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The Closed-End Fund Analysis Trifecta, Part 2: Dividend Risk & Security

The Closed-End Fund Analysis Trifecta, Part 2: Dividend Risk & Security

This is the second installment of a three-part series covering closed end funds. This content was produced by John Cole Scott, CFS at Closed End Fund Advisors.

The average closed-end fund is currently showing a 7.1% annualized forward looking distribution yield (CEFU as of 11/8/13) making it clear that dividends are often a significant component for total return. For the 602 current CEFs, 86.5% have distribution yields over 5%. There are more than a few CEFs that have dividend levels CEFA considers ridiculous (usually 10+%) and unsustainable going forward. Here are a few ways to identify those funds.

Step I - Take a fund’s distribution amount and take out the impact of a discount or premium. For example, if a CEF has a 10 cents per share expected annualized dividend and a NAV of $10, the fund has a NAV Yield of 10% (often different than it’s market price yield due to discount and premiums). The second analysis is to remove the amount of leverage from the yield for comparison. If a fund has 33% leverage, then you need to remove 33% of the NAV yield to come to a NAV leverage adjusted distribution yield. In the previous case, this would mean an approximate 6.67% leveraged adjusted NAV yield. Next, review the portfolio holdings and allocations to decide if the distribution is realistic and sustainable over time. Can the board of director’s policy be easily maintained by the portfolio manager? 

Step 2 - For equity CEFs, look at the percentage of the dividend recently reported as Return of Capital (RoC). Return of Capital is not always bad and sometimes simply an accounting measure, especially for Master Limited Partnerships (MLPs), Real Estate Investment Trusts REITs), option premium (Covered Call/Buy-Write Funds) or a delayed sale from the fund’s portfolio by the manager. It is also important to note that the final dividend breakdowns for tax purposes will not be 100% accurate until January of the following year when the 1099 DIV form is generated by the fund for its shareholders.

We break-out RoC and define the destructive RoC, Return of YOUR Principal (RoP). When this occurs, it is essentially the fund charging a fee on money it plans to return to you as a dividend. Outside of pure trading reasons vs. investing reasons, we see no reason to buy a CEF with a consistent history of significant RoP in their monthly or quarterly dividend payments. We suggest looking at how peer funds have classified their dividend break-down in their section 19 notices or regular press releases. We care more about recent announcements, and we use 90 day and 12 month figures to calculate the percentage of the dividend expected to be RoC. It is worth noting dividends categorized as RoC, vs. income or capital gains, are not taxable but write down your cost basis on the CEF and would be considered tax-deferred. When a security is sold, you would need to account for this reduced cost basis when calculating capital gains.

Step 3 - For fixed-income CEFs, we like to look at two data points: 1. The Earnings Coverage Ratio and 2. Relative Undistributed Net Investment Income (UNII) and UNII Trend. When UNII is negative it is often called “over-distributed net investment income” in the fund’s reports. In most cases, to purchase a bond CEF, we require it to be earning its distribution (or above peer-group avg) to avoid the increased risk of a potential dividend cut. We also like a fund to have 8-17% positive relative UNII, which equals 1-2 months of income cushion on the fund’s balance sheet. However, it is important to note that a small positive Rel UNII cushion could be eroding to a deficit, and a small to moderate Rel UNII deficit could be building towards a surplus. That is why it is important to monitor the UNII and Earnings Trend and not simply the absolute level. Not to confuse the matter more, but some funds over time build UNII balances; both positive and negative that we feel are due to the Fund’s accounting vs. an actual deficit or reserve. This makes the trend far more useful in our opinion.

If the data is only 1-4 months old, then we consider it to be “fresh”. We discount heavily the data from funds with earnings/UNII data 5 months or older. More and more bond funds are offering this data monthly. Most quarters 90%+ of the funds announce dividend “maintains” vs. “increases” or “decreases." It is the roughly 3-6% dividend cut announcements we are trying to help you avoid by understanding and monitoring this data for CEFs.

Dividend Risk - Rules of Thumb

  • No single data point can guarantee a dividend increase or decrease. It only can suggest where risk or opportunity might lie. Only a fund’s Board of Directors / Trustees can make dividend changes.
  • Even if UNII or Earnings are negative or lower than the dividend level, remember to look at how peer funds are doing for the same data points to give a more realistic analysis.
  • The current level of a fund’s discount or premium can also help identify how much anticipated risk is built into a fund's distribution policy or level.  
  • Do not forget that an investor’s performance is a combination of “yield” and “capital appreciation or loss." Both factors need to be combined for any accurate comparisons.
  • Another important concept to note with UNII data is that it shows a fund’s life-to-date balance and can be impacted from accounting and IRS adjustments over time. The older a fund, the more important the trend is vs. the absolute level of UNII.    

Posted-In: CEF closed end fundsEducation General


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