Tag Archives: closed-end-funds

Tax-Free Income For Those Who Need It Most: California Municipal Bond CEFs

Summary California’s tax-free income investing is covered by 22 closed-end funds. These present a diverse array of offerings varying in distribution, leverage and all aspects of portfolio composition. In this article I take a look at all 22 of the funds. I look at municipal bond closed-end funds periodically and try to keep readers up to date on the category as changes occur . In doing so, I focus specifically on national funds because I feel it interests a broader audience than any single state fund. Being a Californian I do watch the California funds carefully, and the bulk of my muni bond fund holdings are California state funds. But I’ve not taken the time to write up my research in these funds because I thought the broad interest would not be there. I get frequent requests for coverage of state muni bond funds, especially the high-tax, high-population states, California and New York. So, with this effort, I’ll put together some of my results on California state municipal bond tax-free CEFs. These funds invest exclusively in California municipal bonds and are, therefore, exempt from both federal and state taxes. My fellow Californians appreciate how much it can add to the value of a fund’s distributions when you take away the tax bite from the country’s highest state tax levels. Several years ago, California allowed an exemption for the California portion of national muni bond funds, but as I understand current tax policy in order for a fund’s distributions to be exempt from California taxes, it must have at least 50% of its holdings from eligible California holdings. Why Single State Muni Bonds? Determining how much advantage one gets from federal and state tax-exempt income can be opaque. Fund sponsors and data aggregators tend to report tax-equivalent returns based on the highest marginal brackets. Few of us qualify at that level, so the reported (or should I say, advertised?) data is near meaningless. It is fairly straightforward to find a tax-equivalent return for federal taxes; one simply has to plug in the marginal rate for a simple calculation. But for state taxes it is more complex. For one thing federal and state marginal rate increments do not correspond. For another, in California at least, federal tax is a deductible, which means one has to adjust the income from the muni bonds to take the federal exemption into consideration. I am not even remotely a tax expert, but real tax experts at Eaton Vance have created an excellent calculator for determining tax equivalence for national and state tax funds based on an individual’s filing status and income level. To make it more useful, it includes equivalent yields not just for ordinary income, but for government bonds, for which interest is tax-exempt in California, qualified dividends, and long- and short-term capital gains. You can find this useful resource here . I know of nothing more comprehensive. I’ve run up a chart showing taxable equivalents for distribution yields of California muni bond funds. This only covers the case for married filing jointly status, so do check out the EV site for your precise situation. The California Municipal Bond CEFs A good thing about trying to get a handle on California muni bond CEFs is that there is a manageable number to deal with. There are 99 national funds which makes ferreting out comparative information not available from screeners and data aggregators a daunting task. I am not aware of any screeners that let me filter on important metrics like portfolio duration or credit quality or AMT percentage. For me, this mean filtering on metrics like discount status, distributions, Z-scores, maturity, leverage and the like to narrow the pool and then try to fill in the gaps. Things get overlooked with this approach and one of the advantages I’ve found from making my results public here is that some very knowledgeable readers will pass along some of their favorites that I overlooked using this approach. With only 22 funds for California munis, one can dig out these data manually with a reasonable investment of effort. Indeed, it’s worth listing all 22 of them here, along with some key characteristics of the funds. First, the funds: Alliance California Municipal Income Fund (NYSE: AKP ) Blackrock California Municipal Income Trust (NYSE: BFZ ) Blackrock California Municipal 2018 Term Trust (NYSE: BJZ ) MFS California Municipal Fund (NYSEMKT: CCA ) Eaton Vance California Municipal Income Trust (NYSEMKT: CEV ) Eaton Vance California Municipal Bond Fund II (NYSEMKT: EIA ) Eaton Vance California Municipal Bond Fund (NYSEMKT: EVM ) Blackrock Muniyield California Quality Fund, Inc. (NYSE: MCA ) Blackrock Muniholdings California Quality