As we find ourselves in the seasonally weakest time of the year, most investors are hoping to see 2015 come to a close with at least a marginal gain in risk assets.  Yet, for closed end fund (CEF) investors it’s been a tough pill to swallow after such vigorous upside momentum during the first half of the year.  Unfortunately, most funds have given back their ample headway and then some, squarely putting total return figures in the red for the year. 

Furthermore, it “feels” like when long-term interest rates rise, CEFs fall, and when rates fall, CEFs fall; which isn’t the outcome retail investors are seeking for taking  the marginal step-up in risk by owning CEFs.  However, those same investors must remember that being long CEFs is akin to being short volatility.  Meaning when volatility rises, all funds will trade as risk assets and likely fall in due order.

The positive part of the conundrum we find ourselves in is that many beloved and popular funds are trading at record discounts.  For investors with free cash to put to work, now is as good a time as any to begin making purchases.  A few of the funds within our Dynamic CEF Income Portfolio could make a lot of sense for investors seeking to add an additional layer of income and don’t particularly mind the additional volatility.  Namely funds such as the NexPoint Credit Strategies Fund (NHF) and the PIMCO Dynamic Credit Income Fund (PCI) recently reached new 52-week lows in discount.

The key to my suggestion that investors take a strong look at funds such as these is that the majority of the decline in price has been simply just that, a decline in market price.  Their respective NAV’s have held up relatively well, so really all that has transpired is a widening of a fund’s discount in relation to its NAV.  Many CEF veterans know that these opposing forces are usually transitory, and can be quickly snapped up once risk assets stabilize or new positive economic fundamentals are revealed.

The one kink in the chain is the Federal Reserve, and its policy direction of raising short term interest rates in 2015.  Or will it be 2016? No one really knows, hence the risk vs. reward in battered down funds.  Just keep in mind that CEF investors have a primal fear of rising short-term interest rates because it raises leverage borrowing costs.  This means that a fund produces a narrower income spread on the difference between the higher yielding or longer dated securities within its portfolio and the cost of borrowing capital.

A narrower spread eats into the amount of income the underlying portfolio earns, which in-turn has a tumble down effect of possibly lowering a funds distribution policy and in effect deteriorating market price competitiveness.  For highly levered funds, or sponsors that don’t have the ability to shop different credit facilities, this can be a serious problem.

Yet on the flip side, I also believe this problem is over-hyped and the outcome will be relatively muted once the Fed makes its first move.  Primarily because there is only a 0.25% interest rate rise on the table in the first place.  The key barometer to watch will be the LIBOR rate, which is the rate that most credit lines are tied to.

One way to head-off these potential risks within your existing portfolio of CEFs is to analyze the spread between a fund’s distribution policy and underlying portfolio earnings; which is also referred to as Undistributed Net Investment Income (UNII). These figures are reported in a fund’s semi-annul and annual report.  The fundamental underlying portfolio analysis we perform on all of the CEFs within our client’s portfolio insures that there is at least a small safety net of UNII so that a dividend cut doesn’t come out of left field.

Investors must always weigh the benefits of current distribution rates against the possibility of further declines.  Making informed decisions will always insure you’re not caught off guard by an unexpected outcome.  Just remember prices are always most attractive at the most desperate point of a market cycle low.