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Third Quarter 2017 Review and Outlook

Closed-End Funds

Investment Review

Closed-end funds had broad-based gains in the third quarter on both market price and net asset value (NAV) as conditions were mostly favorable for financial markets. Economic data generally exceeded expectations as the global economy expanded at its fastest pace in seven years, although momentum appeared to slow modestly in September. Despite strong labor markets and improving consumer confidence, inflation remained subdued. The 10-year U.S. Treasury yield was unchanged for the quarter at 2.3%, rising in mid-September after touching year-to-date lows on concerns over political tensions with North Korea and the potential effects of powerful hurricanes hitting the U.S. central banks provided more clarity on interest rate policy and reducing the size of their balance sheets, but expectations remained for gradual credit tightening in the United States and Europe.

Closed-end funds’ discounts to their underlying NAVs generally narrowed during the quarter. The average equity fund discount went from 3.7% to 3.2%, compared with the group’s long-term average of 5.2%. For taxable fixed income funds, the average discount narrowed slightly to 2.5%, remaining below the long-term average of 2.9%.

Sector Highlights

  • The global equity (7.6% return on market price) and global equity dividend (5.6%) sectors were top performers, benefiting from improving global economic growth and a decline in the dollar, which aided U.S.-based exporters that are typically well-represented in these funds.
  • The energy-resources sector (6.8%) rallied amid a recovery in crude oil prices, while commodities funds (2.5%), which invest mostly in precious metals, were aided by a modest increase in gold prices.
  • Master limited partnership (MLP) funds (–1.3%) declined despite the rise in oil prices, due to generally disappointing earnings results and a number of guidance reductions from MLP management teams.
  • Utilities funds (–0.3%) underperformed as investors favored less-defensive areas of the market.
  • All sectors within fixed income advanced on both market price and NAV, led by emerging market income funds (4.4%), which performed well in a period of increased risk tolerance. High yield funds (3.3%) also outperformed.
  • Multi-sector funds (3.9%), which have the flexibility to shift assets among a wide range of fixed income classes, were positive standouts as well.
  • The preferreds sector (2.0%) had a relatively modest gain in the quarter but maintained solid year-to-date outperformance.
  • There were two closed-end fund IPOs (initial public offerings) in the quarter, a $130 million emerging market debt term trust fund and a $210 million floating-rate securities fund, also a target trust. 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 expect positive global economic growth conditions to continue into 2018, with improving employment and rising personal incomes likely to spur consumer spending and business investment alike. Growth in the United States has the potential to accelerate further if Congress is successful in passing tax cuts, regulatory reforms and infrastructure spending, in our opinion. 

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 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. 

Valuations on equity funds may continue to improve, but with discounts 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 ended the period trading at a slight premium to NAV, that premium remained below the sector’s historical average. In addition, looking at sector yield spreads to the 10-year U.S. Treasury relative to respective historical averages, MLP funds maintain the widest spread among closed-end funds. 

We believe the broad equity dividend income group 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. However, the funds’ discount to NAV became somewhat less attractive in the quarter on an absolute basis and relative to the their long-term average. 

Covered call funds, which had another quarter of solid performance, saw a further tightening in their yield spread to the 10-year U.S. Treasury, as well as a modest decline in their yield against the 10-year compared with the long-term average. While still trading below their NAV, the discount on these funds moved in as well, and further away from the historical discount.

Valuations on convertible closed-end funds improved in the third quarter, based on current yield and discount to NAV. Although the funds’ average discount to NAV remains below historical norms, convertible funds continue to score high on yield spreads over the 10-year Treasury, both on a current and historical basis.

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. 

 

Investment Review
Global equity markets made record highs in the third quarter as economic data generally exceeded expectations and the global economy expanded at its fastest pace in seven years. Despite strong labor markets and improving consumer confidence, inflation remained subdued. The 10-year U.S. Treasury yield was unchanged for the quarter at 2.3%, rising in mid-September after touching year-to-date lows on concerns over political tensions with North Korea and the potential effects of powerful hurricanes hitting the U.S. Central banks provided more clarity on interest rate policies and on reducing the size of their balance sheets, but expectations remained for gradual credit tightening in the U.S. and Europe.