Fund, Inc. (NYSE: MUC ) Blackrock Muniyield California Fund, Inc. (NYSE: MYC ) Neuberger Berman California Intermediate Municipal Fund Inc (NYSEMKT: NBW ) Nuveen California Dividend Advantage Municipal Fund (NYSE: NAC ) Nuveen California Municipal Value Fund Inc (NYSE: NCA ) Nuveen California Municipal Value Fund 2 (NYSEMKT: NCB ) Nuveen California AMT-Free Municipal Income Fund (NYSE: NKX ) Nuveen California Dividend Advantage Municipal Fund 2 (NYSEMKT: NVX ) Nuveen California Select Tax Free Income Portfolio (NYSE: NXC ) Nuveen California Dividend Advantage Municipal Fund 3 (NYSEMKT: NZH ) Pimco California Municipal Income Fund II (NYSE: PCK ) Pimco California Municipal Income Fund (NYSE: PCQ ) Pimco California Municipal Income Fund III (NYSE: PZC ) Invesco California Value Municipal Income Trust (NYSE: VCV ) Sorted by market cap the category breaks down like this: (click to enlarge) Some of the funds at the right side of this chart can present liquidity issues. I tend to put limit, all-or-none orders in when I bid on CEFs. I was unable to buy EIA at terms that might not have been a problem for more liquid funds. Leverage is an important driver of high distribution income from muni bond funds. People will fret about leverage and the threat of rising rates, but that’s how these fund deliver better than 5% yields from such low yielding assets. For those who dread the thought, there are 4 minimally leveraged funds in the mix. (click to enlarge) The whole point of holding any income fund, taxable or tax-free, is, of course, income. So, what sort of income can we expect from the California muni bonds CEFs. Here is a chart of current distribution yields at market price and NAV. (click to enlarge) Note that the two high-yielding PIMCO funds at the left have market yields below their NAV distributions. This is, of course, a reflection of their premium valuations. For most of the remaining funds their discounts give a boost (albeit smallish right now) to their yields. So, let’s turn to discounts and premiums. Seventeen of the 22 funds currently hold a discount. True to PIMCO form, their 3 funds have premium valuations. This is a recurring story throughout fixed-income CEF space. PIMCO, by application of their secret sauce, manages to generate NAV yields appreciably above their peers. Investors respond by bidding the funds up into premium territory, reducing the yields from NAV, but keeping them above the pack at market price. Interestingly, the other premium funds are two low-yielding, low-leverage funds from Nuveen, NCA and NXC. BIZ, the fund with the skimpiest discount is the fund that carries the least leverage. It appears investors are willing to pay premium prices and accept lower distributions (see distributions chart above) to forego leverage. More than three-quarters of the funds have discounts, but for each of them the discount is shrinking. This is something one might infer from the RSI data above; a look at Z-scores for three months confirms it. (click to enlarge) Z-Score is a measure of how far the current discount/premium varies from the average discount/premium for a time period. A negative Z-score indicates that the discount has deepened relative to the mean. Not one of these funds has a negative Z-Score for the past three months. The most accessible way to approach the Z-statistic is to read it as the number of standard deviations the current value is above or below the mean for the period. Seventeen funds are more than a standard deviation away from the mean discount/premium. Thirteen are more than two standard deviations away, and one, NXC, is more than 3.5 standard deviations above its mean value. The message here, coupled with the RSI data at the top, is that now is not a timely entry point for California muni bond CEFs. For the record, here are the 6 and 12 month Z-scores using the same sort to facilitate comparisons. (click to enlarge) It was not so long ago that California muni bond funds were a great bargain. Deep discounts were the norm. Funds were discounted to the extent that it was possible to buy funds that were returning higher yields on market price than comparable national muni bond CEFs. What changed? To answer this we need to understand what was driving those bargains. Two California municipalities were in the news as bordering on bankruptcy. The larger of the two, Stockton, is a good size city and the press was full of doom and gloom for the fiscal condition of the Golden State. At time, I began writing about muni bond CEFs and numerous commenters referenced Stockton and put California in the same category as Puerto Rico on the at-risk scale. Predictably, holders of California CEFs jumped ship in droves. Bargains were the order of the day. At the time I argued that 1) California was in no worse fiscal condition than any