EIC - Closed-End Funds: Term Structure Potential Vs. Perpetual Funds

Summary

• Term funds have a few topics making them different that I hope to clear up with today's overview.
• Term funds can benefit shareholders as NAV is realized one way or another.
• Given that almost all publicly traded CEFs launched after 2018 are term funds, you likely hold some of these whether you know it or not.
• Important to note that we are talking about the actual limited-term CEF structure; there are limited-term or limited-duration funds that invest in bonds with relatively lower durations, and that's a whole different subject.

Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on January 17th, 2023.

Limited-term or term closed-end funds have been a growing part of the overall CEF pool. While there can be some confusion around them, they are generally a good thing. Having a term fund structure is actually quite a good thing, as it means that a fund shouldn't carry a discount into perpetuity. Unless, of course, they vote to go perpetual; in that case, the floor is removed. However, that's not as bad as it first sounds, either.

These funds also don't have to indicate in any way that they are a term fund from their name - although some do. This can cause some confusion when investors first realize this. This is a surprising thing for some investors because some CEF investors probably don't know that almost all publicly traded CEFs launched from 2018 to the present are term funds.

Today, I wanted to give a quick rundown on a few topics and hopefully clear up some topics on limited-term funds.

Almost All New CEFs Launched Are Term Funds

As of January 17th, 2023, there are around 450 publicly traded CEFs. Important to note here is publicly traded because fund sponsors have been launching more tender and interval funds.

Tender and interval structures have their own importance, but we won't discuss them because the vast majority aren't publicly traded. Of course, there are always exceptions; BlackRock Enhanced Government Fund ( EGF ) and RiverNorth Capital and Income Fund ( RSF ) say hello.

In 2022, 23 new non-listed interval and tender CEFs were launched. For publicly traded CEFs, there were four that I'm aware of - although I could be missing a couple. Still, the main point is that fund sponsors have been putting more effort into non-listed funds.

With that being said, here is one thing that seems to come up as a bit of a shock in some of the articles I published when discussing something like the PIMCO Dynamic Income Opportunities Fund ( PDO ). It isn't immediately apparent that PDO is a term fund. On their website, it is listed at the bottom of the disclosures. Then in the annual reports, it is also mentioned. However, none of the details are really found except in the prospectus .

Then we have First Trust High Yield Opportunities 2027 Term Fund ( FTHY ). In that fund, the name of the fund clearly gives away what type of structure it is.

These CEFs can often be referred to as CEF 2.0 because they share the characteristic of launching in more recent years as term funds. They also launched now when the fund sponsor eats the launch costs.

Did you know that before this, a CEF could launch and immediately trade at a discount because the offering fees were taken directly from the fund's assets? The fiduciary rule becoming law for investment advisors means that's not something an advisor could, in good faith, put a client into at IPO.

There are only two exceptions that I know of that since 2018 have not been the term or target term (don't worry, we will address target term) funds. Again, there could be a few that I'm missing, as I'm only human.

That is Eagle Point Income Company Inc ( EIC ). This fund launched in mid-2019, and why it didn't launch with a term structure doesn't seem overly apparent to me at first. One of the reasons I thought is because of the more unusual approach of being a CLO fund. They do things differently but are structured as a closed-end investment company registered under the Investment Company Act of 1940.

The other fund was the Nuveen Multi-Asset Income Fund ( NMAI ). In this case, the fund was a merger of three older and perpetual funds. So essentially, this was just a shell of a CEF that took in and wrapped together three other longer-established funds.

Target Term Vs. Term Fund

One other way that limited-term funds can be confused is with target-term funds. Target-term funds were more popular around 2015, before the CEF 2.0 structure was established. Then, as usual, there are always exceptions to the rules.

BlackRock 2037 Municipal Target Term Fund ( BMN ) (one of only several funds to launch in 2022) came to the scene with the target term structure. This is pretty straightforward when you think about it: a "target" term fund has a target they want to return to investors.