The Russell 1000 Dividend Growth Index returned 3.2% in the quarter, led by the energy sector, which rose with crude oil amid strong demand and falling stockpiles. Within financial services, banks advanced on news of robust capital return plans and optimism that the administration’s late-period tax-cut proposal will become law. Industrial companies, while positive, trailed as international growth outpaced the domestic economy, drawing investor interest away from the sector’s highly valued equities.

Master limited partnerships (MLPs) posted a –3.0% loss, as measured by the Alerian MLP Index. Despite stronger crude oil prices, MLPs declined as earnings results disappointed and managements lowered guidance, partially the result of companies continuing to take steps to de-lever their balance sheets and increase distribution coverage. In the “bad news is good news” vein, although the announcements of such moves typically resulted in near-term price weakness, they should be a long-term positive for the companies. The midstream industry appeared to have suffered negligible long-term damage from Hurricane Harvey.

Real estate investment trusts (REITs), as measured by the FTSE NAREIT Equity REIT Index, advanced 0.9%. Companies reported solid earnings growth amid strengthening demand, reasonable levels of new supply and continued low financing costs. Earnings multiples for real estate companies remained near the lower end of their five-year range, whereas multiples for broad equities expanded to near their cycle high. Interest rate concerns appeared partly to blame for REITs lower multiples, even as the Federal Reserve remained accommodative and is expected to maintain a gradualist rate-hike policy, consistent with subdued inflation along with continued economic expansion and job growth. Investor sentiment toward REITs was also affected by the on-going struggles of brick-and-mortar retail. However, other property sectors, such as data centers, industrial warehouses and cell towers continued to benefit from the growth of e-commerce, underscoring the varying prospects for individual sectors.

Preferred securities rose 1.1%, as measured by the Bank of America Merrill Lynch Core Fixed Rate Preferred Index—continuing their recent string of solid quarterly returns—amid subdued inflation, low interest rates and strong investor appetite for income. Preferreds outperformed Treasuries and investment-grade bonds, due partly to higher income generation, but as a group they trailed high-yield debt, which is well represented by energy-related securities and benefited in part from the recovery in crude oil prices. 

Taxable equity closed-end funds returned 2.6%, based on the Morningstar U.S. Equal Weighted All Equity Closed-End Fund Index. Closed-end funds produced broad-based gains on both market price and net asset value (NAV), as conditions were mostly favorable for financial markets. Discounts to funds’ underlying NAVs generally narrowed during the quarter. The average equity fund discount went from 3.7% to 3.2%, compared with the group’s long-term average of 5.2%. For taxable fixed income funds, the average discount narrowed slightly to 2.5%, remaining below the long-term average of 2.9%.

Investment Outlook
Market expectations for faster growth and increasing inflation related to President Trump’s legislative agenda appeared to return in September after fading in previous months, pushing bond yields up in the month. We anticipate that growth will continue in the coming months although its pace may moderate somewhat. We look for interest rates to continue to climb gradually in response to decent economic growth, reduced monetary stimulus, and in light of modestly rising inflation, but the uptick in yields should not have an adverse impact on most investments, in our opinion.

Dividend-paying equities may take on more importance as interest rates rise, in our view, as dividend growers generally outperform higher-yielding, lower-growth stocks when rates rise. In this environment, companies with stronger business models and solid cash-flow generation appear to be better able to grow earnings and dividends through market share gains or acquisitions, supporting dividends and dividend growth.

We believe MLPs should benefit from firming oil prices and the continued growth in North American oil volumes, which is translating into improving cash flows for midstream companies. We believe this will eventually lead to a re-acceleration of distribution growth for the sector. We find it encouraging that more companies are taking steps to reduce their downside risk by strengthening balance sheets and increasing distribution coverage ratios and being less reliant on capital markets to fund their growth.

The REIT market remains favorable, and we anticipate that the demand for commercial real estate will outstrip new supply across most sectors, driving rents and cash flows in the coming months, although supply is accelerating in some areas. We also see the potential for positive earnings surprises for the remainder of the year, given the generally conservative guidance companies have recently provided. We believe an uptick in yields should not have an adverse impact on real estate, provided the U.S. economy continues to grow. The positive operating environment, coupled with attractive valuations, could draw increasingly favorable attention to the asset class, which has widely underperformed the S&P 500 over the past year.