other large, diverse and complex state; and 2) muni bond defaults were so rare as to be negligible. It took about a year or so, but investors have decided that California may not be so bad after all. What is worrisome to a less skittish CEF buyer is whether or not the current upsurge is an overreaction. I depend on my California muni CEFs for income but I am seriously considering taking profits here with an eye to coming back in when the prices compensate yet again in the next direction. That’s part of my recent interest in national muni bonds as I look for alternative income sources. Oh, what’s that I hear. Something about hand waving on that muni defaults comment? Ok, here’s some evidence from Oppenheimer’s year-end Chart Book comparing muni bond defaults to corporate defaults for BBB rated bonds. Next time you hear about how muni bonds are ready to crash and burn remember this chart: (click to enlarge) NAV Yield and Discount Trend As those who follow my work on munis are aware, I like to look at the relationship between NAV Yield and Discount/Premium. One factor that contributes to a fund finding its market discount or premium is yield on NAV. Investors tend to drive fund prices toward an equilibrium on market yield by price up funds with high NAV yields and pricing down funds with low NAV yields (see PIMCO discussion above for extreme examples). We can plot that relationship thusly: (click to enlarge) I’ve omitted the low leverage funds from this chart. The r2 is very high (0.88) indicating the strength of the relationship in this case. By this indicator funds that fall below the trendline tend to be better priced than those above it. It’s telling us to look closely at VCV, NZH, EVM, EIA, and perhaps, NAC. I’ll fit these funds into other metrics as I proceed. Portfolio Composition This raises the issue of portfolio compositions. Two components are of special interest in this regard: Duration and Credit Quality. This table is from Morningstar’s analyses of the funds. The effective durations are unadjusted and adjusted for leverage. Average weighted credit rating is based on Morningstar’s weightings which gives higher weight to lower quality bonds. It varies from what you might see elsewhere, but it is consistent from fund to fund, unlike what you might see elsewhere. It tends, like much of what Morningstar puts out, to present the most conservative case. (click to enlarge) I’ve included discount and distribution yield here to show relationships. I’ve also put in a column showing Morningstar’s category for each fund to point out how unreliable such categorizations can be. While BIZ, one of the two intermediate funds, does have the shortest adjusted duration, NCB, the other, is well into the upper middle of the pack. EIA, a long fund according to Morningstar has the shortest unadjusted duration and lags BIZ by a trivial 0.23 when adjusted for its leverage. But I digress, let’s go on to credit quality. I’ve sorted the table on credit quality. One might expect yield to reflect that sort but it doesn’t. PCK with a BB+ portfolio has the highest yield here, and that’s with a 12% premium which means the managers are generating 7.4% yield from California muni bonds. It does, however, also somewhat typical for high-premium, high-yield PIMCO funds, post negative undistributed net investment income. PCK’s UNII runs about -7.2% of its annual distribution (at market) or somewhat less than a single month’s premium. While not at a level that puts up worrisome red flags, it is the highest in the category. The fund last cut its distribution in April 2014 (-14%). Two Blackrock funds, MCA and MYC, have the strongest credit quality with average ratings of AA-. They fall mid-pack for distribution, near the top for leverage, and about the middle for adjusted duration. For anyone concerned about credit risk, they may represent the best choice. A step down the credit quality scale is NBW which shares a BB+ rating with PCK. It has a moderate discount of -3%, a mid level yield of 5.47%, and the second highest leverage (41.02% to PCK’s high value of 41.12%) in the category. It pays more than a point less than PCK, slightly less then the better-rated portfolios from MCA and MYC, so I see no reason one would purchase it at this time. Dropping down to BBB+ takes us to another Blackrock fund, BFZ. It offers a solid distribution yields of 5.62%, medium low adjusted duration and a discount of -2.34%. Eaton Vance’s EIA holds one of several BBB rated portfolios and generates the highest yield of the set. It does so with an impressively short leverage-adjusted duration (3.7) second only to the unleveraged BIZ. For all but the most yield-hungry or credit-wary, it should be the choice of group. I’ve tried to summarize portfolio compositions in this chart. Funds are grouped