INSIGHTS

On April 27, 2017

Closed-End Funds: First Quarter 2017 Review and Outlook

Investment Review

The first quarter was broadly positive for closed-end funds as stocks and credit-sensitive bonds generally built on gains made in the wake of November’s U.S. elections in anticipation of possible new stimulus measures and pro-business policies. However, momentum slowed toward the end of the period when Congress’s failure to move on health care legislation raised questions about the future of other proposed reforms.

Financial markets were supported by an ultimately benign interest-rate backdrop. The yield on the 10-year U.S. Treasury ended the period a few basis points lower at 2.40%, despite a run-up in yields ahead of the Federal Reserve’s mid-March increase in the fed funds rate. 

In this environment, nearly all sectors of the closed-end-fund market advanced on both a price and NAV (Net Asset Value) basis. Equity funds collectively outpaced fixed income funds and saw their average discount to NAV narrow from 8.1% to 5.9% in the period, compared with their long-term average of 5.2%.

Top performers in the equity category included health-biotech funds (14.3% return on market price), which was the only equity closed-end-fund sector to have a negative return in 2016. Commodities funds (12.1%), which invest mostly in gold and silver, rallied along with prices for precious metals. U.S. general equity funds (8.0%) benefited from their typically modest use of leverage in a period where the broad U.S. stock market rose about 6%. U.S. equity dividend funds (9.2%) and global equity dividend funds (10.9%) both performed well in a period of stabilizing bond yields.

Despite weak energy prices in the period, MLP (Master Limited Partnership) funds (9.0%) had a strong showing, with sentiment aided by the Trump administration’s efforts to create a more favorable environment for energy-related projects. The sector’s average discount narrowed significantly in the quarter from 5.4% to 1.2%, compared with a historical average premium of 1.9%. 

Underperformers within equity funds included the energy/resources group (3.9%), reflecting a lackluster backdrop for energy prices. The finance sector (–3.4%) was hampered amid dimmed expectations for a steeper yield curve (wider lending margins), as the failure of President Trump’s health care initiative raised uncertainty around the prospects for tax reform and other items on the Trump agenda supportive of the reflation trade.

Taxable fixed income closed-end funds were not as strong as equity funds as a group, although all sectors in the category had positive returns. The average discount for the group modestly narrowed in the period, ending the quarter at 3.8%, slightly wider than the long-term average.

Convertibles funds (7.2%) were a top performer within fixed income, drawing support from rising stock markets. Emerging market income funds (7.4%) also outperformed, as did multi-sector funds (7.5%), which remained the highest-yielding fixed income fund group. Investment grade funds (5.7%) outpaced limited duration (3.5%) and senior loan funds (2.6%), which tend to have shorter durations, and both took a breather after outsized returns in 2016.

New Issues Market

There were three closed-end-fund initial public offerings in the quarter, which were all relatively small ($220 million or lower) fixed income strategy funds with finite terms. Term funds have mandates to wind-up/cease operations at a prescribed date, and will return capital to shareholders either at the initial NAV or the ending NAV, which may be at, below, or above the initial NAV.

Investment Outlook

We believe global economic growth will likely improve, supported in part by continued strength in the U.S., as well as signs of improving growth in Europe and Asia. However, some of the enthusiasm that greeted the Trump administration’s pro-growth policies of tax reforms and increased fiscal spending, which initially lifted expectations for higher asset prices and yields in the U.S., has lately been replaced with uncertainty. While we ultimately expect the effect of new policies to add to the growth and inflation trends that were already underway, we believe the pace of growth in the U.S. may depend in part on how successfully President Trump can work with Congress to enact pro-growth legislation, leaving a wide range of possible outcomes.  