Among fixed income assets, we believe preferred securities remain well positioned if rates continue to move higher. Their high income rates and wide yield spreads relative to U.S. Treasuries and corporate bonds could help to cushion the impact of rising rates over time. Additionally, over the medium to longer term, we believe that banks and insurance companies, which are the primary issuers of preferred securities, may benefit from a rising-interest-rate environment, as higher rates could potentially bolster their net interest margins. Reduced regulation and lower tax rates could also prove beneficial for financial companies, by reducing regulatory costs and increasing earnings, which will strengthen credit fundamentals.

In the closed-end market, with valuations on both equity and fixed income funds more expensive than their long-term averages, the potential for valuation compression may be limited for the remainder of the year. However, attractive values remain across various closed-end-fund categories. The best long-term returns among closed-end-funds are likely to be found in categories where discounts to net asset values are near their historical averages—and where the underlying asset classes offer relative value.

 

Master Limited Partnership (MLP) Closed-End Fund

Index Performance

Third

Quarter

Total Return

Third

Quarter

NAV Return1

MLP Closed-End Funds2

–1.3%*

–1.5%

All Taxable ex-Foreign Equity
Closed-End Funds3

+3.2%*

+2.7%

Alerian MLP Index

–3.0%

 

Standard & Poor’s 500 Index

+4.5%

 

Barclays U.S. Aggregate Bond Index

+0.8%

 

At September 30, 2017. Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any Fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. The rate of return will vary and the principal value of an investment will fluctuate and shares, if sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Returns are historical and include change in share price and reinvestment of all distributions. An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. *Closed-end fund total returns are based on market price. (1) Return based on net asset value (NAV). (2) Represents performance of the MLP sector of the Morningstar U.S. All Taxable ex-Foreign Equity Closed-End Fund Index. (3) Represents the Morningstar U.S. All Taxable ex-Foreign Equity Closed-End Fund Index.  

Investment Review

Midstream energy master limited partnerships declined in the third quarter due to disappointing earnings results and lowered guidance from managements, partially the result of companies continuing to take steps to de-lever their balance sheets and increase distribution coverage. In the “bad news is good news” vein, although the announcements of such moves typically resulted in near-term price weakness, they likely are a long-term positive for the companies.

The midstream industry appeared to have suffered negligible long-term damage from Hurricane Harvey. The storm and subsequent flooding resulted in the tragic loss of lives and widespread property damage, particularly in the Houston area—the heart of U.S. energy production—but only temporarily disrupted operations for midstream companies in the region.

As a group, market prices for MLP closed-end funds declined less than their net asset values during the quarter, resulting in the funds moving to a modest 0.8% premium to NAV (up from a premium of 0.6% at the end of June) a reversion closer to its historical average premium of 1.9%. The group’s average yield at the end of the quarter edged higher as well, to 9.7% based on market price, the highest yield among all closed-end fund categories.

Stronger Energy Demand Lifts Oil Prices

Oil prices climbed to their highest level since July 2015 amid stronger-than-expected demand from Europe and the U.S. and falling stockpiles. The International Energy Agency reported that second-quarter global oil demand grew by 2.3 million barrels per day (mbpd), the highest year-over-year increase in two years. While demand is rising, global stockpiles continue to decline, causing prices for oil futures for near-term delivery to move above longer-dated contracts (i.e., backwardation). This could make it more attractive to sell oil immediately rather than storing it and could push oil stocks even lower in coming months. Also, there were signs of increased willingness of OPEC suppliers to extend production cuts if inventory levels and/or the oil price do not meet the group’s targets.

Rising Energy Exports Boosting Midstream Companies

Rising exports of liquefied natural gas (LNG) proved beneficial for marine shipping and select pipeline companies during the quarter, a trend we expect will continue. Exports of LNG have grown from essentially nothing in early 2016 to an average of more than 56 billion cubic feet per month in recent months and now account for about 20% of total U.S. gas exports. Global demand for LNG is supported by competitive prices relative to crude oil, particularly in Asia. And with more LNG export facilities under construction, the U.S. is expected to become a net exporter of natural gas on an average annual basis by 2018.

