BTO - BTO: ROC Is No Reason To Set Your Hair On Fire!

Summary

• Many investors mistakenly believe that when a distribution includes Return of Capital, they are getting their own money paid back to them.
• ROC is just the amount a distribution exceeds taxable income. Funds have many ways to generate more cash than taxable income.
• Investors want to avoid funds that pay out distributions that erode the ability of their holdings to generate income.
• John Hancock Financial Opportunities Fund just raised its distribution and the latest distribution contains no ROC. BTO is fully supporting the new higher payout.

Co-produced with PendragonY.

A few weeks ago, we published an article that went into great detail on CEFs (closed-end funds). However, one article cannot cover every facet and detail of any investment. Undoubtedly, the HDO brain trust could write an entire book on the subject!

Today, we focus on a common question/concern posed to us about CEFs. ROC, or Return of Capital: What is it? Should you be concerned about it? What does it mean?

What Is ROC?

ROC stands for "return of capital." Return of Capital sounds scary, and often various commentators describe this as returning your own money to you - but that isn't what it is. ROC is the portion of a distribution that exceeds the taxable income of a fund or company. The only conclusion that you can draw from seeing a distribution labeled ROC is that the fund's taxable income was lower than its distributions.

A closed-end fund, otherwise known as a CEF, is required to distribute almost all of its NII (Net Investment Income) and realized capital gains to its shareholders each year. In certain circumstances, the fund can hold onto some of this cash, but then it must pay a 4% excise tax on that retained cash. The rules are fairly strict, and penalties for distributing too little are quite harsh, so funds tend to distribute more than they are required to do. Often, funds will end the year with special distributions to ensure they meet the distribution requirements.

The requirement on a CEF is a minimum that it must pay. A fund manager needs to ensure they meet that minimum. Yet there are also practical realities. One reality is that CEFs that pay stable and predictable distributions are more popular among investors. Another practical reality is that investment returns will be lumpy. No fund is going to produce the exact same return every single year.

So how does a fund:

• Ensure it meets its minimum distribution requirements annually.
• Provides a stable and predictable distribution for shareholders.
• Keep the distribution at the same level, even as investment performance varies.

A common solution is to have a "managed distribution policy". This means they distribute a pre-determined amount rather than distributing taxable earnings each distribution period. Sometimes this amount is a fixed distribution, and sometimes it is a calculated number like "8% of NAV." The manager will evaluate their likely long-term total returns and set the distribution at a level matching that expectation.

The fund will sometimes overpay and sometimes underpay, but if set at a realistic amount, realized returns will match the distribution in the long run. The overpayments will not be so large as to materially harm future earnings potential, and the underpayments will not be so significant as to be below the minimum.

Every year, a fund will list the sources of the cash for their distribution. Common categories are "income," "short-term capital gains, "long-term capital gains" and "return of capital" in a 1099-DIV. You can get an estimate of these sources with "section 19(a)" notices that are filed with the SEC.

Simply put, ROC is that portion of a distribution that exceeds the taxable income of the entity paying the distribution in a given year.

Why Setting Your Hair On Fire Over ROC Is Unwarranted

Taxable income is not the same as cash flow. There are plenty of ways that a company or fund might generate more cash than taxable income.

Here is what Nuveen , a manager of Closed-End funds (among other financial investments), has to say about it.

A fund's capital - its NAV (Net Asset Value) - starts with shareholders' initial investment in common shares. Once the fund begins operations, the NAV changes as the fund's investment portfolio appreciates or depreciates and as income comes in or expenses are paid.

Taxable income, in most cases, will not exceed the sum of NII (Net Investment Income) plus Net realized capital gains. However, many non-cash deductions will reduce taxable income. Additionally, not all distributions are taxable.

90% of NII and 98% of realized capital gains must be distributed to a fund's shareholders for the fund to retain its status (and tax-free benefits). So there is no option there. However, it is entirely at the fund's discretion how much of the unrealized gains and initial funding is used to fund distributions.

It is also entirely within the fund's discretion to decide which shares to sell. You have probably heard of "tax loss selling," a strategy where investors sell off shares they purchased at a high cost basis, in order to offset previously realized taxable gains and thereby reduce their taxable income. Funds can do that too.

The greatest concern that investors might have with ROC is that it could result in a declining pool of assets and eventually result in cutting the distribution. The easiest way to measure this risk is to look at NAV over the long run.

BTO: A Case Where We Don't Worry About ROC

Using the Income Method, we look for investments that will provide a predictable income stream. In the case of CEFs, that means we want to own shares in funds that are not eroding their capital base by paying unsupported distribution over long periods. NAV will vary, but we want to make sure that declines in NAV can recover.