In the case of BMN, they are looking to return the IPO NAV of $25 back to shareholders on September 30th, 2037 . However, since no investment is guaranteed, this also has no guarantee of that happening. It's merely that they highly intend or want this result.

BlackRock 2037 Municipal Target Term Trust (the "Trust") is a newly-organized, non-diversified, closed-end management investment company with no operating history. The Trust's investment objectives are to provide current income that is exempt from regular federal income tax (but which may be subject to the federal alternative minimum tax in certain circumstances) and to return $25.00 per common share (the initial public offering price per common share) to holders of common shares on or about September 30, 2037. There can be no assurance that the Trust's investment objectives, including to return $25.00 per common share to the holders of common shares on or about September 30, 2037, will be achieved or that the Trust's investment program will be successful.

For term funds, it is no intention that they mean to return the original NAV back to shareholders. This is mentioned in the prospectus. We can go back to PDO again, using their prospectus, but this is the standard language we see from all term funds.

The Fund is not a so-called "target date" or "life cycle" fund whose asset allocation becomes more conservative over time as its target date, often associated with retirement, approaches. In addition, the Fund is not a "target term" fund and thus does not seek to return the Fund's initial public offering price per Common Share upon termination of the Fund or in an Eligible Tender Offer. The final distribution of net assets per Common Share upon termination or the price per Common Share in an Eligible Tender Offer may be more than, equal to or less than the initial public offering price per Common Share.

As they mention here, a target term and term fund can be managed differently, particularly when it comes down to nearing their termination date. Target-term funds can reduce leverage or go into shorter-term or more conservative investments as their target date approaches. They also generally reduce their distributions heading into the final year or two. In that way, they can often have a better chance of hitting their NAV target.

Term Funds Can Extend Termination

With CEF 2.0 becoming more standardized, there are usually ways for a fund to extend its term. Term funds previous to 2018 were more ambiguous. That meant that fund sponsors often found ways around terminating or liquidating their funds without shareholders' approval.

Today that is less often the case. However, some investors seem to be once bitten, twice shy about this, being hesitant of any term fund.

The standard language for extending a term fund's termination date is usually once for up to a year and then again for up to six months. These extensions usually only require the Board to approve the extension. These shorter-term and temporary extensions are put into place so that a fund may avoid liquidating assets into a bear market.

Here's the usual language, once again referring to PDO.

...the Board may, by a vote of a majority of the Board and seventy-five percent (75%) of the Continuing Trustees, as defined below (a "Board Action Vote"), without shareholder approval, extend the Dissolution Date (i) once for up to one year, and (ii) once for up to an additional six months, to a date up to and including eighteen months after the initial Dissolution Date, which date shall then become the Dissolution Date.

Some funds have in their prospectus an extension of only six months plus another six months, or others could have extensions for a year plus another year. I haven't seen any funds launch with wording for extensions for more than two years. Admittedly, two years is quite an extension when most funds set their termination dates 12 years out. That would extend the life of the fund by 16.67%. That could have a meaningful impact on some investors' plans or situations if that happens.

Term Funds Can Go Perpetual

Along with the extensions of termination dates. Funds may also go perpetual. This isn't as bad as it sounds because it leaves investors with options. In this case, it is often at the shareholder's discretion whether a fund goes perpetual or not.

Important to note here again that older-term funds were more ambiguous in their language. They could get away with some shenanigans, but today the language in the prospectus seems more firm and clear. There should be less uncertainty, but we all know that large money managers can be quite crafty. Hiring the best lawyers to make sure things work out in their way.

A fund like PDO, where PIMCO funds consistently trade at premiums, would make a lot of sense to go perpetual. The way that could happen is often through a tender offer.