Midstream energy companies also benefited from U.S. shale oil garnering a greater share of global production. Rising shale oil exports averaged nearly a million barrels per day in the first six months of 2017—triple the amount shipped abroad in the same period just three years ago. China is the fastest growing destination for these exports. U.S. oil deliveries to the country now exceed shipments from several OPEC members.

Investment Outlook

We believe crude oil prices will remain range-bound between the mid-$40s to high-$50s per barrel. This range is supported on the low end by production cuts from OPEC and its partners. The oil price is likely bounded on the upper end by relatively low-cost supply and short-cycle from North American producers taking market share of global energy production.

The growth in North American oil volumes is driving a positive shift in the fundamental cycle for midstream energy companies, translating into improving cash flows, which we believe will eventually lead to a re-acceleration of distribution growth. We find it encouraging that more companies are taking steps to reduce their downside risk by strengthening balance sheets and increasing distribution coverage ratios and being less reliant on capital markets to fund their growth.

We believe that midstream energy continues to represent an attractive investment opportunity and that MLP closed-end fund valuations are appealing, although there appears to be limited room for additional fund discount narrowing in the coming quarters. Nevertheless, MLP closed-end funds currently offer high income rates relative to stocks and bonds, which, coupled with potential price appreciation, represents what could be a compelling total return proposition, in our opinion.

 

Preferred Securities

Investment Review
Preferred securities continued their recent string of solid returns in the third quarter amid subdued inflation, low interest rates and strong investor appetite for income. Coming into 2017, many investors may not have expected much more from preferreds than the coupon payments considering the outlook for higher interest rates. And yet, prices of preferred securities increased modestly in the quarter, adding to the group’s sizable total returns year to date through September, well above most fixed income classes.

While higher prices have meant somewhat lower absolute yields, preferreds continue to offer the highest income rates available in investment-grade fixed income, maintaining a relatively wide yield spread over other classes, where yields have also fallen.

Market Highlights

  • The 10-year U.S. Treasury yield was unchanged for the quarter at 2.3%, rising in mid-September after touching year-to-date lows on concerns over political tensions with North Korea and the potential effects of powerful hurricanes hitting the U.S.
  • The Federal Reserve turned somewhat more hawkish, indicating that low inflation may be temporary and that another rate hike this year is likely. The Bank of England also raised expectations for a near-term rise in interest rates, while the European Central Bank continued to signal a modest pending wind down of quantitative easing.
  • Preferred securities outperformed Treasuries and investment-grade bonds in the quarter, due partly to higher income generation.
  • Preferreds as a group trailed high-yield debt, which benefited in part from a recovery in crude oil prices. Unlike preferreds, high yield is well represented by energy-related securities.

Higher Premiums Underscore Importance of Call Protection

As a result of the prolonged rally in fixed income, a number of preferred securities now trade at premium to par. Many of these securities—including about one third of the exchange-traded market—have little or no call protection remaining and could be redeemed at par at any time, well below current prices in some cases. In this environment, we have generally looked to own securities with meaningful call protection, which may limit the risk of redemption and allow more room for the security’s price to appreciate.

New Issuance Has Continued

The recent solid performance of preferreds partly reflects ongoing improvements in the credit fundamentals of financial companies, the primary issuers of preferreds. With financial companies continuing to raise regulatory capital, preferred issuance has been steady this year, totaling about $82 billion through September, an amount equal to 9% of total global preferred securities supply. Investors have readily absorbed this issuance, as reflected in the market’s year-to-date gains.

 

Investment Outlook

Market expectations for faster growth and increasing inflation related to President Trump’s legislative agenda appeared to return in September after fading in previous months, pushing bond yields up in the month. If rates continue to move higher, we believe preferred securities remain well positioned relative to other areas of fixed income. Their high income rates and wide yield spreads relative to U.S. Treasuries and corporate bonds could help to cushion the impact of rising rates over time. 

