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On August 03, 2017
Closed-End Funds: Second Quarter 2017 Review and Outlook
CloseInvestment ReviewClosed-end funds advanced in the second quarter amid a supportive macro backdrop that was broadly favorable for financial assets. Stocks climbed to record highs on an improving earnings outlook, as global economic growth continued at a modest pace. Bonds advanced and yields declined as inflation remained subdued.
Fixed income funds collectively outperformed equity funds in the second quarter on both a market price and net asset value (NAV) basis, in contrast to the first quarter, when equity funds outperformed. Fund discounts to NAV continued to narrow, despite the U.S. Federal Reserve (the Fed) raising its benchmark short-term interest rate by a quarter point, the third such increase since December 2016. The Fed also signaled its intention to continue to raise short-term interest rates, which would increase borrowing costs for closed-end funds employing leverage. At the margin, rising borrowing costs pressured the earnings power of most closed-end funds, but investors remained focused on seeking out attractive yields and were willing to pay greater prices for closed-end funds.
Positive investor sentiment could be seen in equity fund discounts-to-NAV narrowing in the quarter from 5.8% to 3.7%, and down from 8.2% at the start of the year. The recent move brings equity fund discounts below their long-term average discount of 5.2%.
Broad-based equity funds advanced along with the major U.S. and global stock market averages, adding to the funds’ healthy year-to-date gains. Global growth & income (7.4% return on market price) and equity tax-advantaged (7.2%) were among the top-performing diversified funds.
The performance of more specialized equity funds was largely a function of changes in interest rates and energy prices. Utilities funds (8.6%) benefited from the decline in long-term interest rates, as low rates were seen as a positive for companies that rely on borrowing for their capital-intensive businesses. For real estate funds (6.2%), faster growth and the decline in rates were a positive as well, although gains were tempered by weakness in retail-related sectors in light of recent bankruptcies and store closing announcements and the potential impact on landlords’ cash flows.
Master limited partnership or MLP (–6.9%) and energy resources funds (–2.9%) were among the few equity sectors to experience negative returns in the quarter. The two groups were hurt by a decline in crude oil prices, which fell on concerns that the oil market would take longer to reach balanced conditions as rising U.S. supply threatened to offset production cuts from the Organization of Petroleum Exporting Countries (OPEC) and participating non-OPEC producers. For MLPs, those concerns were largely misplaced as rising oil volumes are beneficial to midstream energy companies, translating into improving cash flows that could be used to strengthen balance sheets and increase cash distributions. Commodities funds (–3.5%) declined as precious metals prices edged lower as the market reacted negatively to the unanticipated hawkish tone of the Fed’s June policy statement after the recent run of soft inflation data.
Most fixed income closed-end funds enjoyed healthy gains in the quarter thanks to the decline in long-term interest rates and strong investor demand. Taxable fixed income and municipal bond funds saw discounts to NAV come down. The average discount for taxable fixed income funds ended the quarter at 2.6%, which is slightly narrower than their long-term average. Municipal fund discounts narrowed to 3.5%, compared to a long-term average of 3.8%.
Preferred securities funds (7.8%) were the top-performing fixed income segment on both a market price and NAV basis. The funds continued to benefit in the declining interest rate environment from the long duration and high quality of their underlying holdings. Investor demand for the funds pushed prices to a premium to NAV.
Mortgage bonds (6.7%), which tend to hold high-quality, long-duration securities, and multi-sector funds (6.1%), which have the flexibility to shift assets among fixed income categories and currently offer the highest yields among closed-end funds, likewise enjoyed strong gains. These two categories trade at premiums to their NAVs as well.
Convertibles funds (5.2%), the most equity-like fixed income category, benefited from positive stock market sentiment as well as the decline in interest rates. High yield funds (2.9%) lagged most other fixed income categories as investors favored higher-quality bonds in what was both an interest rate and credit rally. The group was one of the few sectors to not benefit from an improvement in valuations and they continue to trade at a 6.7% discount to NAV.
Senior loan funds (0.7%) trailed more interest-rate-levered funds. The funds invest in bundles of adjustable rate loans that banks extend to corporations and therefore don’t particularly benefit from declining interest rates. Government funds (0.0%), which predominantly invest in U.S. Treasury inflation-protected securities, also lagged as softer economic data eased the inflation outlook.
Taxable municipal bond funds (3.4%) and national municipal bond funds (3.9%) posted strong returns due to the high credit quality and long duration of the securities in their portfolios. Against a backdrop of rising leverage costs and yields being pressured due to bonds being called, investor sentiment for municipals continued to improve with fund market prices rising faster than NAVs. Positive sentiment could also be seen in the strong inflows into open-end mutual funds in the quarter.
New Issues Market
There were no closed-end fund initial public offerings in the quarter, continuing the recent trend of light issuance. The few fund offerings that have occurred this year have been limited to 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 OutlookWe expect positive global economic growth conditions to persist through the second half of the year, with improving employment and rising personal incomes likely to spur consumer spending and business investment alike. Growth in the U.S. has the potential to accelerate further if Congress is successful in passing regulatory reforms and infrastructure spending.
Interest rates may rise gradually in response to continued growth and a modest increase in inflation. Additional Fed rate hikes could increase borrowing costs for levered closed-end funds and modestly impact their income potential. However, with borrowing costs not rising at a rapid pace, the spread income that levered funds can earn remains an attractive proposition, in our opinion.
Valuations on equity funds may continue to improve, but with discounts now below their long-term average, we believe there is only modest room for additional valuation compression. Similarly, fixed income funds trade at discounts to NAV that are below historical norms, which may limit total returns going forward.
Sector Valuations
The MLP & midstream energy sector ended the quarter with attractive valuations. The sector’s current yield is the highest among closed-end fund categories at more than 9%. While the funds now trade at a slight premium to NAV, that premium remains below the sector’s historical average. In addition, MLPs’ yield spread to the 10-year U.S. Treasury note relative to their respective historical averages remains the widest among closed-end funds. The equity dividend income sector also appears to be attractively valued based on a relatively wide yield spread to the 10-year Treasury and a current dividend yield roughly in line with its long-term average. The funds’ discount to NAV ended the quarter only slightly narrower than their long-term average.
Given their favorable returns in the quarter, the covered call sector’s yield spread to the 10-year U.S. Treasury worsened and the dividend yield, while still above the broad closed-end fund average, slipped. The sector’s discount to NAV is now slightly below its long-term average. In our view, the group offers a fair risk-adjusted return profile at this time. Valuations on convertible closed-end funds improved in the past quarter, based on the current dividend yield and with their yield spread to the 10-year Treasury having swung from a discount to a premium above the long-term average. However, the funds’ average discount to NAV remains below historical norms.
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. Continued strong fund investor inflows and little new bond issuance may prove favorable for municipal funds, although total returns between now and year-end may consist entirely of tax-exempt income streams.
We believe investment opportunities among closed-end funds may remain largely dependent on future economic and employment data, as well as changes in expectations to the Fed’s interest-rate policies. Interest rates may rise gradually in response to continued growth and a modest increase in inflation. Additional Fed rate hikes could increase borrowing costs for levered closed-end funds and modestly impact their income potential. But with borrowing costs not rising at a rapid pace, the spread income that levered funds can earn remains an attractive proposition, in our opinion.
CRN: 2017-0803-6080 R
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.
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.
All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at https://www.aamlive.com/legal/commentaries-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
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