FMD Capital Management

Dealing With A Dividend Cut In Your CEF Portfolio

Written by David Fabian, July 12th, 2017

If you dabble in the closed-end fund market long enough, you are probably going to own a fund that sees its dividend cut.  This seemingly innocuous event can have numerous ripple effects for shareholders that should be carefully evaluated before you respond with any knee-jerk reactions. 

Closed-end funds generally operate their dividend schedules in two ways: 1) a managed distribution schedule set by the board of directors or 2) an income-only policy that distributes the actual dividends generated by the underlying portfolio.  Both dividend strategies are subject to continual review and can change out of left field even when the market appears calm on the surface.

The most recent example is the PIMCO California Municipal Income Fund III (PZC), which announced a 25% decrease in its distribution rate beginning in August.  PIMCO cut the dividend from a steady $0.06/share down to $0.045/share monthly.  See if you can guess on the chart when this was announced.

The quick reaction by the market was a huge sell off on high volume as a result of the income cut.  After all, CEF investors want yield and they want it now.  This is particularly true for municipal bond holders that receive a lower front-end dividend stream in exchange for an attractive taxable-equivalent yield.

In the case of PZC, PIMCO is making a proactive change to balance the lack of available yield in the marketplace without compromising its asset management strategy.  They likely don’t want to add duration or lower credit quality just to satisfy the short-term thirst for income that so many have become complacent with.  They also don’t want to start returning capital within the dividend just to hit a yield bogey.  It’s a good move over the long-term even if the current shareholders take a bit of a hit.

The reality is that you can’t feel all that bad for owners of PZC who experienced this drop.  The fund was trading at approximately a 25% premium to net asset value when the announcement was made and is still clinging to an 11% premium at today’s prices.  There were also warning signs when its sister fund, the PIMCO Municipal Income Fund (PMF) underwent a similar distribution cut in March.

In other words, the fund was already trading at a frothy valuation and there were yellow flags within the same sector.

There are numerous lessons here with respect to closed-end funds that investors should heed:

  1. CEFs can do weird things at unexpected times. They don’t operate within the same guidelines as a traditional ETF or open ended mutual fund that trades at net asset value daily.  Expect the unexpected.
  2. These dislocations may ultimately create opportunities for those who are seeking out relative value disparities for certain sectors or asset managers.
  3. Dividend cuts can come in many forms: asset valuations, asset liquidity, regulatory changes, and structural investment changes. Sometimes these are in the investment managers/boards control and other times they are not.
  4. Owners of CEFs that experience a dividend cut should carefully analyze whether the strategy is still consistent with their goals or a sign of deeper trouble within the fund. There is a difference between a change in light of portfolio capability and a change in response to a market crisis.

The Bottom Line

A dividend cut can initially be scary factor for CEF investors as the market quickly rushes to judgement.  However, those who take their time to analyze the implications of their own portfolio standing and that of the fund will make better behavioral choices over the long run.

Like this article?  Read: 3 Mistakes To Avoid When Choosing the Perfect Closed-End Fund