Financial company fundamentals improving from strong levels. Over the medium to longer term, we believe that banks and insurance companies, which are the primary issuers of preferred securities, may benefit from a rising-interest-rate environment, as higher rates could potentially bolster their net interest margins. Reduced regulation and lower tax rates could also prove beneficial for financial companies, by reducing regulatory costs and increasing earnings, which will strengthen credit fundamentals. While U.S. bank capital levels could decline over time from historically high levels, we believe capital is nevertheless likely to remain very strong and supportive for preferred investors.

REIT fundamentals favorable. We believe fundamentals for commercial real estate are likely to remain strong, with improving demand for most types of real estate and generally modest property supply growth. This favorable combination has helped drive operating incomes and reduce REIT preferreds’ risk premiums. And while the net supply of REIT preferreds may remain positive in the next few months given their attractiveness as a source of capital compared with equity, we expect demand to readily absorb it.

We remain somewhat defensive relative to interest rate risk. The somewhat cautious stance is based on our outlook for continued economic growth, tight labor markets, the potential for stimulative government policies, less accommodative central banks and broader investor positioning within fixed income. With the sharp decline in interest rates in recent months and the very benign inflation outlook priced into them, yields could rise modestly in the near term. We therefore are focused on attractive income opportunities in securities that offer solid absolute yields, call protection, wide credit spreads and fixed-to-floating-rate and floating-rate structures, which we believe will provide favorable risk-adjusted returns.

 

Investment Review
Fixed income assets had broadly positive returns in the third quarter amid subdued inflation, low interest rates and strong investor appetite for income. The 10-year U.S. Treasury yield was unchanged for the quarter at 2.3%, rising in mid-September after touching year-to-date lows on concerns over political tensions with North Korea and the potential effects of powerful hurricanes hitting the U.S. The Federal Reserve turned somewhat more hawkish, indicating that low inflation may be temporary and that another rate hike this year is likely. The Bank of England also raised expectations for a near-term rise in interest rates, while the European Central Bank continued to signal a modest pending wind down of quantitative easing. 

Credit-sensitive classes such as preferreds and high-yield bonds outperformed Treasuries, which had relatively small gains in the quarter, as well as investment-grade bonds. In addition to some encouraging economic data, high-yield bonds benefited from a recovery in crude oil prices, as the asset class is well represented by energy-related securities.

The senior loan sector generated a 1.1% total return in the quarter, as measured by the J.P. Morgan Leveraged Loan Index. In the closed-end-fund universe, senior loan funds modestly outperformed the J.P. Morgan Leveraged Loan Index on both a market price and net asset value (NAV) basis. The funds’ average discount to NAV widened slightly in the quarter, to 3.8%, moving away from their long-term average of 3.4%.

Demand for senior loans slowed in the quarter with $251 million in outflows. However, year-to-date inflows for senior loans were $17.3 billion through the end of September, compared to outflows of $3.7 billion in the first nine months of 2016. Investor appetite for senior loans this year has been supported in part by the relatively low credit risk the leveraged loans have presented. At 1.31%, the 12-month default rate for senior loans compares favorably to a recent peak in excess of 4% in 2015 and a high of 14.2% in November 2009.

 

Investment Outlook
We expect positive global economic growth conditions to persist into 2018, with improving employment and rising personal incomes likely to spur consumer spending and business investment alike. We believe the Fed will likely continue to tighten monetary policy at a gradual pace and begin to reduce the size of its balance sheet, even if inflation remains in check. This could put upward pressure on bond yields, as could an improving growth outlook, tight labor markets, government initiatives—such as the effort for tax cuts and reform—and less-accommodative central banks.  

From a longer-term perspective, we continue to view fixed income assets as being vulnerable to rising yields. But senior loans offer characteristics that we believe have historically helped them outperform other fixed income classes during periods of rising interest rates. Their floating interest-rate structure potentially limits duration risk, as rates reset frequently—often every 60 days or less. The leveraged loans also offer the potential for attractive income rates, as well as low historical correlations to other fixed income sectors, potentially acting as a cushion against rising interest rates, in our view. 

 

CRN: 2017-1103-6240R

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

Opinions in this piece are those of Cohen & Steers and are not necessarily that of AAM.

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, and is not intended to predict or depict performance of any investment. We consider the information in this commentary 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.

Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and sustainability specifications. All expressions of opinions are subject to change without notice.

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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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.