Let's take a look at John Hancock Financial Opportunities Fund ( BTO ). Over the past 20 years, BTO has outperformed its index.

The total return relative to the index makes it an attractive option to evaluate for investors interested in increasing exposure to financials. BTO went through the Great Financial Crisis and came out the other side.

When we look at NAV, the underlying value of the assets that BTO invests in, we can see that this has recovered as well. NAV today is essentially flat from where it was in 2003.

This is what we want to see from a CEF. Please keep in mind distributions are subtracted from NAV when they are paid. As a CEF investor, you should expect most of your total return to come from the dividends you collect over decades.

The Outlook For BTO Is Great

The top 5 or so banks that BTO holds have P/E ratios at a very reasonable 8-10x. Due to uncertainty over what actions the Fed would take on interest rates during the past year, bank valuations have struggled. The wild variations in the bond markets have been a challenge for lenders of all stripes. This has put downward pressure on bank valuations. Going into 2023, at the minimum, the Fed is slowing down its hikes as has already been shown with the smaller increase in December. With inflation in the 2nd half of 2022 substantially lower than inflation in the front half, slower rate hikes, and even a pause in such hikes, become more certain. This increase in certainty in interest rate policy will make the environment much more hospitable for banks.

Additionally, we do not see the borrowing excesses associated with the GFC. Corporations and consumers are relatively healthy, with many taking time during COVID to repair their balance sheets and refinance debt at historically low-interest rates. This starkly contrasts with 2007-2008, when consumers were leveraged to the hilt.

But What About The ROC?

The general environment for banks is strong. However, last year and in 2020, BTO designated some of its distributions as ROC. Here is BTO's ROC as reported in their December Section 19(a) filings.

It should be no secret that the financial sector has had a tough year. Most of that is due to uncertainty over how much and for how long the Fed will continue to increase interest rates. BTO's assets have taken a hit on their share price. That can have a big negative impact on total return metrics. BTO saw a downturn last year, but so did the entire financial sector.

Against that backdrop, it should not be a surprise that BTO had negative total returns and its distribution contained some ROC.

What matters most is the long-term outlook for the sector. While I don't like the phrase "the safest distribution is the one just raised", the fact remains that management doesn't increase the distribution from a fund unless they think they can support it long term. For one-time gains, CEFs pay out special distributions.

BTO increased the distribution by 10 cents, starting with the June payment. This indicates management has confidence it can meet or exceed that return for the foreseeable future. The ROC in recent years has not negatively impacted the ability of the fund to generate cash flow. Its NAV today is higher than it has been since before the GFC, and its future potential is bright.

When ROC Is Damaging

Whenever I see ROC from a CEF, the question I ask myself is whether the current distribution is consistent with reasonable expectations for future returns in the sector. BTO is paying out a 7.8% yield on NAV. So to sustain that payout, the holdings that BTO invests in need to be able to generate total returns above 7.8% from today's prices. We believe the banking sector will be able to provide much higher returns than that over the next 10 years.

Let's look at another CEF, MFS Intermediate Income Trust ( MIN ), which has a managed distribution policy to pay out 8.5% of NAV. A very reasonable distribution to sustain in many sectors - but an unsustainable distribution in MIN's chosen sector of Investment Grade bonds.

MIN does not use leverage, so to sustain its 8.5% distribution, it would need to realize an average return of 8.5% on its portfolio of U.S. Treasuries and IG Corporate bonds. Over the decades, it is very clear that this policy has led to a steady decline in NAV.

With a fund like MIN, you should understand that much of the dividend you are receiving is, in fact, repayment of principal and that NAV is shrinking. As NAV shrinks, the dividend will as well.

Conclusion

When you invest in a CEF, you are investing in a portfolio of investments. Typically, CEFs will focus on a particular sector, which allows investors to gain diversity in an entire sector through a single ticker. CEF rules require distributions of taxable income, while CEF managers are generally rewarded for providing income stability and predictability.

We all know that no sector goes up every single year. The stock market, and certain sectors, will rise a lot in some years and decline in other years. So it is natural that a CEF will occasionally pay out a higher distribution than its taxable income. This isn't something that is particularly concerning. Taxes are done annually, and investing is done over many years. We know that some years will have higher taxable income than others. What matters is how the fund performs over the long run.

John Hancock Financial Opportunities Fund has demonstrated over the long haul that it can provide great total returns to investors while also ensuring that NAV recovered from the worst financial crisis in modern times.

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