Roxanna Islam talks about generating income with CEFs on TD Ameritrade
Closed-end funds are an attractive structure for those seeking market yield.
Investors in CEFs do not necessarily allocate total return potential to the structure, but rather value CEFs for their income-generating properties, as many have a primary goal of producing high current incomes, said Roxanna Islam, Director research associate at VettaFi, host Oliver. Renick on TD Ameritrade Network‘s “Market on Close” segment on Thursday.
CEFs differ from open-ended funds because the structure raises capital by issuing a fixed number of shares through a single IPO, and then invests that capital in stocks, bonds, or other securities.
In the current environment, Islam said investors are concerned about the sensitivity of CEFs to rising rates, as many of these funds use leverage.
“When you have rising rates, borrowing costs can also rise, which could deteriorate fund income, which could threaten distribution payments,” Islam said. “Typically, that means when you’re in a rising rate environment, you expect some funds to cut.”
Islam warned that it is easier to pay more attention to bad news; Looking at the CEF industry as a whole, the distros have actually held up well and been more stable over time than many thought.
“We are looking at…the S-Network Composite Closed-End Fund Index, which focuses on CEFs with taxable returns. When we looked at that through the last round of interest rate hikes that we had from 2015 to 2018, that was really interesting because we saw prices and asset values drop, and that was at their early days, and a lot of that was based on that investor sentiment,” Islam said. “We saw dividend cuts early on, but they weren’t really as big as I think a lot of people were expecting. In 2016 and 2017 you might have had 5-10% payout cuts at all levels, then from 2018 you saw this flattening.
“I think relative to what people expect, these distributions tend to be more stable over time, especially when you look at these returns,” Islam added. “Percentage-wise, you’ve seen them hover around that 8% median range for the last ten years or so, and that’s a much higher rate than most other asset classes.”
Islam notes the Invesco Senior Income Trust CEF (VVR) and the PIMCO Dynamic Income Opportunities (PDO) Fund are two income-generating CEFs that are exposed to fixed income securities but are not as sensitive to rising rates. PDO even increased its distribution by 8% a few months ago, Islam said.
“When you look at a fund like this, you can actually see that their earnings are actually way above their payout ratio and that percentage is well over 100%, which means the earnings really cover the distributions,” Islam said. “They also have a large net income reserve, which means that even if earnings deteriorate for a few months or a few quarters, they have a sort of contingency reserve to pay for that.”
Isam said that when looking at funds, you would tend to look for those with higher earnings-to-payout coverage ratios and those that invest in certain asset classes.
“VVR, for example, has exposure to these floating rate assets,” Islam added. “So in this case, you can actually see the distribution increasing in a rising rate environment rather than decreasing, and we saw that distribution increase by about 25% in April of this year.”
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