AGG - EVV: Good In Concept But Distribution Sustainability Is A Big Concern

Summary

• Eaton Vance Limited Duration Income Fund claims to invest in a portfolio of low-duration bonds.
• Low-duration bonds should outperform high-duration bonds during rising rate environments, yet EVV is significantly underperforming the broader indices.
• Despite the closed-end fund's claims, there is significant exposure to high-duration assets in the portfolio.
• The CEF is failing to cover its distributions and its asset base is quickly declining.
• The fund is trading at a discount to NAV but it is still historically expensive.

Without a doubt, one of the biggest problems facing most Americans today is the incredibly high level of inflation that has been permeating the economy. For the past year, there is no month in which the consumer price index has increased by less than 6.5% on a year-over-year basis:

This has caused real wages to decline for 21 straight months and has pushed many families to drain their savings or resort to credit cards to pay their bills and keep themselves fed. Others have been resorting to second jobs, as 81% of Generation Z members and 77% of Millennials have entered the gig economy or are strongly considering doing so to obtain the extra money that they need to feed and clothe themselves.

Fortunately, as investors, we do not have to resort to such drastic actions to obtain the extra money that we need to keep the bills paid and feed ourselves. This is because we can put our money to work for us to obtain higher incomes. One of the easiest ways to do this is to purchase shares of a closed-end fund that specializes in the generation of income. These funds are nice because they provide easy access to a professionally managed portfolio of assets that can usually deliver a higher yield than any of the underlying assets possesses.

In this article, we will discuss the Eaton Vance Limited Duration Income Fund ( EVV ), which is one closed-end fund ("CEF") that can be used for this task. This fund yields a whopping 11.59% at the current price, which is certainly enough to turn anyone’s head. It is also substantially higher than the 1.54% yield of the S&P 500 Index (SP500), but this is hardly unusual for a closed-end fund. As the fund certainly looks impressive at first glance, let us have a deeper look at it and see if it could be a good addition to a portfolio today.

About The Fund

According to the fund’s webpage , the Eaton Vance Limited Duration Income Fund has the stated objective of providing its investors with a high level of current income. This is not surprising, since this is a fixed-income fund. As we can clearly see here, nearly all of the fund’s assets are invested in various bonds:

The reason why the fund would then focus on current income becomes fairly obvious. After all, bonds are by their nature an income vehicle. This is because their capital gains tend to be fairly limited as they have no connection to the growth and prosperity of the issuing company. After all, a company will not increase the amount that it pays its creditors simply because its profits go up. Rather, bonds and other fixed-income securities trade based on the prevailing interest rates in the economy. In short, when interest rates increase, bond prices decrease, and vice versa. This is because a newly issued bond will have a yield that corresponds to the prevailing interest rate in the economy at the time of its issuance. If rates are increasing, this means that newly-issued bonds will have a higher yield than the existing ones that are currently trading. As a result, nobody will buy an older bond when they can purchase a brand-new bond that is essentially identical but has a higher yield. Thus, the price of the existing bond needs to decline so that it provides the same effective yield to a purchaser as a newly-issued bond with identical characteristics.

As everyone reading this is no doubt well aware, the Federal Reserve has been tightening monetary policy and raising interest rates over the past several months. In February of 2022, the effective federal funds rate was 0.08% but it is 4.33% today:

This is the biggest cause of all of the market turbulence that we have seen over the past year. The most important thing for our purposes here though is that it caused bond valuations throughout the American economy to decline. In fact, the Bloomberg U.S. Aggregate Bond Index ( AGG ) is down 9.78% over the past twelve months:

The Eaton Vance Limited Duration Income Fund has certainly not been spared from this carnage. The Eaton Vance Fund is down 15.99% over the past year:

It is admittedly surprising that this fund would underperform the index, but there are a few possible reasons for it that we will discuss throughout this article. One reason why it is surprising is that the name of the fund implies that it is invested in bonds with low duration. The fund’s fact sheet confirms this as it specifically describes itself as a low-duration bond fund. Duration is a measure of a bond’s sensitivity to interest rate changes. Basically, a low-duration bond should decline less in price than a high-duration bond when interest rates increase. Thus, a fund that focuses on investing in low-duration bonds should outperform a broad bond index during a rising rate environment. Clearly, this did not happen with Eaton Vance Limited Duration Income Fund.

