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Summary Closed-end funds are often targeted to the income investor. A predictable and stable income stream is among a CEF investor’s highest priorities. When funds are forced to cut distributions, the market response will frequently be an immediate sharp decline in the fund’s price and its premium/discount. In this article, I look at five income CEFs that have cut distributions from 15% to 33%. For the most part, CEFs are designed for and targeted to income investors. For the income investor, closed-end funds are hard to beat. Average distribution yields are in the 8%-9% range for taxable funds (general equity, 8.99%; preferred stocks, 8.09%; fixed-income, 8.55%). Tax-free national municipal bond funds pay an average yield of 5.92% with no federal tax liability. Many funds make an effort to maintain stable distributions; others pay out variable distributions based on the fund’s earnings. Distribution increases are rare for funds that maintain stable distributions. Managers often prefer to issue special distributions when earnings exceed regular distributions in part because they can do so without creating potentially unrealistic expectations. Decreases are uncommon as well, but managers are often find themselves in situations where there is no choice but to cut payouts to shareholders. One could argue that modest distribution cuts, when they are essential, are not completely negative. It may be preferable to the alternative, which is a return of investor capital at the expense of the fund’s net asset value. Income investors, however, can be a fickle lot and will react when a fund that has maintained a stable distribution reduces that payment. On the other hand, others who are not invested in a fund that cuts distributions (and therefore not subject to the cut in income) may find opportunities in such cases. For CEF investors, especially those who have not experienced the aftermath of a sharp distribution cut, a look at some recent occurrences may be instructive. The topic is timely because it is clear that at some point in the near future, interest rates will begin going up. When that happens, it is not unlikely that many funds will feel the pinch on their holdings and from rising leverage costs. One consequence may well be distribution cuts by CEFs, especially fixed-income CEFs that have been paying out unsustainably high distributions. One highly visible case occurred just last week when PIMCO High Income Fund (NYSE: PHK ) cut its payout amount on Sept 1. PHK has maintained an exceptionally high distribution yield over many years. Investors flocking to that high yield drove the premium for the fund into the 80% range. The fund had many detractors, but shareholders who enjoyed the high income the fund generated were often vigorous advocates. The fund’s share price and premium had been declining for months. Then PIMCO declared a 15% reduction in the distribution (the first distribution deduction in fund’s history), and there was a strong sell-off. The high yield, extraordinary premiums and regular controversy surrounding it made PHK’s plight highly visible. But it is not the only fund to have cut distributions this month. Two Allianz funds, AGIC Convertible & Income (NYSE: NCV ) and AGIC Convertible & Income II (NYSE: NCZ ), did so as well. I want to look at those three funds and two other examples. Two tax-free municipal bond funds from Pioneer: Pioneer Muni High Income Advantage (NYSE: MAV ) and Pioneer Municipal High Income (NYSE: MHI ), which cut their distributions in May. This chart illustrates the extent of the distribution cuts for these five CEFs. Distribution cuts ranged from 15% to 32.35%. These are drastic cuts. Anyone depending on the funds’ distributions for stable income would find a 15% income cut difficult and a 32% cut devastating. The first thing that comes to mind is the importance of diversification. Obviously, a portfolio with a high allocation to one or more of these would have delivered an income shock well in excess of a portfolio where they fill a moderately small fraction of the income holdings. This is such a primary factor in portfolio building; I will not discuss it here other than to point out how these actions underscore the need for holding a diversified portfolio. The second is to ask if an investor might have anticipated the cuts, a point I recently considered ( here ) for PHK with an eye on other PIMCO funds. And the third involves the aftermath: How might the cuts affect new investment decisions in the funds? What these CEFs had in common is high distributions and moderate to high premiums relative to their peers. Income CEFs tend to modulate discounts/premiums to adjust payout at market price to a point near some market equilibrium level. This creates a feedback loop: A manager does a good job generating high returns. The high returns drive investors to bid up prices into premium ranges. The high premiums mean that the distributions on NAV that fund managers have to earn to pay those high distributions on premium market prices are even higher. Eventually it becomes impossible to sustain such high NAV yields and managers are forced to cut distributions. Because it was the high yield that drove investors’ decisions to own the fund, many take a quick exit when that yield drops. Market price declines and premiums shrink or go to discounts to bring market distribution yields closer to the equilibrium value. PHK PHK is an extreme example. From the chart above, we see the distribution was cut 15.1%. The price dropped 10.4% the next day and 15.6% by the week’s end. NAV stayed completely stable, thus the premium dropped from 32.9% to 12.1% at Friday’s close. The net result was that distribution yield at market price remained stable. Obviously, this is a short window. Deeper losses may be in the offing, or the share price may stabilize near the 15.5% yield point. There were clear predictors of PHK’s cut and many observers have been pointing them out for a long time. The most glaring was PHK’s failure to cover its distribution. I’ve discussed this in detail in a recent postmortem analysis of the cuts in the article linked above and will not repeat that. As for opportunity, I do not see anything approaching opportunity in PHK’s slide. The 15% distribution cut may not have been adequate to stabilize the fund as its coverage ratio prior to the cut was only 65%. As I’ve said previously, more cuts may well be on the horizon for PHK. NVC and NVZ Distribution cuts for the two Allianz funds came the same day as PHK’s cut. These were much steeper than PHK’s: distribution for NCV was sliced by 27.8% and for NCZ by 32.4%. The market’s response was equally rapid. NCV’s share price dropped 11.3% in a day and was down 8.82% at the week’s close. NCZ, which suffered even larger distribution cuts, lost 12.8% the first day. It too picked up a bit by the week’s close. NCV was priced at a small premium (0.83%) prior