FMD Capital Management

CEF Investors: Your Window Of Opportunity Is Beginning To Close

Written by Michael Fabian, October 17th, 2013

Since the May Federal Reserve announcement closed-end fund (CEF) investors have been given a gift. As prices collapsed, investors with cash and a strong understanding of the hedging practices implemented by many popular CEFs portfolios began to make additions. To them it was apparent that this selloff was going to be just a temporary adjustment. Over the last 3 months capital had the opportunity to be put to work for 85-90 cents on the dollar, as many CEFs earning in excess of 8-9% expanded their discounts to 10% or more. For investors mentally prepared to take advantage of the inherent inefficiencies in CEFs, you are now being rewarded for the risk you assumed. Like many changes that have occurred in the open market over time, all that was needed was a catalyst. It appears the debt ceiling and government reopening was exactly what many investors were looking for to restore confidence.

Looking back prior to the Fed’s announcement most CEF market prices became frothy, trading at excess premiums to their net-asset value or NAV, especially when looked at through the lens of an excessively low interest rate environment. Most funds that I have on my watch list began to expand their premiums, or narrow their discounts far above their trailing twelve month average, which I consider to be a warning signal for investors in our Dynamic CEF Income portfolio. Naturally, as a result of the Fed’s taper talk, interest rates began an upward trajectory that dwarfed many of the prior backups over the last 20 years. This has ultimately brought about one of the best opportunities in CEFs that investors might see for years.

Interestingly, even newly minted CEFs that IPOed in the latter stages of the fixed income rally cracked under the pressure of heavy selling. Funds that lost their sponsor support or simply ended up in the hands of investors not willing to endure price volatility took on heavy losses.

In my opinion, there is a lot that can be gleaned from this market correction, since no two are exactly alike. CEF investors must always remember that even if the current selloff is protracted, or the recovery is slow, they are participating in a market that is largely influenced by psychology. This is primarily due to the fact that CEFs are subscribed to by the retail investing public, not institutional investors. As a result, even CEFs that are fundamentally intact can be tossed out due to the habitual fear and greed cycle. Use this cycle to your advantage to add to funds that appear undervalued. It often times amuses me to observe a bond CEF’s price influenced by something completely unrelated such as a jump in the Volatility Index (VIX) or a correction in the equities market.

Over the last several months we have used this opportunity to add to our favorite funds such as the PIMCO Dynamic Income Fund (PDI), the PIMCO Dynamic Credit Income Fund (PCI) and the Western Global High Income Fund (EHI), to name a few. We have favored these funds since their underlying NAV has held up relatively well in comparison to index products, and our familiarity with the management team has given us confidence strong performance will continue. These funds also have the added margin of safety of positive undistributed net investment income, meaning the portfolio yields more than what the board distributes to shareholders. This provides a cushion to maintain the dividend even in the event the fund’s portfolio endures capital losses. Furthermore, with rates rising, any bonds maturing could be reinvested at yield not seen for years.

Conversely, one fund in particular we have trimmed from our portfolio over the last several days is the Pioneer Diversified High Income Fund (HNW). Due to its strong performance, its market price extended to a premium over its NAV that is above what we believe its fair value should be. If HNW were to pull back below its 52-week average premium over the next several months, we would view that as an opportunity to reload exposure.

Based on the price action in almost all the CEFs I monitor, I believe we are in the beginning stages of the window of opportunity closing. It could take another few months for that window to completely close, however I think we have seen the lows for the year in all the funds within our Dynamic CEF Income portfolio. A prudent approach would dictate that investors get their portfolio aligned with their risk profile for the next several months, and evaluate each fund on an ongoing basis to take advantage of pricing anomalies. Like any strategy, developing a plan and then implementing it decisively will always produce the best results.