One possible explanation can be found in the fact that the Eaton Vance Limited Duration Income Fund has an incredibly high turnover. The fund’s annual turnover of 137.00% is easily the highest that I have ever seen in a fixed-income fund and in fact, it is higher than most equity funds. The reason that this may be a problem is that trading bonds or other assets costs the fund money, which is then billed to the shareholders. This creates a drag on the fund’s performance because management must generate sufficient returns to both cover the trading costs and still have sufficient investment profits left over to satisfy the shareholders. This is a task that few management teams manage to accomplish and it is one reason why actively-managed funds have a tendency to underperform index funds over the long term. Eaton Vance has not provided an actual benchmark index for this fund, which is somewhat typical for Eaton Vance, but the Vanguard Short-Term Bond ETF, which also invests in low-duration bonds has significantly outperformed both the Bloomberg U.S. Aggregate Bond Index and the Eaton Vance Limited Duration Income Fund over the past twelve months:

Thus, we can clearly see that the Eaton Vance fund is clearly failing to match the index in terms of price performance. However, the Eaton Vance fund also has a substantially higher yield, which helps to narrow the difference between it and the index. That is especially true for those investors that reinvest the distributions, which is highly recommended unless you need all the money to cover your living expenses.

The Eaton Vance Limited Duration Income Fund does not fully live up to its name of investing in low-duration bonds, despite what the fact sheet says. The fund currently has 26.94% of its assets in bonds that do not mature for twenty years or more:

As a general rule, the longer a bond’s maturity is in the future, the greater its duration. A low-duration fund, such as the ones included in the short-term bond index above, is generally considered to have a maturity date of fewer than five years into the future. As we can see, that is only 28.82% of the fund’s assets. The current portfolio composition can hardly be considered a low-duration bond portfolio unless all of those long-term bonds have incredibly high coupons. This is because duration is the amount of time that it takes for the bond to pay out its entire face value. As a high-yield bond will have higher interest payments, an investor will receive the entire face value back more rapidly. When we consider how low interest rates have been over the past fifteen years, however, it is hard to believe that the fund is holding a considerable number of very high-yielding long-term bonds. With that said though, the fund’s portfolio is more heavily invested in speculative-grade bonds than might be expected. We can clearly see this by looking at the credit ratings of the bonds in the portfolio:

A speculative-grade bond is anything rated BB or lower. As we can see, that is fully 52.14% of the fund’s portfolio. In fact, it may be even more than that, as we have no way of knowing the credit quality of the issuers of the 11.19% allocation to unrated securities. It is hard to believe that these are investment-grade bonds, however. This is because any company that has a strong enough financial situation to qualify as investment-grade will spend the money to get its bonds rated. The cost of getting that rating is much less than the extra interest that it would have to pay by issuing speculative-grade securities. Thus, we can conclude that at least 60% of the fund is invested in speculative-grade bonds.

A speculative-grade bond is colloquially called a “junk bond.” The fact that the fund is so heavily-weighted toward these securities may be concerning to more risk-averse investors. After all, we have all heard about how these bonds have a high risk of losses due to default. Fortunately, we can see that most of the junk bonds in the bond portfolio have a BB or B rating. According to the official bond ratings scale , a company whose securities have one of these ratings has a strong enough balance sheet and cash flow profile to weather a short-term economic shock. While these companies may be vulnerable to long-term macroeconomic problems, the United States has not experienced one of these since the Great Depression. As such, the speculative-grade securities in the fund are probably reasonably safe from default losses. However, the fund’s portfolio in aggregate still does appear to be riskier than one might think from just a cursory look at the fund’s webpage.

Leverage

As mentioned in the introduction to this article, closed-end funds are able to use certain techniques that enable them to pay out a higher yield than any of the underlying assets actually possess. One of these techniques is the use of leverage. Basically, the Eaton Vance Limited Duration Income Fund borrows money and uses those borrowed funds to purchase fixed-income securities, primarily bonds. As long as the yield of the purchased assets is greater than the interest rate that the fund has to pay for the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. The fund can borrow at institutional rates, which are significantly lower than retail rates, so we can assume that this is generally going to be the case.

However, the use of leverage is a double-edged sword. This is because leverage boosts both gains and losses. This is therefore one likely contributor to the fund underperforming the broader index funds. As such, we want to ensure that the fund is not employing too much leverage because that would expose us to too much risk. I generally do not like to see leverage exceed a third as a percentage of the fund’s assets for this reason.

Unfortunately, the Eaton Vance Limited Duration Income Fund is currently a bit above that level, as the fund’s levered assets currently comprise 34.30% of its portfolio. While this is a bit above the limit that I just specified, the fact is that this fund is investing in generally safe fixed-income assets and the Federal Reserve seems to be slowing down on its monetary tightening, which means that the worst days for bonds are likely behind us. When we combine this with the fact that the fund’s leverage is barely above the cut-off, its debt is unlikely to pose any real problems for investors. Overall, the balance between risk and reward seems to be acceptable here.

