Investors who are looking at alternative ways to generate high-income in a rising interest rate environment may consider an ETF strategy that tracks yield-producing closed-end funds.
On the recent webcast (available On Demand for CE Credit), Closed-End Funds vs. ETFs: Why Not Both?, Leah Jordan, Vice President of Marketing and Investor Relations at Saba Capital, helped explain that closed-end funds are investment pools with limited number of shares that are traded on a secondary market, so they come with intra-day trading. Additionally, many CEF shares trade at a discount or premium to their net asset value.
The universe of closed-end funds covers a range of yield-generating asset categories, such as Corporate Bonds, Government Bonds, Convertible Bonds, Municipal Bonds, U.S. Equities, Global Equities, Preferred Securities, Mortgage-Backed Securities, Senior loans, REITS and MLPs.
One of the more defining trait or potential benefit of CEFs is the fact that the fund structure trades at a discount to net asset value. The discount to NAV offers additional yield over underlying securities and investors may also seize on the opportunities as the discount or premium changes or capitalize if price converges to NAV, Jordan said.
For example, Jordan reasoned that closed-end funds trading at $10 and paid a $1 dividend would generate a yield of 10%, but if the closed-end price falls but continued to pay a $1 dividend, the yield would be 11.1%.
Looking at the 10 largest fixed-income closed-end funds, they currently provide 28% more yield than the benchmark Markit iBoxx $ Liquid High Yield Index, a common gauge for high yielding tradable products.
More Value in CEFs
Investors may also find more value in CEFs now as the current discount to NAV of the 10 largest fixed-income closed-end funds is 8.0%, compared to a historical average of 2.2% – discounts to NAV greater than these levels only occurred twice in the past 25 years, during the tech crash and the financial crisis.
Jordan also argued that activism may add an additional source of return. A team would engage with management on ways to narrow the discount by tendering for shares, increasing distribution, conversion to an open-end fund or liquidation. Saba has acted as an activist to monetize some of the discount to NAV in a number of CEFs, including the Deutsche High Income Trust (KHI) and Franklin Limited Duration Income Trust (FTF), among others.
To help investors capture the potential opportunities in the CEFs space, Saba has come out with the actively managed Saba Closed-End Funds ETF (BATS: CEFS). CEFS tries to generate capital appreciation and high income by investing in closed-end funds that trade at a discount to their net asset value while hedging the ETF’s risk to rising interest rates. CEFS shows an annualized distribution yield of 8.37%.
“Daily investment decisions are made by portfolio managers with extensive backgrounds investing in closed-end funds and ETFs, who seek to capitalize on a wide range of opportunities,” Paul Kazarian, Portfolio Manager at Saba Capital, said.
Kazarian explained that Saba follows a proprietary screening tool that generates real-time scores for closed-end funds which are ranked across a variety of factors, including historical premium/discount, earnings coverage, undistributed net income, shareholder friendly provisions, activist holders, leverage ratio, maturity and duration, yield, volatility metrics, issuer and expense ratio, security-level portfolio analysis, manager and asset class.
Furthermore, the team hedges against interest rate in an effort to protect investors from the rate risk associated with the underlying fixed income securities of many closed-end funds.
When incorporating something like CEFS into a diversified investment portfolio, Kazarian said the fund can act as part of the fixed-income allocation – the ETF includes a 73% tilt toward fixed-income assets. Additionally, CEFS may be included in the alternative sleeve for high yield and income generation.
Financial advisors who are interested in learning more about closed-end funds can watch the webcast here on demand.