by weighted average credit rating and scored on the basis of distribution yield. The dot size represents the level of leverage. (click to enlarge) From this view, MCA, MYC, PCK look like the top choices. But this view does not factor in PCK’s premium. Nor does it include our knowledge of that negative UNII. So I’d go with Blackrock’s offerings with the race going to MCA on the basis of those few basis points of higher yield generated by its deeper discount. Both of those factors could change in a day, so let’s call them a wash. BFZ could be considered next along with EIA and EVM. BFZ offers a better credit quality (BBB+ to BBB) but trails a bit in yield. EIA wins handily on effective duration with BFZ near and EVM trailing slightly. Beyond these fund, one is looking primarily for high yield, so there’s PCZ with its 12% premium, or Invesco’s VCV with a -6.1% discount. One would have to be satisfied that PZC’s quarter point of yield justified the premium purchase to chose it over VCV. Finally, for an investor who puts yield second to leverage (or lack of leverage), the two choices would seem to be Nuveen’s NCA or NCB. I did not try to find AMT liability for all of the funds but the few I’ve singled out range from AMT free to having moderate levels of their income subject to AMT. The Eaton Vance funds (EIA and EVM) are AMT free as are the PIMCO funds (PCK, PCQ and PZC). Blackrock’s funds do have AMT liability: BFZ (1.43%), MYC (3.53%), MCA (4.70%). Invesco’s VCV has 4.56% subject to AMT and for Neuberger Berman’s NBW it’s 5.27%. The low leverage funds top the list with NCA at 11.58% and NCB at 6.27%. Summing Up California Muni Bond CEFs are likely overbought and investors who are inclined to trade funds as discounts and premiums rise and fall should likely be looking to sell rather than make purchases at this time. Investors interested in opening or expanding long term positions in California tax-free income have some solid choice depending on one’s priorities. EIA with is high quality portfolio and short durations is a strong contender as is its stable mate EVM. MCA and MYC offer the lowest credit risk and give up only trivial amounts on yield. Other funds with solid reasons to own and hold include VCV for high yield, NBW for its portfolio quality, and NCA and NCB for low leverage. PCK is a solid choice for someone willing to overlook the premium and the negative UNII. It’s not for me but PIMCO’s premium funds have their staunch advocates.

Tax-Free Income From Municipal Bond CEFs

Municipal bond CEFs can provide attractive yields free from federal taxes. I survey the tax-free CEF category in this report. The category has seen an upsurge in interest which has begun to take a toll on the attractiveness of some funds. Tax Free Income I’ve been spending a lot of time looking at tax-free-income, closed-end funds (municipal bonds) recently. It would appear that I am not alone. For the last two months, muni bond CEFs have sustained the highest relative strength index of all CEF categories as classified at ETF Screen . This chart showing RSI for CEF categories is built from their data. (click to enlarge) I find it interesting that the upsurge in RSI for muni bond CEFs dates from just about the time I wrote a series about them ( Tax Free Income from Municipal Bond Closed End Funds ) in mid-August when I felt the category was rife with bargains. It seemed clear to me at the time that the category was ready to move up. In light of the intense interest the data in the chart indicates, I thought I’d take another look. Keep in mind, however, that chart technicians tend to see RSI values this high as an indication of being overbought, so the chart may well be trying to tell us that this is not the time to be adding municipal bond CEFs. As I’ve done in the past I want to try to paint a graphic picture of the space and follow up with a brief look at some funds that look interesting. I’ll follow up in a few days with details on specific funds. First, a look at distributions. Here’s the spread for the whole muni bond category of CEFs. (click to enlarge) To put the tax-free return in perspective, I’ll add this table of equivalent taxable returns for federal tax rates assuming normal interest income. (click to enlarge) Regular readers know that I like to buy funds at a discount, especially at a discount that is outsized relative to the fund’s recent history. This chart shows the current distribution of discounts and premiums for the 99 funds in the category as listed on CEFanalyzer . (click to enlarge) Over the past six weeks the range has shifted toward lesser discounts. The average discount has lost two points. Discount/Premium 25-Aug 12-Oct Average -8.81% -6.84% Median -9.86% -8.31% Low -14.68% -13.12% High 7.36% 12.87% Z-Scores tell us a lot about the