NIM - Closed-End Funds: Revisiting Valuations As We End Q3 2023

2023-10-17 07:34:32 ET

Summary

• Closed-end funds are currently trading at historically deep discounts, with the average discount at -9.64% at the end of Q3 2023.
• Municipal bond funds are experiencing particularly wide discounts, with an average discount of -12.89%.
• Non-leveraged funds are also being punished just the same as their leveraged counterparts, presenting attractive opportunities for CEF investors.

Written by Nick Ackerman, co-produced by Stanford Chemist.

Closed-end funds offer investors the opportunity to exploit their discount/premium mechanics as their share prices can vary wildly from the net asset value per share of the underlying portfolios. Through 2022 and into 2023, we've seen CEFs go to some extreme discounts - trading near historically deep levels. This shift seemed fairly drastic as through 2021; funds were trading at historically narrow discounts.

As of the end of Q3 2023 (9/29/2023), the average closed-end fund was trading at a discount of -9.64%. This is based on CEFConnect's data - which is provided by Morningstar - across 432 closed-end funds. That is down from the 440 CEFs in the database earlier this year . Liquidations and mergers are seeing a number of funds disappear. At the same time, IPOs have been very few and far between while the environment remains bad for most investments - unless you are the Magnificent Seven.

According to RiverNorth , this current discount translates into a historically deep discount as from 1996 to today; wider discounts have only been observed 5% of the time. That leaves 95% of the time during this period when discounts were narrower.

For some perspective, at the end of 2022, the average discount came to -8%. This was also a slight widening in fund discounts from what we observed earlier this year, on April 14, 2023 , when CEFConnect had the average discount of all CEFs at -8.48%. Then, finally, for some further context, 2021 ended with historically narrow discounts, which averaged just ~2.5% discounts across the board.

This is happening across the board as well, but it is most notably in the municipal bond fund space. As per RiverNorth's data, muni bond CEFs have only seen discounts wider 1% of the time since 1996. Currently, the average discount in that category comes to -12.89%. Tax-free muni funds represent 109 out of the 432 CEFs on the market.

The average taxable CEF is trading at a discount of -6.92%, reflecting a discount that has only been observed to be wider 16% of the time. Equities are the richest, relatively speaking, as their current discount might average -9.30%, but a wider discount has been observed only 26% of the time. While that means that equities might be relatively more expensive compared to their fixed-income counterparts, it's still looking like a space that is ripe for opportunity.

One of the culprits I expected to see a noticeable difference, which I touched on earlier this year, was the fact that the majority of CEFs utilize leverage. I surmised that investors are cautiously avoiding adding leverage while borrowing costs are rising for those funds. However, that theory was thwarted when I observed the average discount of no leveraged funds came to -8.44% while the leveraged fund basket had carried an average discount of -8.49%.

This was not a material enough difference for it to really matter. Today, leveraged funds carry an average discount of -9.68%, and non-leveraged funds carry a discount on average of -9.36%. The spread here is getting wider, but honestly, there is still no real relief, even in the non-leveraged space. I believe that could represent a fairly attractive place to put capital to work in these non-leveraged funds while they are getting punished mostly just the same as leveraged funds.

That being said, some funds are hedged against the rising borrowing costs through shorting futures and/or interest rate swaps. So, it should be taken on a case-by-case basis. The closed-end fund world is filled with variety as they aren't an investment sector or asset class in themselves; they are merely an investment wrapper or vehicle for gaining exposure to various areas of the investment world. That variety is also reflected in how they implement their investment policy and strategy as well.

Screening For Opportunities

Deepest Discounted Funds

This is where opportunities can come from in the CEF space-taking advantage of discounts and premiums in funds. Funds with the deepest discounts can be a normal starting place, but sometimes, these funds deserve to trade at deep discounts. With that, here are the funds with the deepest discounts. All data is from CEFConnect.

Funds With The Highest Premium

While we often look at discounts for opportunities, opportunities can also come in the form of selling funds when they are at rich premiums. Despite the deep discounts we see through most funds, some outliers still command strong premiums. These could represent funds worth consideration for selling.

Low/No Leverage Listed Funds With The Deepest 1-Year Z-scores

Finally, I also wanted to provide a screen for the low or no leveraged funds that could be presenting more attractive opportunities with a negative z-score. As we touched on above, some funds are hedged in different ways from the negatives of higher interest rates, but that doesn't mean they aren't susceptible to more volatility. With leverage, that poses more risks for portfolio losses. Thus, in an uncertain market such as we are in, it can be best to avoid leverage.

I believe that a few funds here represent interesting prospects. In particular, HQH and HQL are interesting plays at this time. That is if one is looking for exposure to the biotech space. Both of these funds carry substantial weighting to that subsector of the healthcare field. It is the more volatile part of the field, but with the sizeable discounts on these funds plus the significant drop in biotech, it makes it an interesting place to put capital to work.

I recently put some capital to work in the BlackRock Health Sciences Term Trust (BMEZ), which operates somewhat similarly but also contains riskier holdings as they invest in the private investment space as well. While it doesn't show up on this list, the discount there is quite appealing, and it also offers exposure with no borrowings. However, it does implement an options writing strategy.

FUND also represents an interesting name to consider. It's a somewhat diversified equity fund, but it actually overweight basic materials in its exposure. That makes it a fairly unique investment choice in the CEF space. I covered that name just earlier this year .

Conclusion

Closed-end funds of all shapes, sizes and strategies are trading at historically deep discounts. The muni space, in particular, is showing some massive discounts. Perhaps that's for good reason, as higher interest rates impact their strategies the hardest. The short-term borrowings on most of their leverage go up immediately while they carry a long-duration asset, with munis often having 30 years to maturity. That being said, not all funds are created equal and even in the muni space, there are some funds with no or very minimal leverage being utilized.

More broadly speaking, there is a wide variety of funds that also don't implement leverage in the forms of borrowings through their funds, too. Despite that, they are being mostly penalized just the same as their leveraged cousins. I believe that creates a longer-term opportunity in several funds, which is why every month I share what I've bought, and this year's theme has primarily been no or low-leveraged funds for me.

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