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March, 2016

THE INCOME ADVANTAGE OF DISCOUNT CLOSED-END FUNDS
by LARRY

For quite some time and into the foreseeable future as well, very little revenue return is available from certificates of deposit, Treasuries, or short-term bond funds. In 1982, one could receive on average over 12.00% a year back from simply owning an essentially risk-free money market account. These days, even after a recent federal rate hike, not so much. A typical money market yield now is just 0.40%. What is more, buying longer term corporate bond funds and so-called junk bonds that offer better yields are not necessarily a good idea. As the Fed keeps raising the discount rate, such investments are likely to lose principal.

Yet suppose you are hoping to retire in the next several years and want then a definite minimum level of income? One option is to buy an annuity through a financial services company. However, their commissions are commonly high, decreasing the net return on your hard-earned investment. In addition, if it provides much income the investment is probably not going to increase significantly. Another choice is to buy the stocks of dividend bearing strong growth companies and watch their yield grow over time. Personally, I find this an excellent option. Yet the average growth company's dividend is fairly low at first, so if one will need income in the first few years, he or she may be out of luck or have to decrease principal in order to receive the needed income before such a portfolio has matured.



Another possibility is to invest in closed-end funds that already offer above average dividends. Such assets usually provide distributions at least annually for both capital gains and income. With the capital gains plowed back into the fund, one still has income distributions. They are often competitive with the income available from open-end mutual funds.


To clarify, a few definitions:

  1. Open-end mutual funds are investment vehicles that have no limit on the number of shares that may be issued. More shares are created as people buy into the funds. Thus their prices are not affected by supply and demand.

  2. Closed-end mutual funds have a fixed limit on the number of their shares and trade in the equity markets like stocks. If demand is high relative to the number of shares outstanding, the prices per share tend to go up. When demand is lower, prices generally go down.

  3. Market Value applies to the current price at which an asset, such as a house, common stock, real estate investment trust, or share in a limited partnership is selling. In the case of closed-end funds, as demand for the security goes down, the market value tends to be lower than the net asset value, hence selling at a discount. As demand is higher, the price tends to be greater than the net asset value, hence available only at a premium.

  4. Net Asset Value means for each share of a particular closed- or open-end fund the current price of all shares of the security less all liabilities, divided by the total number of issued shares.


For long-term income seeking investors, the characteristic of closed-end funds to sometimes sell at a discount to their net asset value has an intriguing consequence: assuming equal investments in both, assets selling at or above their nest asset value (NAV), as is most always the case for open-end mutual funds, are at a disadvantage compared with interest paying closed-end funds selling at a discount.


Income Producing Closed-End Funds at a Discount
FundTicker
Symbol		Recent
Price		Income
Only
Yield		Yield
After
Discount		Discount
to N.A.V.
Cohen & Steers Closed-End Opportunity FundFOF$10.754.72%5.39%12.47%
Cohen & Steers Infrastructure FundUTF$19.552.78%3.27%15.11%
Cohen & Steers REIT & Preferred Income FundRNP$18.494.76%5.59%14.87%
Eaton Vance Tax-Advantaged Global Dividend Income FundETG$14.606.47%7.28%11.14%
First Trust Specialty Finance & Financial Opportunities FundFGB$6.009.14%9.34%2.12%
John Hancock Tax-Advantaged Dividend Income FundHTD$22.835.88%6.45%8.79%
Nuveen Real Estate Income FundJRS$10.613.35%3.72%9.86%
Reaves Utility Income FundUTG$29.852.67%2.81%4.97%
Tortoise Power & Energy Infrastructure FundTPZ$17.103.26%3.70%11.81%
Tri-Continental Corp.TY$19.722.91%3.46%15.80%


Consider the following example:

Investment A is an open-end mutual fund selling for $1 a share that provides a total return of 10% a year on average, of which 6% is price appreciation and 4% of the NAV (or 4 cents a share) is an annual income distribution. If one were to invest $10,000 in this fund, he or she would have 10,000 shares, and after the average year's results (for simplicity, disregarding taxes and commissions or fees [or figuring most would be offset due to the purchase being a no-fee fund for a tax-deferred account]) the asset would be worth $10,600 and would have provided $400 of income, that is 4.00% of the $10,000 investment.

Investment B is a closed-end fund selling for $0.90 a share, i. e at a 10% discount to its NAV of $1 per share. It also provides a total return of 10% a year on average, of which 4% of the NAV (or 4 cents a share) is an annual income distribution. If one were to invest $10,000 in this fund, he or she would start with 11,111 shares ($10,000 divided by $0.90), and after an average year's returns the asset would be worth $10,600 and would have provided $444 of income, that is, 4.44% of the $10,000 investment.

In short, everything else being equal, the closed-end fund selling at a discount to its NAV provides an income advantage over open-end funds approximately equal to the percentage discount.

Due to the power of compounding of the principal, the differences in annual income distributions between the open- and closed-end funds would over time be significant.



After 20 years, the total income received from Investment A would have been $13,502 , 135.02% of the original investment. The assets' total market value (assuming just average 6% a year returns) would be $28,543, nicely higher than one could expect from most other income investments. (Admittedly there is no guarantee one's portfolio performance would be so regular. In fact, it is almost guaranteed to have been substantially up in some of those years and badly down in others.)

That for the total income received from Investment B would have been $14,975, 149.75% of the original investment. The assets' total market value (assuming just average 6% a year returns) would be $31,715, not too shabby. Including income, the overall gain would have been $36,690, greater than a three-fold increase.



At the table above are several income producing closed-end funds currently selling at discounts to their net asset values. Their average discount to NAV is 10.69%. Their average income only annual yield is 4.59%. Due to the discount to NAV, compared with an open-end mutual fund yielding 4.59%, their effective yield with a $10,000 investment would be 5.10%. I believe these are all good financial assets, yet the closed-end funds shown are for illustrative purposes only. Folks are encouraged to do their own research and/or see respected financial advisors before making carefully selected investments.


DISCLAIMER

Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)



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