directions discounts and premiums are moving. Here are current Z-score distributions for 3, 6, and 12 months. (click to enlarge) (click to enlarge) (click to enlarge) What we see is a strong shift over the past year toward more positive Z-scores demonstrating reversion to the mean for discount/premiums across the category. A year ago the median Z-scores stood at -1.43%; today it is 0.13. Another interesting metric is the relationship between NAV distribution and discount. What makes this indicator valuable is the tendency for CEFs to move toward some price distribution yield equilibrium through adjustments of discount status. CEF investors are primarily investing in the income. We see the repeated occurrence of high discounts on funds with lower distributions on NAV as buyers are less willing to pay for the lesser income distributions. Similarly more modest discounts, even premiums are found on funds with higher distributions on NAV. This relationship is seen in the next chart. I’ve added labels, but the amount of information here is such that the labels are in many cases, unreadable at this scale. The primary point of the chart is to show the overall relationship, so it should not matter except at the edges, which are readable. I’ll zoom in on the most interesting cluster next. (click to enlarge) The trend line here shows the positive relationship between NAV distribution and discount/premium. Funds that lie below the trend line tend to present more attractive entry points than those above the trend line. That is not to say that funds above the line are unacceptable for purchase. There are many complex factors that go into the market’s pricing of any given fund, distribution yield is only one, an important one but not the only one. The r 2 for the linear trend is only 0.15, so this relationship only accounts for 15% of the variation in discount/premium. Quality factors especially will often override the tendency shown in this chart. A fund might be priced at a lesser discount because, for example, has a more attractive portfolio on credit quality or effective duration. My own bias is to avoid funds at the upper ranges of distance from the trend line and to use this chart to identify candidates for a closer look. With that in mind, let’s look at that dense cluster crowded around the -10% discount and 5.5% NAV distribution point. (click to enlarge) I’ll note here that some of my favorite funds lie just above that line: The Dreyfus Strategic Municipals (NYSE: LEO ) and the Blackrock Investment Quality Municipal Trust (NYSE: BKN ) are two that I have owned in the past and I consider them both to be good funds. Note that the cluster most distant from the line holds a large fraction of Nuveen funds. I don’t know why it is, but Nuveen funds seem to hold deep discounts over long time frames. Last time I looked at this, I picked out 13 for a closer look. Five of these were Nuveen funds which, as I noted, tend to carry a perennially deep discount, so this is not a great indicator for those funds. Those 13: The MFS High Yield Municipal Trust (NYSE: CMU ) and the Municipal Income (NYSE: MFM ); the Dreyfus Muni Bond Infrastructure (NYSE: DMB ); the Eaton Vance Municipal Bond I (NYSEMKT: EIM ) and II (NYSEMKT: EIV ); Nuveen’s Muni Advantage (NYSE: NMA ), Muni Mkt Opps (NYSE: NMO ), Select Quality Muni (NYSE: NQS ), Dividend Advantage 2 (NYSEMKT: NXZ ) and 3 (NYSEMKT: NZF ); and Invesco’s Muni Investment Grade T (NYSE: VGM ), Adv Muni II (NYSEMKT: VKI ) and Muni Opps Trust (NYSE: VMO ). The 13 funds have a total gain of 2.51% which sounds good until I add that the entire muni bond space averaged 2.41% over the same time frame. Here are those 13 and their returns since that time. The funds in green beat the category average. Note that if we drop the Nuveen funds from consideration, the average goes to 3.05%. That’s not to say that Nuveen funds should be avoided, merely that I don’t think this indicator applies as well to them as it does to funds with more volatile discounts. If we look at the Nuveen funds alone it turns out there is no correlation between discount and NAV distribution. (click to enlarge) This suggests that the indicator has no value for evaluating Nuveen’s muni bond funds. There are other factors driving discount dynamics that are more important for this set of funds. Of course discounts alone are not sufficient to make a decision on a fund. Duration is an important consideration, especially with interest rate anxiety so prevalent in everyone’s thinking. The nature of how data is reported means that one can only screen on average maturity, which is a much less telling metric than effective duration. The top five funds for portfolio maturity and a distribution greater than 5% are the Deutsche Municipal Income (NYSE: KSM ), the Deutsche Strategic