to the cut; it fell to a discount (-8.94%) but still above the average for fixed-income CEFs (-11.9%). NCZ’s 3.12% premium went to a discount of -9.72%. For both funds the distribution yields at market price ended the week at 11.8%, well off the yields before the cut, but still in the upper reaches of their category, ranking 10 and 11 among the 146 taxable income funds in the cefconnect screener. Note that after the initial drop, each fund saw a meaningful uptick. This suggests that there may be opportunity in NCV and NCZ. I will be researching both in more detail with an eye to determining if the distribution cuts were sufficient to bring the funds into a sustainable position. Others interested in income CEFs may want to do the same. On first look, it’s hard for me to decipher what drove the sharp decreases in payout for these two funds and I certainly will want a clearer picture here before I consider any moves into either. Undistributed net investment income or UNII certainly does not raise red flags. For NCZ, it was slightly negative (-$0.0667) at the end of February, and for NCV, it was slightly positive ($0.0319) (both from cefconnect.com). For the August distributions, NCV management estimated “that approximately 22% is from net investment income and approximately 78% is from net profits from the sale of portfolio securities or other capital gains.” For NCZ , “$0.0652 per common share [77%] of this distribution is from net investment income and $0.0198 [23%] is from paid-in capital in excess of par.” These factors need to be looked at more closely. Michael Foster addressed this issue in July, and for NCZ, he tells us that “these payments are not returns of capital; they are profits from sold bonds and convertible notes that the fund has held and liquidated.” He did not consider this to be cautionary with regard to the sustainability of NCZ’s distributions. The UNII numbers would seem to support his conclusion, but the distribution cuts call that into question. Most importantly, I see none of the indicators I (and others I’ve looked to for knowledgeable input on CEF investing) look to as signs of pending distribution cuts other than a subjective reaction to the fact that the funds had to generate high, possibly unrealistically high, returns on NAV to sustain those high distributions. I would certainly appreciate hearing any insights readers may have here. MAV and MHI I want to turn my attention to the two muni bond CEFs which have a bit of history following their cuts. Here again there is a tale of sky-high premium valuations coming down to earth. Fours months ago, the funds announced distribution cuts of 15.8% and 17.7%. Both funds were posting distributions above the peers, sufficiently above to generate premium valuations for each: 24.5% for MAV and 10.6% for MHI. Investors were paying those premiums for 9.1% and 7.7% yields on NAV, either without asking or answering to their satisfaction the question of how the managers were getting those returns from low-yielding municipal bonds. Here again, it is hard to find, even in retrospect where it’s usually easy, what might have predicted the distribution cuts and warned investors that a fall was coming. UNII was strongly positive for both funds. UNII was reported for MAV as $0.2021 at the end of March 2015, and $0.1622 for MHI in April. I suspect neither of those reports were in investors’ hands on May 5 when the axe fell, but I think it’s safe to say UNII would not have provided a clue that cuts were imminent. Neither fund was holding the highest-quality bonds, but that was nothing new for them. Duration was moderately long, but not out of line with peer funds that were returning lesser distributions. Sure the funds were on the riskier end of the muni-bond spectrum, but both had been handling that position for some time. If investors were concerned, as well they might be, there was little in the obvious data to heighten that concern in April. The most telling point might have been the exceptionally high distributions on NAV required to fund the payouts to shareholders. Muni-bond portfolios simply do not earn 9.2% or even 7.7% sustainably in the present ultra-low interest rate environment. MAV and MHI are leveraged, which would enhance their income-generating potential, but at 33% and 25%, neither is leveraged to a degree sufficiently above its peers to account for those exceptional yields. Unlike the other funds, we now have a four-month, post-cut record. Both funds continued to fall. MAV’s price has fallen 16.7% from its pre-cut level. It still maintains a premium (5.6%), albeit reduced substantially from its pre-cut level of 24.5%. MHI’s market price is 15% below its pre-cut level, and its premium is now down to a -5% discount. Both funds saw premium/discount levels pop a bit after their initial falls but then decline sharply. This chart shows MAV’s YTD premium/discount status. And this shows MHI’s. Are the funds offering buyers opportunity at these prices? Perhaps a case can be made that they are. Management has shown the ability to outperform peer funds over time. Distributions have been brought down to levels more consistent with their muni-bond fund peers. Bottoms seem to have been set for market price and possibly for discounts. The funds may well falter, but I think that’s more likely to be as part of a broad, sector-wide downturn for muni bonds rather than something specific to these funds. As a muni-bond CEF investor, I had considered MAV as the discount was falling but I am loath to buy any CEF at a premium valuation. Regardless, I did take the plunge in early August when the premium was close to zero and looked like it may have reached bottom. So far, that has turned out to be a reasonably good call but it’s still early days. Meanwhile the 7.5% distribution, free from federal taxes, is a welcome addition to my income stream. MHI with its lower leverage, similar portfolio and deeper discount may be the preferable opportunity at this time. I began this exercise in pursuit of a cautionary tale. Regrettably, the only one of these five funds that showed clear signs of imminent disaster is PHK, where the situation was so ripe for a crash that anyone should have been able to see it. For the others, the indicators are more subtle, sufficiently so that I would certainly have been taken by surprise had I been invested in any of them. The most I can infer is that if it looks too good to be true, it likely is. Not very satisfying, but the most noteworthy lesson I can take away from NCV, NCZ, MAV and MHI is that funds selling at premium valuation and turning in exceptional returns on NAV to support those valuation are best avoided even if there is no obvious marker for trouble ahead. I would appreciate any input from readers who have more substance to put on those sketchy bones. Disclosure: I am/we are long MAV. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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