The Board may, by a Board Action Vote, cause the Fund to conduct a tender offer, as of a date within twelve months preceding the Dissolution Date (as may be extended as described above), to all Common Shareholders to purchase 100% of the then outstanding Common Shares of the Fund at a price equal to the net asset value per Common Share on the expiration date of the tender offer (an "Eligible Tender Offer"). The Board has established that the Fund must have at least $200 million of net assets immediately following the completion of an Eligible Tender Offer to ensure the continued viability of the Fund (the "Dissolution Threshold"). In an Eligible Tender Offer, the Fund will offer to purchase all Common Shares held by each Common Shareholder; provided that if the number of properly tendered Common Shares would result in the Fund having aggregate net assets below the Dissolution Threshold, the Eligible Tender Offer will be canceled, no Common Shares will be repurchased pursuant to the Eligible Tender Offer, and the Fund will terminate as scheduled. If an Eligible Tender Offer is conducted and the number of properly tendered Common Shares would result in the Fund having aggregate net assets greater than or equal to the Dissolution Threshold, all Common Shares properly tendered and not withdrawn will be purchased by the Fund pursuant to the terms of the Eligible Tender Offer. Following the completion of an Eligible Tender Offer, the Board may, by a Board Action Vote, eliminate the Dissolution Date without shareholder approval.

There are a lot of words here. However, to put it more simply, before the fund's termination date, a tender offer can be conducted. This tender offer would be for 100% of outstanding shares at 100% of NAV. Essentially, an investor can get out if they would like to, at NAV.

If the fund has $200 million in net assets after the tender offer, it may switch to perpetual (though not required, and the Board could decide to terminate the fund anyway.) Some smaller fund sponsors have set the limit to $100 million in net assets. However, $200 million is pretty much the standard for most of these term CEFs.

Now, if a fund trades at a premium, no shareholder would accept less than the current price. Therefore, a fund at a premium would mean there is no reason to participate in the tender off. Thus, a much better chance that assets stay where they are, and the more likely the Board will switch to a perpetual structure.

Suppose we look at something like BlackRock Science and Technology Trust II ( BSTZ ), a fund that has been trading at a discount for most of its life. This was the case even when the tech sector was on fire; it would make sense to participate in a tender offer.

Of course, heading into the termination date, the fund should naturally start losing its discounts. That is still quite a ways off, so anything can change from now until then. However, if they continue trading at a large discount, it would only make sense for investors to cash out to realize that discount. Even if the fund ultimately survives and switches to perpetual, one could reinvest back when the discount opens up but have received NAV. The risk at that time is that the fund runs much higher or a discount doesn't return.

All this being said, it becomes a case-by-case basis if it makes sense or not to participate. The call can't be made until we get much closer to these termination dates.

Conclusion

Here are a few term funds to watch for consideration as we get closer to their term dates;

• Nuveen Intermediate Duration Municipal Term Fund ( NID ) - liquidation anticipated March 31st, 2023
• The Miller/Howard High Income Equity Fund ( HIE ) - liquidation is expected to be on November 24th, 2024
• Western Asset Global Corporate Defined Opportunity Fund Inc. ( GDO ) - anticipated liquidation on December 2, 2024
• Western Asset Investment Grade Defined Opportunity Trust ( IGI ) - anticipated liquidation on December 2nd, 2024

Down the road, we will have more termination dates to look forward to as the funds being launched from 2018 onward start running into their liquidation dates.

Term funds can be a shareholder benefit as it should mean no CEFs trading at perpetual discounts anymore, at least when investing in newer funds launched after 2018-providing a term date when a fund can potentially liquidate means that investors can get NAV back in one way or another.

Which might bring up one last point that could be worth touching on, as investors often ask, "what if it's terminated and you have a loss?" And for me, that doesn't really change anything at all. You can move those assets to a similar CEF or ETF.

The term structure also means guaranteed alpha against non-termed funds. If there was a fund with theoretically the same exact portfolio composition but was perpetual and both traded at a discount. Then, the one that can realize the discount will always generate greater returns upon liquidation.

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