Muni Income (NYSE: KTF ), the AllianceBernstein Nat Muni (NYSE: AFB ), the EV Municipal Bond II and the Putnam Municipal Opportunities (NYSE: PMO ). Working from this list, we can go to Morningstar where effective duration, leveraged and unleveraged, plus weighted average credit ratings for the portfolios can be found. Note that Morningstar’s weighted credit rating score may differ from that of other sources as their weighting system more heavily weights lower credit quality holdings. (click to enlarge) We see that the screenable metric, maturity, is a poor predictor of the more relevant metric, duration, but it’s the best starting point we have for a group of funds this size. EIV would seem to be the choice here. It rose to the top at my last look and it is still there today. It is paying 5.9%, somewhat under the category median of 6.1% and right on the category median. The discount just beats the median of -8.31%. Portfolio maturity is in the top 10 and effective leverage is the best of the five top funds for average maturity and distribution greater than 5%. Its weighted average credit rating is the best of the lot. Also worth noting is that EIV is an AMT free fund. The two Deutsche Investment Management Americas funds (KSM and KTF) are interesting. They are yielding about a half point more than EIV. Their modest discounts, especially KSM, and lesser credit quality puts them a step behind EIV for me. KTF beats KSM on credit quality and discount, but lags on distribution and duration, so it’s a bit of a wash choice between the two. Expenses on the Deutsche funds are modest at 0.64%, well below EIV (1.20%), AFB (1.04%) and PMO (0.96%). Leverage for each of these is in the mid 30% range which is typical of the category. For those who prefer to avoid leverage, there are two funds with under 2% leverage. They also have the shortest portfolio maturities in the category. As expected they have significantly reduced yields relative to the leveraged funds. These are the BlackRock Muni 2018 Term Trust (NYSE: BPK ) and the Nuveen Select Maturities Muni (NYSE: NIM ). (click to enlarge) Fees on these two funds are low, 0.64% for BPK and 0.58% for NIM. Yields are, as noted, low relative to the leveraged CEFs, but competitive with unleveraged municipal bond ETFs such as the iShares National AMT-Free Muni Bond ETF (NYSEARCA: MUB ) which has an effective duration of 6.34 years, weighted average credit rating of AA, and at 2.58% yields significantly below either of these two funds. It is AMT free, however. BPK is 28% subject to AMT, but NIM is only 3.2%. I’ll be back with a closer look at interesting funds that may provide attractive entry points at this time.

CEF Portfolio Generates 9% Income With Reasonable Risk

Summary The CEF portfolio had an average distribution of 9.4% coupled with lower risk than the S&P 500. The CEF portfolio is diversified among many types of funds including bonds, preferred stocks, equities, and covered calls. Most of the selected CEFs are selling at historically large discounts. As an income focused investor, I’m a fan of Closed End Funds (CEFs), and have written many articles on Seeking Alpha discussing their risks and rewards. Many CEFs have recently taken it on the chin because of fear that the Fed may begin raising rates. To my mind, this has created CEF bargains among many asset classes. This article constructs a diversified portfolio of CEFs that are selling at large discounts and also have reasonable risk-versus-reward profiles. Below is a summary of the CEFs I have selected. I apologize in advance if I did not include your favorite CEF and I welcome alternative suggestions from readers. The data is based on the 2 October market close. BlackRock Corporate High Yield Fund (NYSE: HYT ). This is one of the largest high yield CEFs with a market cap of $1.3 billion. Over the past 5 years, this CEF has sold for a both discounts and premiums. Premiums were relatively rare and reached a high of 6% in 2012. The fund typically sells at a discount, averaging about 5% over the past 5 years but increasing to a 12% average during the past year. The current discount is 15.2%. The portfolio is a combination of high yield bonds (87%) and equities (7%). The fund utilizes 31% leverage and has an expense ratio of 1.3%. The distribution is 8.7%, funded by income with a small amount of Return of Capital (ROC). The ROC is typically only about 1% of the total distribution. Brookfield Total Return Fund (NYSE: HTR ). This fund focuses on mortgage backed securities (MBS). Over the past 5 years this CEF has sold primarily at a discount. The 5 year average discount was 5% but the discount has grown to a 9% average over the past year. The current discount is 16.5%. The portfolio consists mostly of MBS and asset backed securities with the majority