FMD Capital Management

Will Tax Loss Selling Really Hold New CEFs Underwater?

Written by Michael Fabian, November 08th, 2013

Right around this time of the year many closed end fund (CEF) market participants become worried about the potential implications of tax loss selling from underwater IPO participants. The basis of the theory is sound, and in the past it could be argued that investors harvesting losses contributed to larger than normal supply, thereby becoming a detriment to secondary market participants. This year could prove to be even more preeminent for many fixed income funds in light of the interest rate backup that occurred from May to September. Certainly we can all relate to the desire to balance our books by year’s-end in an effort to lessen the tax man’s bite. However, I encourage investors to look beyond this short-term seasonal nuisance, and give it no more credence than you would other so called psychological market phenomenon’s such as “The Santa Claus Rally” or “The January Effect.”

This year appears to be quite different for CEF IPOs, as two of the largest fixed-income offerings in CEF history came to market near an all time low in treasury yields – the PIMCO Dynamic Credit Income Fund (PCI) and the DoubleLine Income Solutions Fund (DSL), each attracting over 2.5 billion in assets. In fact, using data provided by the CEF Association’s IPO calendar, the average fund offered during 2013 was 660 million, vs. an average of 541 million in 2012, and 346 million in 2011. This clearly exhibits strong investor demand for income and levered bond holdings, but also begs the question: Will sellers be persuaded to lower their tax bill in lieu of their income needs?

The question is obviously up for interpretation, however in my opinion, even if sellers are ultimately motivated by a lower tax bill, it won’t necessarily equate to a poor investment outcome for holders of these funds. In my experience evaluating a fund’s place in your portfolio shouldn’t be overridden by the need to offset other gains or income. Rather, sticking with an investment should be predominantly based upon the fund’s ability to meet or exceed its dividend, NAV performance vs. comparable offerings, or even the management team’s strategy in the prevailing market environment.

As is the case with both PCI and DSL, even though market price performance has been poor since inception, superior NAV performance alongside an attractive discount has begun to convince buyers of future prosperity, which could ultimately convince IPO participants the fund is worth holding onto. Besides, if individual IPO participants were going to sell, it would have likely been at the depths of the sell off as fear overcame the market, and probably and not now, as performance has been steadily improving. For more details, reference the graph below:

Furthermore, for funds that have built up a small margin of UNII throughout the year such as PCI, there could be the chance of a special year-end distribution which could work to further mitigate investor unease. Finally, if all else fails, and these funds do go through the next month and a half with an outsized overhang of supply, realize that fundamentally it will be an isolated event, which could even be used opportunistically to continue to add any undersized holdings.

As it happens in virtually every market, keep the psychological factors from influencing your portfolio management approach. Focus on your intermediate term goals and income objectives for your individual holdings and envision the way you would like your portfolio to look starting 2014. For investors in our Dynamic CEF Income Portfolio, I continue to focus on funds that are trading below their trailing twelve month average premium or discount in an effort to capitalize on oversold fixed income and preferred stock opportunities. As always developing your personal plan and implementing it decisively will always yield the best result.