Market gains and more-investor-friendly structures have spurred a spate of new closed-end funds.
So far this year, there have been six new funds totaling $3.6 billion, the most since 2014, and up from four funds totaling just $350 million in 2018, according to Morningstar.
The closed-end market is dominated by yield-oriented funds focused on bonds and high-yielding equities like master limited partnerships and real estate investment trusts. The 2019 crop has been true to those themes. The year’s largest closed-end funds have been BlackRock Science & Technology Trust II (BSTZ), Nuveen Municipal Credit Opportunities (NMCO), and Pimco Energy & Tactical Credit Opportunities (NRGX).
The BlackRock fund, which combines tech stocks with the sale or writing of call options to generate income, has a current yield of 6%. The Nuveen fund, focused on the hot low-grade municipal bond market, hasn’t set a dividend but is expected to yield about 5%. The Pimco fund, which owns MLPs, other energy infrastructure companies, and energy-company debt, has a current yield of 9.5%.
One way that closed-end fund boost yields is through leverage, and lower short-term interest rates help that strategy. The leverage, however, leads to higher share-price volatility and magnifies declines in a falling market. Several of the new funds trade at a discount to their asset value, enhancing their appeal.
Unlike open-end mutual funds, closed-end funds issue a fixed number of exchange-traded shares that generally can’t be redeemed by holders. The price is determined in the open market and can be at a discount or premium to the fund’s net asset value. While closed-end funds have had a revival this year, the $270 billion market is still tiny relative to open-end mutual funds and ETFs.
New issuance of closed-end funds had been low for several years for a few reasons. Many existing funds traded at discounts of 10% or more to net asset value, which made it tough for new funds to have competitive yields. Narrower discounts this year have made new issuance easier.
The old way of issuing closed-end funds worked against investors. Underwriting fees, including sales commissions to financial advisors, were paid out of fund assets. This meant that a fund with an offering price of $20 a share might start with $19.20 a share in assets. Generally, the price of the shares fell toward the net asset value, resulting in investor losses.
The new funds take a different approach. Sponsors have paid the underwriting fees so that a fund issued at $20 a share starts with $20 in assets. Another plus is that this year’s funds are due to terminate—or give investors the option to redeem shares at asset value—in 12 years. This is intended to limit the discounts at which the funds trade to net asset value.
The new funds, however, tend to have ample fees, often averaging more than 1% annually. At a time when investors are increasingly fee-conscious, closed-end funds don’t stack up well.
Still, “the funds this year have been more differentiated, and the pricing mechanism with the sponsor paying the upfront fees has expanded the number of financial advisors looking at the funds,” says David Lamb, a managing director at Nuveen.
The $232 million Angel Oak Financial Strategies Income Term Trust (FINS) focuses on a little-known area of the bond market: community-bank debt. Issuers include Midland States Bancorp (MSBI) in Illinois and Luther Burbank (LBC) in California. The shares trade around $20, in line with net asset value, and yield 7.2%.
Angel Oak buys investment-grade debt or unrated bonds that it views as investment grade. Navid Abghari, one of the fund’s portfolio managers, says the yields compare favorably with double-B-rated junk debt yielding about 4%. The high yields reflect the small size of the bank deals—under $300 million—which can make for illiquid markets.
The $236 million Tortoise Essential Assets Income Term fund (TEAF) is an unusual hybrid, combining energy infrastructure stocks and bonds with what the firm calls socially responsible investing (loans to charter schools and senior-living centers) and sustainable investing (renewable energy).
Investors aren’t won over yet. The shares are down 20% since the fund’s inception in March and trade at $16, a 14% discount to net asset value. They yield 8.3%.
The wrinkle on the $365 million RiverNorth Managed Duration Municipal Income fund (RMM) is that it combines a traditional muni investment strategy with one focused on buying closed-end muni funds trading at a discount to asset value. It trades around $20 and yields 5.5%.
One new fund—AllianzGI Artificial Intelligence & Technology Opportunities fund (AIO)—is expected to be offered in coming weeks. The fund plans to invest in a range of equity and debt securities that are “positioned to benefit from the evolution and disruptive power of artificial intelligence and other new technologies.”
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