coming from the commercial and residential non-agency sectors. About 40% of the bonds are investment grade. The fund utilizes 28% leverage and has an expense ratio of 1.3%. The distribution is 10.9%, funded by income with no ROC. Nuveen Credit Strategic Income Fund (NYSE: JQC ). JQC has a market cap of about $1.1 billion and is the largest CEF focused on floating rate loans. Over the past 5 years, this CEF has sold mostly at a discount. The only time this fund sold at a premium was a short period in 2013. The five year average discount is 8% and the one year average is 12%. The current discount is 15.2%. The portfolio consists of a combination of floating rate loans (68%) and corporate bonds (19%). Less than 10% of the holdings are investment grade. The fund utilizes 38% leverage and has an expense ratio of 1.8%. The distribution is 7.6%, funded by income with no ROC. AGIC Convertible and Income Fund II (NYSE: NCV ). This fund focuses on convertible securities. Over the past 5 years, this CEF has sold mostly at a premium, sometimes as high as 15%. It was not until the second half of 2015 that the fund, began selling at a discount. The five year average was a premium of 7% and the 1 year average was a premium of 5%. The current discount is 14.4%. The portfolio consists of a combination of convertible bonds (58%) and high yield bonds (41%). Less than 10% of the holdings are investment grade. The fund utilizes 33% leverage and has an expense ratio of 1.2%. The distribution was recently reduced but is still 13.3%. The distribution is funded by income with no ROC. Nuveen Preferred Income Opportunities Fund (NYSE: JPC ). This fund focused on preferred shares. Over the past 5 years this CEF has sold only for a discount. The smallest discount was about 1% in 2012. The 5 year average discount is 9% and the 1 year average discount increased to over 10%. The current discount is 11%. The portfolio consists primarily of preferred stock (88%) with a small amount of equities (6%). The fund utilizes 29% leverage and has an expense ratio of 1.7%. The distribution is 9%, funded by income with no ROC. Cohen Steers Quality Income Realty Fund (NYSE: RQI ). This fund is focused on REITs. Over the past 5 years this CEF has sold only at a discount. The discount has oscillated between less than 1% to over 14%. The 5 year average has been a discount of 8% but the 1 year average has increased to a discount of 12%. The current discount is 12.5%. The portfolio consists of a combination of REITs (80%) and preferred stock (19%). The fund utilizes 25% leverage and has an expense ratio of 1.9%. The distribution is 8.6%, funded by income with no ROC. Eaton Vance Enhanced Equity Income Fund II (NYSE: EOS ). This is a covered call fund. Over the past 5 years this CEF has sold for a both a discount and a premium, but mostly at a discount. The premium was as high as 5% in 2010. The premium turned into a discount in 2011 and has stayed at a discount ever since. The discount sunk to 15% in 2011 but has been improving in recent years. The 5 year average has been a discount of about 8% and the 1 year average is only 5%. The current discount is 8.5%. The portfolio consists equities that are used for call writing on about 50% of the portfolio. The fund managers have a flexible mandate and can invest in all size companies but most are medium to large cap. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 8.4%. The fund has a small amount of ROC but this is not unusual for covered call funds. Cohen & Steers Infrastructure Fund (NYSE: UTF ). This fund focuses on utilities. Over the past 5 years this CEF has always sold at a discount. The discount has grown larger in 2015. The 5 year average has been a discount of about 11% and the 1 year average is 13%. The current discount is 16.8%. The portfolio consists of investments in utility and infrastructure companies. The portfolio contains 80% equities, 10% bonds, and 5% preferred shares. About 60% of the holdings are domiciled in the US. The fund utilizes 29% leverage and has an expense ratio of 2%. The distribution is 8.5% funded by income and capital gains with no ROC. The characteristics of an equally weighted portfolio of these CEFs are summarized in Figure 1. The portfolio has an average distribution of 9.4%, which definitely achieves the objective of high income. The average discount is also large at 14%. (click to enlarge) Figure 1: Portfolio averages Even more important than the value of the discount is how it relates to the average discounts over the past year. This is measured by a metric called the Z-score, which is a statistic popularized by Morningstar to measure how far a discount (or premium) is from the mean discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A good source for Z-scores is the CEFAnalyzer website. A