Distribution Analysis

As stated earlier in this article, the primary objective of the Eaton Vance Limited Duration Income Fund is to provide its investors with a high level of current income. In order to achieve this, the fund invests in a portfolio of fixed-income securities and then applies leverage to boost the effective yield. As such, we can probably assume that the fund has a fairly high yield itself. This is certainly the case as the fund currently pays a monthly distribution of $0.10 per share ($1.20 per share annually), which gives it an 11.59% yield at the current price. The fund’s distribution has varied quite a bit over the years but it has been steady since October 2019:

The fact that the fund was fairly consistent in its distributions through both strong and weak economies, including the unprecedented pandemic-related economic shutdowns, will likely prove appealing to those investors that are seeking a safe and secure source of income. Unfortunately, the fund’s history prior to 2019 is not nearly as attractive as it steadily decreased the pay-outs to investors. One thing that may prove very concerning, though, is that a significant proportion of its recent distributions have consisted of return of capital:

The reason why this may be concerning is that a return of capital distribution can be a sign that the fund is returning the shareholders’ own money back to them. This is obviously not sustainable over any sort of extended period. However, there are other things that can cause a distribution to be considered a return of capital, such as the distribution of unrealized capital gains. As such, it is important for us to investigate exactly how the fund is financing its distributions and how sustainable they are ultimately likely to be.

Fortunately, we do have a fairly recent document to consult for that purpose. The fund’s most recent financial report corresponds to the six-month period that ended on September 30, 2022. As such, it will not include any information to allow us to judge the fund’s performance during the fourth quarter but we should still be able to get a good idea of how the fund weathered the first few rounds of interest rate hikes, which were the cause of most of the problems in the bond market last year. During the six-month period, the Eaton Vance Limited Duration Income Fund received a total of $1,626,832 in dividends and another $51,620,301 in interest from the assets in its portfolio. This gives the fund a total income of $53,247,133 during the period. It paid its expenses out of this amount, leaving it with $36,661,543 available for the shareholders. That was not nearly enough to cover the $69,722,076 that the fund actually paid out in distributions, though. This is likely to be somewhat concerning as the fund did not have nearly enough net investment income to cover its distributions, which explains the return of capital distributions.

However, there are other methods through which the fund can obtain the money that it needs to cover its distributions. One of these is by earning sufficient capital gains. As might be expected from the volatility in the bond markets during most of 2022, the fund failed miserably at this. During the six-month period, the fund had net realized losses of $11,090,983 and had another $189,511,356 net unrealized losses. Overall, the fund’s assets declined by $236,400,482 after accounting for all inflows and outflows.

This is highly concerning, as the fund appears to be bleeding capital simply to maintain its distributions. It is unlikely that the fund has managed to correct this problem as the bond market did not improve in the fourth quarter, although it is possible that the fund has managed to purchase some higher-yielding assets. It is difficult to believe that it managed to increase its income by enough to cover the $33 million difference between its net investment income and distribution payments, however.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a sure-fire way to generate a suboptimal return on that asset. In the case of a closed-end fund like the Eaton Vance Limited Duration Income Fund, the usual way to value it is by looking at the fund’s net asset value. The net asset value of a fund is the total current market value of all the fund’s assets minus any outstanding debt. This is therefore the amount that the shareholders would receive if the fund were immediately shut down and liquidated.

Ideally, we want to purchase shares of a fund when we can acquire them at a price that is less than the net asset value. This is because such a scenario implies that we are purchasing the fund’s assets for less than they are actually worth. Fortunately, that is the case with this fund today. As of January 31, 2022 (the most recent date for which data is currently available), the Eaton Vance Limited Duration Income Fund had a net asset value of $10.75 per share but shares currently trade for $10.49 per share. This gives the fund’s shares a 2.42% discount to net asset value at the current price. This is not nearly as attractive as the 9.97% discount that the shares have traded at on average over the past month though, so it might make sense to wait until a more attractive price is presented by the market before buying in. This is particularly true because we want to have a margin of error given the fund’s inability to cover the distribution.

Conclusion

In conclusion, the Eaton Vance Limited Duration Income Fund is a good idea in theory. A low-duration bond should prove much more stable than a typical bond during times of rising interest rates. This should therefore comfort risk-averse investors that are concerned about the loss of principal.

However, this fund appears to be investing in far more than just low-duration funds. In fact, its portfolio has a great deal of exposure to long-term bonds. When we combine this with the fund’s inability to cover its distribution, Eaton Vance Limited Duration Income Fund may not be a good purchase right now. The fund is fairly expensive today relative to its historical price, although it is still selling at a discount. Overall, it might be a good idea to wait on the sidelines for Eaton Vance Limited Duration Income Fund until we get more insight into the fate of the distribution.

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