Sector valuations

The MLP & midstream energy sector ended the period with attractive valuations based on current yield, discount to NAV (it has historically traded at a modest premium) and yield spread to the 10-year U.S. Treasury note relative to their respective historical averages. Compared to other sectors, the MLP & midstream energy sector ended the quarter with one of the highest average yields and one of the widest yield spreads to the 10-year U.S. Treasury note. The equity dividend income sector also appears to be attractively valued based on the same methodology, ending the quarter with an above-average yield, significant discount to NAV and relatively wide yield spread to the 10-year Treasury.

While the covered call sector ended the quarter with a narrower yield spread to the 10-year U.S. Treasury note than its historical average, and a yield below the long-term average (but still above average in absolute terms), the sector’s discount to NAV was wider than its long-term average. In our view, the group offers a favorable risk-adjusted return profile that has historically performed well in a variety of market conditions.

The national municipal sector appears to be fairly valued, as its current yield, discount and yield spread to the 10-year U.S. Treasury are all in line with their historical averages. Looking ahead, we expect periods of volatility in this highly interest-rate-sensitive sector, which may offer attractive entry points in 2017 for this tax-exempt asset class.

Ultimately, we believe investment opportunities among closed-end funds may be largely dependent on economic and employment data, as well as changes in expectations to central bank interest-rate policies, particularly at the Federal Reserve. While rate hikes can act as a headwind to discount narrowing, we expect any increases to be gradual and modest. As such, borrowing costs are likely to remain below historical averages at low absolute levels, which may continue to benefit most closed-end funds with leverage in their capital structure.

­­CRN: 2017-0411-5905R

Data represents past performance, which is no guarantee of future results.

The views and opinions in the preceding commentary are as of the date of publication and are subject to change. There is no guarantee that any market forecast set forth in this presentation will be realized.  The preceding commentary does not reflect the performance of any fund or account managed or serviced by Cohen & Steers and there is no guarantee that investors will experience the type of performance reflected in this commentary. This material should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice, is not intended to predict or depict performance of any investment and does not constitute a recommendation or an offer for a particular security. We consider the information in this presentation to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment.

The preceding commentary is provided for informational purposes only. It is not an offer to buy or sell any product or service. Opinions in this piece are those of Cohen & Steers and are not necessarily that of AAM.  

All AAM employees, including research associates, receive compensation that is based in part upon the overall performance of the firm. AAM may make a market in or have other financial interests in any given security with which this analysis suggests may be benefited from its conclusions. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Past performance does not guarantee future performance.

Risks of Investing in Closed-End Funds. Shares of many closed-end funds frequently trade at a discount from their net asset value. The funds are subject to stock market risk, which is the risk that stock prices overall will decline over short or long periods, adversely affecting the value of an investment in a fund.

Risks of Investing in MLP Securities. An investment in MLPs involves risks that differ from a similar investment in equity securities, such as common stock, of a corporation. Holders of equity securities issued by MLPs have the rights typically afforded to limited partners in a limited partnership. As compared to common shareholders of a corporation, holders of such equity securities have more limited control and limited rights to vote on matters affecting the partnership. There are certain tax risks associated with an investment in equity MLP units. Additionally, conflicts of interest may exist among common unit holders, subordinated unit holders and the general partner or managing member of an MLP; for example, a conflict may arise as a result of incentive distribution payments. MLPs are subject to significant regulation and may be adversely affected by changes in the regulatory environment, including the risk that an MLP could lose its tax status as a partnership. MLPs may trade less frequently than larger companies due to their smaller capitalizations, which may result in erratic price movement or difficulty in buying or selling. MLPs may have additional expenses, as some MLPs pay incentive distribution fees to their general partners. The value of MLPs depends largely on the MLPs being treated as partnerships for U.S. federal income tax purposes. If MLPs were subject to U.S. federal income taxation, distributions generally would be taxed as dividend income. As a result, after-tax returns could be reduced, which could cause a decline in the value of MLPs. If MLPs are unable to maintain partnership status because of tax law changes, the MLPs would be taxed as corporations and there could be a decrease in the value of the MLP securities.