeping rates low and in some cases negative. Now, more than ever, investors are looking for new sources of income as traditional fixed income assets aren’t providing the same level of cash flow they once were. In this environment, we believe coupon income is crucial and could be a significant portion of fixed income total returns going forward.

Often overlooked, closed-end funds (“CEFs”) could fill the income gap as they have historically provided above-average levels of cash flow. Given certain structural advantages and the potential to buy assets at a discount, we think that taxable fixed income CEFs could offer investors access to attractive income opportunities across the credit spectrum.

CEFs are built for income

The “closed” structure allows portfolio managers to employ unique investment strategies that may enhance income and returns over time:

Investing for the long term

CEFs typically raise capital through an initial public offering (“IPO”) similar to other publicly listed companies. Following the IPO, a CEF trades on a national stock exchange, one investor to another, in a set number of shares. This stable pool of capital means portfolio managers don’t have to consider deploying new cash inflows or forced sales from cash outflows and allows them to stay invested for the long term.

Leverage

Leverage seeks to profit from the spread between borrowing costs, typically based on short-term interest rates, and higher investment rates. Current borrowing costs are historically low given the Fed’s commitment to hold short-term rates near zero, creating a favorable environment to employ leverage to increase income in the portfolio.

Harvesting the illiquidity premium

CEFs may pursue investment strategies that focus on a broader opportunity set, including less liquid and private investments that may offer higher return and income potential.

These structural advantages mean CEFs may offer higher income relative to traditional fixed income investments. For example, the average taxable fixed income CEF is currently yielding 8.5% compared to the Bloomberg Barclays Aggregate Index which yields 1.3%.

Exhibit 1: Taxable Fixed Income CEFs offers competitive income in a low yield world

Exhibit 1: Taxable Fixed Income CEFs offers

Source: Morningstar as of 6/26/20. Aggregate Bond Index is measured by the yield to worst of the Bloomberg Barclays US Aggregate Bond Index. High Yield Index is measured by the yield to worst of the Bloomberg Barclays US Corporate High Yield Index. Taxable Fixed Income CEFs are represented by the following Morningstar CEF Categories: Bank Loan, Convertibles, Corporate Bond, Emerging Markets, High Yield, Inflation Protected, Intermediate Core Bond, Intermediate Core-Plus Bond, Intermediate Government, Long Term Bond, Multi-sector Bond, Non Traditional Bond, Preferred Stock, and World Bond. Intermediate Core Bond is represented by the Morningstar Intermediate Core Bond CEF category. Past performance is not indicative of future results. You cannot invest directly in an unmanaged index.

Finding income across the credit spectrum

The credit quality of the underlying portfolio is also an important factor for investors to consider. The taxable fixed income CEF universe is a diverse group of funds with varying degrees of credit risk.  The recent sell-off illustrates that higher credit quality CEFs, which includes the Morningstar Intermediate Core Bond Category, displayed relative resilience amid heightened volatility whereas credit CEFs, which includes the Morningstar High Yield Category, tracked equities lower (Exhibit 2). Conversely, credit CEFs have rebounded with equities, outperforming higher credit quality CEFs, as the economy shows signs of recovery and the market has rallied from the March lows.

Exhibit 2: Higher Quality CEFs have held up better during the volatility in 2020
Growth of $100

Exhibit 2: Higher Quality CEFs have held up better during the volatility in 2020

Source: Morningstar as of 6/26/20. Growth is based on CEF net asset value. Taxable Fixed Income CEFs are represented by the following Morningstar CEF Categories: Bank Loan, Convertibles, Corporate Bond, Emerging Markets, High Yield, Inflation Protected, Intermediate Core Bond, Intermediate Core-Plus Bond, Intermediate Government, Long Term Bond, Multi-sector Bond, Non Traditional Bond, Preferred Stock, and World Bond. Intermediate Core Bond is represented by the Morningstar Intermediate Core Bond CEF category. Past performance is not indicative of future results.

Long term investors seeking above-average income with a higher risk tolerance may want to consider credit CEFs. Despite the recent rally in risk assets, credit spreads have widened year to date (see Exhibit 3) and the average credit CEF is trading at a 8.9% discount. Aggressive measures by central banks, including purchases of corporate debt, have provided a favorable backdrop for credit. We believe the combination of high income and potential capital appreciation from rising bond valuations and narrowing discounts, could provide an attractive investment opportunity.

Exhibit 3: Credit spreads are still wider than year end, potentially leaving room for upside

Exhibit 3: Credit spreads are still wider than year end

As of 7/6/20. 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 6/16/20. 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.

Ultimately, investors should evaluate CEFs based on their risk tolerance, knowing the more risk you take, the greater the potential yield and return, and vice versa. Below you can find a list of all BlackRock’s taxable fixed income CEFs broken down by strategy. BlackRock's higher credit quality CEFs^1^ include EGF, BHK, BKT, and BBN.

 

Ticker Fund Strategy Premium/Discount Distribution Rate (Market Price)
FRA Floating Rate Income Strategies Fund Bank Loan -15.4% 8.6%
BGT Floating Rate Income Trust Bank Loan -14.1% 8.4%
DSU Debt Strategies Fund Bank Loan/High Yield -13.9% 9.1%
BLW Limited Duration Income Trust Multi-Sector -12.4% 8.6%
BIT Multi-Sector Income Trust Multi-Sector -11.9% 10.6%
BTZ BlackRock Credit Allocation Income Trust Multi-Sector -8.7% 7.6%
HYT Corporate High Yield Fund High Yield -6.3% 9.3%
EGF Enhanced Government Fund Government -4.2% 3.8%
BGIO 2022 Global Income Opportunity Trust Multi-Sector -2.7% 7.3%
BHK Core Bond Trust Multi-Sector -2.5% 5.2%
BKT Income Trust Agency Mortgage -1.7% 6.6%
BBN Taxable Municipal Bond Trust Taxable Municipal 0.1% 5.4%

Source: BlackRock as of 6/26/20. Distribution rate is calculated by taking the latest declared distribution, annualizing it, and dividing by the fund’s market price.

1 A higher credit quality fund is defined as having a portfolio credit quality with greater than 50% of managed assets in securities rated investment grade or above.