Z-score more negative than minus 2 is relatively rare, occurring less than 2.25% of the time. With the exception of JPC and RQI, the selected CEFs are selling at historically large discounts as evidenced by the large negative Z-score. Both JPC and RQI have large discounts but the discounts are close to the average discount for the year. Figure 2 shows the allocation among asset classes as: bonds (50%), preferred stocks (16%), and equities (33%). Most of the equity portion is hedged by using covered calls. Thus, overall this is a defensive portfolio, which I believe is prudent given the current uncertainties in the market. (click to enlarge) Figure 2: Allocations among asset classes The portfolio looks promising in terms of income but total return and risk are also important so I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility for each of the component funds. The risk free rate was set at 0% so that performance could be easily assessed. I equated volatility with risk and used a 5 year look-back period from October 2, 2010 to October 2, 2015. The plot is shown in Figure 3. (click to enlarge) Figure 3. Risk versus reward for past 5 years. In the figure, the risk-versus-reward for each CEF is represented by a green diamond. The performance of the composite portfolio is shown by the blue dot. I also included the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) ETF as a comparison with the overall market. As is evident from the figure, the CEFs had a wide range of returns and volatilities. Were the returns commensurate with the increased risk? To answer this question, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 3, I plotted a red line that represents the Sharpe Ratio associated with the composite portfolio. If an asset is above the line, it has a higher Sharpe Ratio than composite portfolio. Conversely, if an asset is below the line, the reward-to-risk is worse than the portfolio. You may be surprised that the volatility of the portfolio is smaller than the volatilities of the components. This is an illustration of an amazing discovery made by an economist named Markowitz in 1950. He found that if you combined certain types of risky assets, you could construct a portfolio that had less risk than the components. His work was so revolutionary that he was awarded the Nobel Prize. The key to constructing such a portfolio was to select components that were not highly correlated with one another. In other words, the more diversified the portfolio, the more potential volatility reduction you can receive. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds. The data is presented in Figure 4. All the CEFs had relatively low correlations with SPY and each other. The only large correlation is the covered call CEF with the S&P 500. This is not surprising since large and medium cap companies were used for writing covered calls. Overall, these results were consistent with a well-diversified portfolio and hence, the reduction in portfolio volatility. (click to enlarge) Figure 4. Correlations over the past 5 years. Some interesting observations are apparent from Figure 3. SPY generated a higher return than the portfolio but SPY also had a higher volatility. SPY and the portfolio had virtually the same risk-adjusted performance. Thus, I believe that the composite portfolio is a good tradeoff for the risk averse investor looking for income. To get additional views of the how the portfolio performed, I analyzed two other metrics. The first is graphed in Figure 5 and shows the growth of wealth over the 5 years period. The plot assumes that the portfolio is frequently rebalanced to maintain equal weighting. As illustrated by the graph, wealth grew at a steady pace over the 5 year period. (click to enlarge) Figure 5 Growth of wealth for CEF portfolio The value of the portfolio decreased a few times along the way. The second metric is plotted in Figure 6 and provides a measure of the draw downs that an investor would experience. The figure illustrates that you can expect periods of relatively large draw downs, which could reach as high as 14% in a few cases. Thus, the portfolio is best suited for long term investors who can weather moderate draw downs. Note that we are currently in a 10% drawdown period, which is similar to draw downs in the past. (click to enlarge) Figure 6. Draw downs associated with the CEF portfolio Bottom Line Many of the CEFs in this portfolio have recently taken price hits, which have resulted in large discounts. No one knows what the future may hold but if the future is anywhere close to the past, these CEFs will recover and the discounts will revert back to the mean. If this turns out to be true, you can receive high income while you wait. Overall I believe this portfolio provides high income with reasonable risk.